Spending Endowment Funds: A Case Study

National Association of Endowed Presbyterian Churches
October 16, 1997
Spending Endowment Funds: A Case Study
By Richard T. Merriman

My assignment is to speak about spending endowment funds. The best way to discuss this topic is to give a case study: it will probably come as no surprise to you that I have chosen Bryn Mawr Presbyterian church for the discussion today.

Let me explain how the question of spending endowment funds, which we call the Foundation in our church, arose. Traditionally, we have thought of endowment as a pot of funds that generates income in the form of dividends and interest, and we expect to spend only the income from the pot. The assets making up the “pot” are called the principal of the endowment. We hope the principal will appreciate in value over time. When an asset of the pop is sold and there is a gain on the sale, the gain is also added to the pot, making the gain part of the principal of the endowment and, hopefully, enhancing the ability of the pot or principal to generate additional income. Therefore, one might conclude that it is important to invest in assets that generate a lot of income.

In recent years many non-profit organizations have altered their investment philosophy to what is called “total return,” meaning that investments are made based on a combination of how much income and gain in principal can be earned. The non-profit then expects that it will spend traditional income and a certain portion of the realized gain in the endowment, but not so much as to erode the principal of the endowment. It is of interest to observe that the dividend component of stocks has provided 20% of the return of the stock market over the last 15 years, with 80% of their return coming from stock appreciation. Historically, dividends provided 40% of the total return. That’s a big difference.

We concluded that a total return investment philosophy was appropriate for our Foundation. We then had to decide how much of the principal and income of our Foundation e should spend, or what we call the “spending rule.”

Let me put some concerns to rest. Our state law permits us to spend up to 9% of the market value of the endowment but only to the extent of income and net realized capital gains. I emphasize that we also must not violate any trust laws nor any restrictions imposed by donors to the Foundation.

In 1994, Gene Bay, our senior pastor created a task force to study guidelines for the management of the Foundation. Participants of the task force included representatives from the Session and Trustees, and Members At-Large.

We first defined our mission. Out stated goal was:
To establish guidelines by which the Trustees’ administration of the foundation will extend the Christian mission and ministry of this church, while preserving and enhancing the commitment of the congregation in their annual stewardship and commitment to the church.

This mission statement led us to two major questions: how much of the return could be spent without eroding the economic power of the Foundation and would the growing Foundation impact the annual stewardship commitment of our members?

Let’s take the first question: what percentage of Foundation assets should be distributed annually to the operating budget of the church? In 1994, we were taking 7% of the value of the foundation and transferring this sum to a revenue line in our budget. When I say “Value,” I mean the market value of the foundation, plus all of the income earned for the year.

Each year, the value of the Foundation will fluctuate depending upon the stock and bonds markets as well as additional and withdrawals, and those changes will cause variations in the amount that will be distributed to the church’s budget.

To smooth out fluctuations in the size of the distributions due to volatile year-to-year investment returns, we decided to take an average of the preceding three years value as of March 31, and then took 7% of that number. We called this 7% the “spending rate.”

Realizing that a primary objective in managing the Foundation is to preserve purchasing power against inflationary pressures, the trustees were concerned that taking 7% of the value of the Foundation would result in eroding principal to the detriment of continued growth. We also knew the spending rate should be less than total return to increase the Foundation’s value both in real and absolute terms. So, what should the spending rate be?

Let me take the suspense away. After studying the experience of other Presbyterian Churches and spending guidelines for colleges and universities, we decided on a 5 1/2% annual spending rate. This number is consistent with the financial and investment experience of other non-profit organizations, although a bit on the high side with ranges of 4% to 6%.

Let me give you our reasoning as to how we arrived at this spending rate.

We based our decision on an investment allocation of one-third bonds and two-thirds stocks, and we anticipated the Foundation would produce an average annual total return of 9%, including interest, dividends and capital appreciation. This total return is consistent with returns of stock and bonds with this asset allocation over a very long period of time.

We assumed in 1994, that inflation would be a round 3.5% and continue to be so for the foreseeable future. Therefore, the real rate of return of the Foundation would be 5.5% -- 9% return, minus 3.5% inflation factor equals 5.5%. Therefore, if 5 1/2% of the value of the Foundation were distributed annually, the purchasing power of the principal would stay intact. To increase the size of the foundation in real terms then, we would need to have a total return in excess of 9% or augment the size of the Foundation through gifts, and bequests. Please understand that this spending rule does spend principle -- but principal is the form of realized capital gains.

Stated another way, spending above the 5.5% level would reduce the ability of the fund to meet the increased future needs of the church.

When we concluded it was necessary to reduce spending from 7% to 5 1/2%, we thought it best to gradually implement the reduction so as not to impact the church budget dramatically in the first year or subsequent years. We decided to cut the distribution by 1/4% a year, beginning in 1996 and for five years thereafter. In 1996, the Foundation distribution was 6.75%. In 1997 the number is 6/5%. Next year, in 1998, we are reducing the distribution to 6.25%. By 2001, we will be down to the desired spending level of 5.5% of the value of the Foundation. We continue to use a rolling average of the value for the previous three years to event out market fluctuations.

The second question the task force dealt with was the percentage of our total operating budget that the Foundation ought to support. When we considered that issue in 1994, the Foundation provided 20% of our income. What should the target be? If the foundation distribution grew to, let’s say, 50% of the operating budget, what would this say to the members of our congregation about their annual stewardship responsibilities?

As to the contribution of the Foundation to the budget of the church, we concluded that a desirable level would be 25% of the annual budget. We reasoned that a distribution above 25%, would impact the vitality and commitment of the church members to carry on our Christian ministry. It was recommended that if Foundation distributions grew to 25% of our budget, any excess should be allocated to increased outreach and mission programs to the extend allowed by unrestricted funds within the Foundation.

From our experience, I would note the following lessons.

First, each year it is necessary to educate the new church officers about the spending rule. With a good stock market, I find there is the temptation to want to spend some of the extraordinary gains on, for example, the maintenance needs of the church, which tend to get postponed. My response is that one of these days the market may not go up, and perhaps it may even go down -- and the distribution from the Foundation, instead of going up, may drop.

This would case some havoc with our mission and outreach programs as well as impact the appropriate compensation of our staff. Outreach programs tend to increase each year, as do salaries. Therefore, it is critical to adhere to a strict spending guideline, as well as increase the assets of the endowment through development and prudent investment management, in order to grow the size of the fund each year. At the same time, we must be vigorous about our annual stewardship expectations. Even through our endowment has doubles in the past five years, it is still difficult for us to balance our annual budget.

Second, we need to have competent legal advice on what state law permits with respect to the allocation of principal in the form of realized capital gains to income, and what corporate procedures to follow.

Third, we must be able to assure all donors to the endowment that we are adhering to all restrictions regarding the spending of principal and income.

Finally, we must have proper accounting procedures in our place to support our assertion that donor restrictions have been followed. Our auditors certify to us in writing that the income from each restricted fund follows the intent of the donor.

In conclusion, while these comments may sound a bit technical, business-like and legalistic, remember we are called to be good stewards of the treasure we have been entrusted.

Please note that these are all samples and should not be used without careful review.

This is not intended to be legal, financial or accounting guidance but as a guide for the church to write its own material according to your local needs and restrictions. Please refer to your own accountant or attorney for accounting and specific legal counsel.