WACUBO Banff, Alberta

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WACUBOBanff, Alberta

• RISKY CHOICES
• Comparing Endowment Payout Policies
• April 23, 2003
• Rick Biedenweg, Pacific Partners Consulting Group
• Tim Warner, Stanford University

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Overview

• Endowment Equilibrium
• Which Payout Policy Works Best?
• Reserve Requirements, Should You Wish Them
• Communication with Trustees and Others
• Conclusions

A History of Payout Policies
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A History of Payout Policies

• Old Fashioned Payout Policy
• (circa 1960)
• Yield Only (i.e., dividends and interest)
• Resulted in Low Total Return Investments

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A History of Payout Policies

• Unlinking More Recent Payout Policies
• (circa 1975)
• Track Budget Growth - Assumes a constant growth
  rate for endowment payout (i.e., last years
  payout increased by 4.5)
• Fixed Percentage of Endowment Value (i.e., 4.75
  of the September 1 Endowment Market Value)

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A History of Payout Policies
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A History of Payout Policies

• Payout Policies Used Widely Today
• 1. Smoothed Rate Applied to Actual Endowment
  Value
• Proposed payout per share 60 x (current
  payout per share x inflation) 40 x (target
  payout rate x projected share value at start of
  fiscal year)
• 2. Fixed Rate Applied to Three Year Moving
  Average of Endowment.
• 3. Snake in the Tunnel or Collar - Constant
  growth in income with a floor and ceiling on the
  payout rate.

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A History of Payout Policies

• Payout Policies Used Widely Today
• 1. Smoothed Rate Applied to Actual Endowment
  Value
• Proposed payout per share 60 x (current
  payout per share x inflation) 40 x (target
  payout rate x projected share value at start of
  fiscal year)
• -------------
• - Balances need for stability in the budget with
  realities of market performance
• - Weights can be adjusted, depending on how
  quickly one needs to get back to the target

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A History of Payout Policies

• Payout Policies Used Widely Today
• 2. Fixed Rate Applied to N - Year Moving
  Average of Endowment.
• -----------
• - 3 year average is typical--and can be
  problematic
• - Can have significant impacts on budgets

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A History of Payout Policies

• Payout Policies Used Widely Today
• 3. Snake in the Tunnel or Collar - Constant
  growth in income with a floor and ceiling on the
  payout rate.
• ----------
• - Provides certainty in budget planning
• - Over extended periods of growth or decline,
  this method will eventually prompt some sort of
  crisis

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A History of Payout Policies

• One Institutions History of Pay-out Policies
• Spend dividend and interest income only until
  1993
• Undue influence on the endowment management
• Volatility in the annual budget support
• Prevented an asset allocation process that
  focused on total return
• Trustees approved a new endowment spending rule
  in 1993
• Collar Approach.
• 3.5 percent to 6 percent of a rolling
  three-year average of year-end unit market value.
  

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A History of Payout Policies

• One Institutions History Recent Background
• - Donors and Trustees questioned the low level
  of the annual endowment spending rates-- actual
  spending rates were well below 4 percent of the
  most current actual market values
• - Trustees and donors questioned whether the
  University was spending a sufficient level from
  its permanent endowments
• - In response, the Administration proposed three
  separate adjustments to its endowment pay-out
  rates over four years, which were approved by the
  Trustees in all cases
• - In approving the third special adjustment, the
  Trustees requested that we seek a spending rule
  that was more responsive to market performance

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A History of Payout Policies

• Following criteria were identified for a new
  spending rule
• Should be responsive to market performance, both
  favorable and unfavorable
• Should not result in wild fluctuations to the
  annual budget flows
• Should not interfere with the investment
  management of endowment portfolio
• Should be neutral between growth in endowment
  principal and annual income to support the budget
• Neutrality between the present and the future,
  intergenerational equity objective
• Reviewed all categories of endowment spending
  rules

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A History of Payout Policies

• Payout Policies in Use Today
• Yield Only 5
• Fixed of Endowment 12
• Grows w/Budget 9
• Fixed of N-Yr Average 45
• Collar 23
• (Simple Collar 15 AverageCollar 8)
• Rate Smoothing / Other 7
• (Rate Smoothing 3 None 4)

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Overview

• A History of Payout Policies
• Which Payout Policy Works Best?
• Reserve Requirements, Should You Wish Them
• Communication
• Conclusions

Endowment Equilibrium
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Endowment Equilibrium

• Endowment Equilibrium
• Long Term Growth in Endowment
• Inflation Real Return - Payout
• Long Term Budget Growth
• Inflation 1.5
• UNDER EQUILIBRIUM they are EQUAL

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Endowment Equilibrium

• Endowment Equilibrium Example
• LT Growth in Endowment LT Budget Growth
• Inflation Real Return Payout Inflation
  1.5
• Or,
• (Target) Payout Rate Real Return 1.5

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Endowment Equilibrium

• Endowment Return Assumptions
• Average Real Return 6.25 real
• Endowment Payout Assumptions
• Endowment Growth 6.25 real
• Budget Growth 1.5 real
• Target Payout 4.75

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Overview

• A History of Payout Policies
• Endowment Equilibrium
• Reserve Requirements, Should You Wish Them
• Communication
• Conclusions

Which Payout Policy Works Best?
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A History of Payout Policies

• Payout Policies Used Widely Today
• 1. Smoothed Rate Applied to Actual Endowment
  Value
• 60 x (current payout per share x inflation)
  40 x (target payout rate)
• If R 0 Fixed Payout Rate
• R 1 Budget Growth

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A History of Payout Policies

• Payout Policies Used Widely Today
• 2. Fixed Rate Applied to N - Year Moving
  Average of Endowment.
• If N 1 Result is Fixed Rate
• N 100 Result is Budget Growth

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A History of Payout Policies

• Payout Policies Used Widely Today
• 3. Snake in the Tunnel or Collar - Constant
  growth in income with a floor and ceiling on the
  payout rate.
• If Floor and Ceiling are very narrow Fixed
  Rate
• If Floor and Ceiling are very broad Budget
  Growth

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Sample Endowment Returns
Which Payout Policy Works Best?
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Sample Endowment Returns
Which Payout Policy Works Best?
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Which Payout Policy Works Best?
Payout Comparisons
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Which Payout Policy Works Best?
Payout Comparisons
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Which Payout Policy Works Best?
Payout Comparisons
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Payout Comparisons
Which Payout Policy Works Best?
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Payout Comparisons
Which Payout Policy Works Best?
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Payout Comparisons
Which Payout Policy Works Best?
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Payout Comparisons
Which Payout Policy Works Best?
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Payout Comparisons
Which Payout Policy Works Best?
Other Considerations a. Total Payout over
38 years b. Ending Endowment Value
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Payout Comparisons
Which Payout Policy Works Best?

• Ending Total 38 Yr.
• Market
  Value Payout
• Rate Smoothing 169 M 167 M
• Three Year Average 146 M 162 M
• Collar (1.5) 167 M 153 M
• 5.25 Fixed Payout 135 M 163 M

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Payout Conclusions
Which Payout Policy Works Best?
1. Smoothing Rules are important for budget
stability. 2. Collar Approaches have
unacceptably large swings. 3. Three Year Moving
Average pays too much in down years reducing
the overall endowment!
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Overview

• A History of Payout Policies
• Endowment Equilibrium
• Which Payout Policy Works Best?
• Communication with Trustees and Others
• Conclusions

Reserve Requirements, Should You Wish Them
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Protecting the Budget
Reserve Requirements, Should You Wish Them

• What level of Reserves would have protected the
  budget?
• Assumptions
• A. Start with a endowment market value (100M)
• B. Annual returns equal to 1964 - 2002 returns
• C. A Base Reserve is established to protect
  payout
• D. The payout will be protected in real value
• E. If reserve is not needed, reserve
  accumulates
• F. Base Reserve grows at inflation

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Payout Shortfall Study
Reserve Requirements, Should You Wish Them
Shortfall 840M
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Stanford University Endowment Payout Policy Study
Reserve Requirements, Should You Wish Them
(28 Million Base)
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Protecting the Budget
Reserve Requirements, Should You Wish Them

• What level of Reserves would have protected the
  budget?
• A Base Reserve of 1.7 million, available at
  the start of the period, would have been
  sufficient.
• (This is a shocking 34 of the total payout!)
• Note This assumes the base reserve was NOT
  spent if it was not needed (and that funds not
  spent were put into a reserve).

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Overview

• A History of Payout Policies
• Endowment Equilibrium
• Which Payout Policy Works Best?
• Reserve Requirements, Should You Wish Them
• Conclusions

Communication with Trustees and Others
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Risky Choices- Endowment Pay-outs
Communication with Trustees and Others

• Acknowledge that a Smoothing Rule Exists...
• But, recognize that the best smoothing cannot
  restore three years of market declines
• Trustee Involvement
• Principal University officer(s) must engage the
  issue
• Identify a small group of Trustees willing to
  devote the time and effort to understand the
  arcana of endowment spending
• Beware of Trustees who have back of the
  envelope solutions
• Final objective is to end the review process with
  a Trustee or two who can advocate spending rule

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Risky Choices- Endowment Pay-outs
Communication with Trustees and Others

• Keep it simple! Rate smoothing principles and
  mechanics can be complex and difficult to
  understand.
• Keep the modeling scenarios to a minimum. Many
  model iterations may be necessary in the back
  room, but presentations to the trustee work
  group and the principal officer in charge should
  be reduce to a small number, sufficient to make
  the key points.
• Implementation of New Rules- The key is to give
  the new rule a chance to be successful. Three or
  four years of testing is required.

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Overview

• A History of Payout Policies
• Endowment Equilibrium
• Which Payout Policy works best?
• Reserve Requirements, Should You Wish Them
• Communication with Trustees and Others

Conclusions
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Conclusions

• 1. There are MANY Endowment Payout Policies in
  use throughout Higher Education.
• 2. Most of these policies have not had rigorous
  analytic reviews.
• 3. Endowment Equilibrium is important Trustees
  and other Senior Officers should know whether
  their payout policies are present oriented,
  future oriented, or in equilibrium.

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Conclusions

• 4. Smoothing Rules are important for budget
  stability.
• 5. Snake-in-the-Tunnel has unacceptably large
  swings.
• 6. Three Year Moving Average pays-out too much in
  down years reducing the overall endowment.
• 7. There is a free lunch (but its small).

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Conclusions

• 8. Reserves to Protect the Budget need to be
  LARGE.
• 9. Be Careful in Implementing New Payout
  Policies
• 10. Details count
• 11. A trade-off exists between keeping it simple
  and a rate-smoothing approach.

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Contacts

• Rick Biedenweg, President
• Pacific Partners Consulting Group
• 408-374-9957
• Rickb_at_ppcg.com
• Tim Warner, Vice Provost for Budget Auxiliaries
• Stanford University
• 650-725-1263
• trw_at_stanford.edu