Discount Rates and Asset Returns: Implications for Endowment Strategies

Abstract

Many endowments and foundations set the annual dollar amount available for current operations as the product of the market value of assets and a relatively fixed spending rate market value spending policy. We show that a market rate spending policy adjusting the percentage of beginning of year assets available for current operations with changes in discount rates/expected returns better meets the key endowment objectives of stable spending and intergenerational neutrality.Fixed spending rates violate intergeneratinoal neutrality. Declining expected returns cause dollar spending to increase with the associated asset value increase beyond sustainable levels which lowers future spending. Some current spending is at the expense of future spending. The opposite occurs when expected returns rise.Market rate spending policies maintain intergenerational neutrality by adjusting spending rates with expected returns. In addition, when discount rates decline (increase) the lower (higher) spending rate offsets some of the impact of the increase (decrease) in asset values. Thus spending is actually more stable with market rate spending when investing in assets whose values are more sensitive to discount rate changes, i.e. longer duration assets. The impact of discount rates on spending volatility can be driven to near zero with investable long duration assets.Monte Carlo simulation analysis shows that market rate spending applied to an equity portfolio reduces year over year spending volatility by over 30% (versus market value spending). Year over year spending volatility using market rate spending applied to a long duration fixed income portfolio is about 70% lower than year over year spending volatility using market value spending applied to a market duration portfolio.