Foundations and Endowments Specialty Practice
Laurie Bagley,
Senior Vice President
SunTrust Banks
Intergenerational Equity and the Endowment Model
What is Intergenerational Equity and is it still relevant in 2014?
Does Intergenerational Equity apply to my non-profit institution?
What can other non-profits learn from Educational Endowments?
At investment committee meetings, I am frequently asked to “look into my crystal ball” and forecast future investment returns.
We all know the caveat about historical performance – that it is not indicative of future results and should not be used as such.
However, as we are fond of quoting Mark Twain about his observation that “history does not repeat itself, but it does rhyme….,” we
find that the investment markets move in cycles and oftentimes, those cycles can be repetitive. So with one eye monitoring the
rearview mirror, we look into the crystal ball and search for the most successful way to preserve current benefits for future
generations.
A History of Intergenerational Equity
James Tobin, a Nobel Prize winning Economist at Yale University, is generally believed to be the father of the concept of
Intergenerational Equity (IE), in an economical context:
“The Trustees of endowed institutions are the guardians of the future against the claims of the present.
Their task is to preserve equity among generations.”
Tobin is credited with this quote in 1974, which is an interesting point in time as the world economy was in the throes of a
severe bear market that began in January 1973 and lasted through December 1974. All of the global stock indices of the
future G7 countries sank to a bottom over the fall of 1974, with nominal returns that year losing 34% and real returns
bottoming out at 43%1. With double digit inflation in 1974 as well, the threat to the mere existence of future financial
support from endowments was very real. The investment environment over the last fifteen years has been no less
interesting. With two major recessions (2001 and 2007-08) and an historic liquidity crisis in late 2008 into 2009, the
challenges confronting nonprofit investors are greater than ever.
Endowments of educational institutions typically provide operational and budgetary support, with support levels ranging
from a few percentage points to over half of an institution’s budget. Consistency in that level of support is dependent on the
reliability of investment results and is fundamental to future operational viability. Administrations and trustees generally
achieve that consistency by developing and applying spending policies to endowment funds. However, endowments of other
nonprofits do not usually have this type of budgetary need, but they may rely on consistency of results to maintain their
level of support for grant making or other charitable purposes. Most of these institutions also employ a spending policy, and
for some, their spending level is mandated by tax law. Because most endowments are established in perpetuity, the concept
of intergeneration equity is as relevant today as ever.
Investment Policy and Spending Policy
For many colleges and universities, determining a spending policy can be as important a decision as establishing an
investment policy. Inflation is a significant risk to endowments, because costs will increase over time and thus drive up the
level of distributions required to keep services the same over time. This naturally leads us to define the primary investment
objective for most endowments:
Investment Return Objective = Spending + Fees + Inflation
If actual investment results exceed the sum of these three factors, then the endowment is a net saver, and if results are less
than the sum, then the endowment is a net spender. Most will agree that success results from achieving the investment
return objective. But how do we successfully define what that return percentage is, when each factor is variable?
The two most recent major declines in the markets uncovered the inherent weakness in spending policies – most failed to
protect the endowed institution from severe volatility in the level of financial support on which they depend. Many blamed
those failures on another concept known as the Endowment Model; this concept allocates a significant portion of assets to
non-traditional asset classes, such as hedge funds, absolute return, private equity and real estate: investment strategies
with limited or no liquidity. Many endowments believe these strategies provide the “illiquidity premium,” i.e. they are a good
source of excess returns over the traditional markets, and because of their unlimited time horizon, endowments can bear the
liquidity risk of these investments. The credit crisis of 2008 proved otherwise. Many endowments struggled to meet the
liquidity needs of the institutions they support when the marketable portion of their investments declined severely and they
could not access their non-traditional investments. A balance is needed between the return expectations of an endowment’s
investment policy and the funding expectations from the institution’s spending policy.
Return expectations are driven by investment policy and asset allocation. We know that over full market cycles and longer
periods of time, equities outperform bonds (see chart at the end of this article for historical returns), and in moderation,
non-traditional investment strategies can provide an illiquidity premium to returns. Funding expectations are driven by
spending policy and methodology. The majority of educational endowments use a “moving average” based policy, where
the spending formula is calculated by taking an established percentage of the average of several annual market values. Two
widely used examples of this methodology are to spend 5% of a three year (12 quarters) or five year (20 quarters) average
of market values. This methodology is what leads to the most common investment return objective we see:
Net investment return = Rate of Inflation2 plus 5%
This annualized objective is usually measured over a market cycle or specific time period linked to the methodology used in
the spending formula.
Another calculation is the “effective spend rate” and it varies the most from year to year, as it is calculated by taking the
actual spend amount and dividing it by the current year’s market value. The effective spend rate is what makes some in the
public domain believe that an endowment is not spending enough today; some even posit that spending/investing more
today will preserve the value of the institution in the future.
Can an endowment achieve returns that exceed Inflation + 5%? It depends. There are many factors that impact
performance and the point in time of measurement. See the charts below for past performance of traditional portfolios in
varying allocations compared to the performance of Consumer Price Index (CPI) + 5%.
Is CPI + 5% Attainable?
Rolling 5 Yr Returns of Portfolios vs. CPI + 5%
30%
35%
25%
30%
25%
20%
20%
15%
15%
10%
10%
5%
5%
0%
-5%
50 S&P/10 EAFE/40 Agg 60 Period Percent Return
1980
1984
1988
1992
1996
0%
CPI + 5%
2000
2004
2008
2012
-5%
60 S&P/10 EAFE/30 Agg 60 Period Percent Return
1980
30%
35%
25%
30%
1988
1992
1996
CPI + 5%
2000
2004
2008
2012
2004
2008
2012
25%
20%
20%
15%
15%
10%
10%
5%
5%
0%
0%
-5%
-5%
-10%
1984
70 S&P/10 EAFE/20 Agg 60 Period Percent Return
1980
1984
1988
1992
1996
CPI + 5%
2000
2004
2008
2012
-10%
100% S&P 500
1980
1984
1988
CPI + 5%
1992
1996
2000
Source: Morningstar Encorr
Foundations and Endowments Specialty Practice
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Rolling 10 Yr Returns vs. CPI + 5%
20%
25%
18%
16%
20%
14%
12%
15%
10%
8%
10%
6%
4%
5%
2%
0%
50 S&P/10 EAFE/40 Agg 120 Period Percent Return
CPI + 5%
1985
1988
1991
1994
1997
2000
2003
2006
2009
2012
0%
20%
20%
15%
15%
10%
10%
5%
5%
1985
1988
1985
1988
1991
1994
1997
1994
1997
2000
2003
2006
2009
2012
2003
2006
2009
2012
0%
0%
70 S&P/10 EAFE/20 Agg 120 Period Percent Return
-5%
60 S&P/10 EAFE/30 Agg 120 Period Percent Return
CPI + 5%
1985
1988
1991
1994
1997
2000
100% S&P 500
CPI + 5%
2003
2006
2009
2012
-5%
1991
CPI + 5%
2000
Source: Morningstar Encorr
We compared performance of four portfolios of varying asset allocations to the track record of CPI +5%, and evaluated the
rolling five and ten year annualized returns. We used the S&P 500 Index, EAFE Index and Barclay’s Aggregate in multiple
combinations of equity and fixed (60% Equity and 40% Fixed, 70% Equity and 30% Fixed, 80% Equity and 20% Fixed and
100% Equity). The rolling five year returns comparison show greater success at exceeding inflation and spending; the rolling
ten year returns exhibit less volatility, but at the endpoint, arrive much closer to the real return target.
The Future of Intergenerational Equity: Endowment Feng Shui
What will it take to achieve Intergenerational Equity in the future? Endowments are long term investors and this “in
perpetuity” time horizon is difficult for most investors to appreciate. We want to make our mark now: increase payouts to
add scholarships or financial aid so more students can participate; build a new research facility to attract the best and
brightest…the list can go on. What trustees and administrations do now to preserve the purchasing power of their perpetual
pool of assets, may not pay off until the future. It is sometimes difficult to stay the course when the future success of these
efforts may not be readily visible. However, there are some strategies and activities that can be utilized and controlled to
increase the probability of achieving desired investment results and provide future generations with a game plan to follow.
1. Asset allocation – Diversification is the most important decision an investor can make. As Harry Markowitz’s pioneering
work in modern portfolio theory proved, asset allocation is responsible for 90% of investment results. Take care to
ensure portfolios are diversified among asset classes and strategies. Stress test the portfolio with liquidity constraints to
determine the minimum level of liquidity your institution needs to maintain support.
2. Spending Rate – Consider a review of how your institution calculates its spending policy (if allowable). Perhaps there
may be another methodology that can be employed, one that combines a percentage of an average market value with
the last spending amount grown by a measure of inflation. If consistency of spending amounts is more important to
your institution, it is likely this inflation-based or hybrid spend rule may be more effective. And of course, controlling
spending today enables higher future spending levels tomorrow.
3.Costs – Investment costs and administrative costs all factor into performance calculations and can erode investment
returns. This doesn’t mean that cheapest is best; but monitoring results versus how much they cost is important. A
relative performance measure is helpful for determining success here.
4.Gifts – GIFTS! Often overlooked as a factor of growth for endowments, fundraising and consistency of annual gift flow
can significantly increase the probability of success in achieving current cash flow requirements and maintaining that
level in the future. Consider instituting an annual fund for giving that provides unrestricted assets for current operating
support. Capital campaigns are big projects and come with costs of their own; however, the potential payoff from
increased endowment values and reserves that could make a difference in the mission of the institution.
Foundations and Endowments Specialty Practice
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All of these strategies and activities are indicative of best practices in the nonprofit world. While some private foundations
may not be fund-raising charities (capital campaigns would not apply), they can actively manage asset allocation, along
with certain aspects of their spending policy and monitor costs in order to support the perpetuity of their mission.
The SunTrust Foundations and Endowments Specialty Practice Group provides nonprofits with investment advice, best
practices and governance issues that may impact their future. Please let us know how we can help your institution.
Historical Index Returns over Time Periods through 12/31/2013
Index
1 Year
3 Years
5 Years
10 Years
15 Years
20 Years
S&P 500
Cap Wt.
32.4%
16.2%
17.9%
7.4%
4.7%
9.2%
Russell
2000
38.8%
15.7%
20.1%
9.1%
8.4%
9.3%
MSCI EAFE
22.8%
8.2%
12.4%
6.9%
4.5%
5.7%
Barclays
AGG
-2.0%
3.3%
4.4%
4.6%
5.2%
5.7%
Source: FactSet; returns are annualized
Davis, E. Philip (January 2003) “Comparing bear markets – 1973 and 2000” National Institute Economic Review 183(1): pp. 78-79
1
Measures of inflation vary and report price changes with differing components; there is the Consumer Price Index (CPI), Higher Education Price Index
(HEPI) and the Higher Education Cost Adjustment (HECA). CPI is an economy wide price index using a basket of consumer goods and services. Both
HEPI and HECA report on baskets of goods purchased by colleges and universities, and are heavily weighted to salary costs. It is important for the
institution to select the inflation index most relevant to their mission.
2
Estimated Portfolio Statistics
Portfolio and benchmark expected return and risk statistics are forward-looking assumption over the next 10 years and represents SunTrust’s current
expectations for the benchmark return and asset allocation shown. Expected return and risk are derived from a combination of mean-reversion analysis
using historical data over the prior 25 years (if available), the Black-Litterman model and fundamental research. Expected returns are not guaranteed
and are subject to revision without notice. Actual returns related to accounts managed by SunTrust will vary based on the investments contained within
the accounts and the different methods of presenting performance data, i.e. net of fees, gross of fees, or a combination of these. This information should
not be evaluated independent of or without reference to the investment advisory agreement and investment policy statement that more specifically
addresses applicable investments and fees. Portfolio credit quality and income yield are representations of the average credit quality and income yield
of the investments contained in the portfolio – data is sourced from Morningstar Encorr. Benchmark credit quality and income yield represent published
Barclays Capital Aggregate Index data for the period shown.
Benchmark Indices An investor cannot invest directly in an index.
Barclays US Aggregate Bond is an unmanaged index composed of securities from the Barclays Government/Corporate Bond Index, Mortgage-Backed
Securities Index and the Asset-Backed Securities Index. Total return comprises price appreciation/depreciation and income as a percentage of the
original investment. Indices are rebalanced monthly by market capitalization. The S&P 500 Index is an unmanaged index of 500 common stocks that is
often used as a measure of the US stock market as a whole. MSCI EAFE is an unmanaged market capitalization-weighted equity index comprising 20 of
the 48 countries in the MSCI universe and representing the developed world outside of North America. Each MSCI country index is created separately,
then aggregated, without change, into regional MSCI indices. EAFE performance data is calculated in U.S. dollars and in local currency.
MPT Statistics/Other Measurements Risk-free rate used to calculate certain statistics is the 91 Day Treasury Bill.
Alpha is a measure of risk-adjusted performance. Specifically, alpha measures the difference between actual returns and its expected performance,
given its level of risk (as measured by beta). A positive alpha indicates the manager has performed better than its beta would predict. In contrast, a
negative alpha indicates a manager has underperformed, given the expectations established by the fund’s beta. Some investors see alpha as a
measurement of the value added or subtracted by a manager.
Beta is a measure of risk relative to the benchmark or market. It measures the relationship between excess return over T-bills (the risk-free rate) and the
return of a benchmark index.
Sharpe Ratio is a measure of risk-adjusted return that calculates the return per unit of risk, where risk is represented by the Standard Deviation. The high
Sharpe ratio indicates the manager has benefited from taking risk.
Standard Deviation is a measure of volatility and risk. Standard Deviation is a statistical measure of performance. When standard deviation is high, the
range of performance has been very wide, indicating that there is a greater potential for volatility. Statistically, approximately 68% of the time, returns
are expected to differ from the mean return by no more than plus or minus one standard deviation assuming returns fall in a bell-shaped distribution.
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About SunTrust Foundations and Endowments Specialty Practice
SunTrust has nearly a century of experience working with not-for-profit organizations. Fiduciary stewardship is the heart
of our culture. We are not merely a provider for our clients; we are an invested partner sharing responsibility for prudent
management of not-for-profit assets. Our client commitment, not-for-profit experience and fiduciary culture are significant
advantages for our clients and set us apart from our competition.
The Foundations and Endowments Specialty Practice works exclusively with not-for- profit organizations. Our institutional
teams include professionals with extensive not-for-profit expertise. These professionals are actively engaged in the not-forprofit community and are able to share best practices that are meaningful to their clients. Team members offer guidance
and advice tailored to the various subsets of the not-for-profit community, including trade associations and membership
organizations. Our Practice delivers comprehensive investment advisory, administration, planned giving, custody, trust
and fiduciary services to over 700 not-for-profit organizations.1 We administer $30.7 billion in assets for trade associations,
educational institutions, foundations, endowments and other not-for-profit clients.1
1
As of December 31, 2012
For more information about endowments and intergenerational equity, contact your investment advisor
or call 866.223.1499. Please visit us at www.suntrust.com/foundationsandendowments
Or contact one of our team members today:
Jack Nichols, CTFA®, CFP®, SVP,
Head of Foundations and Endowments
[email protected]
+1.202.879.6319
Quanda Allen, CAP®, First Vice President
Client Manager and Thought Leadership Director
[email protected]
+1.202.661.0605
Philip Millians, CTFA®, SVP,
Client Manager Team Leader
[email protected]
+1.404.827.6529
Laurie Bagley, SVP
Senior Investment Advisor
[email protected]
+1.404.813.0909
Alan McKnight, CFA®, SVP,
Head of Institutional Investments
[email protected]
+1.404.813.9059
www.suntrust.com/foundationsandendowments
866.223.1499
The information and material presented in this commentary are for general information only and do not specifically address individual investment objectives, financial situations or the
particular needs of any specific person who may receive this commentary. Investing in any security or investment strategies discussed herein may not be suitable for you, and you may
want to consult a financial advisor. Nothing in this material constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur either profits or losses.
Past performance should not be taken as an indication or guarantee of future performance.
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Clients of SunTrust should consult with their legal and tax advisors prior to entering into any financial transaction.
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