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The long-term historical record regarding investment returns on endowments is well documented, and the math for arriving at a payout consistent with the objective of perpetuity is simple. Permanent endowments can maximize their risk-adjusted returns with an asset mix in the neighborhood of 70 percent equities and 30 percent fixed income. As reported by Cambridge Associates and other institutions that track financial markets, from 1900 through 2002, U.S. equities had an average annual return of 9.7 percent, and bonds of 5.5 percent, producing a weighted return of 8.4 percent. The average inflation rate for this period was 3.0 percent, while average annual investment costs and taxes were at least 0.4 percent for large foundations. Thus, using history as a guide, a foundation can just maintain the real value of its corpus by spending around 5 percent each year. Such analysis underlay the 1981 federal requirement that foundations spend at least 5 percent annually.
In the extended 1982-2000 bull stock market, the average annual return on stocks rose to 18.3 percent, increasing the long-term (1900-2000) average return to 10.5 percent and leading some to believe that foundations could afford higher payouts than those based on the earlier long-term market record. The bear market experience of the last three years, however, has demonstrated again the proclivity of equity market returns to regress to their long-term mean of 9-10 percent, and indeed to dip well below the long-term average in the course of correcting the excesses of a bull market. There is no debate, therefore, among financial experts on the appropriateness of 5 percent as the maximum annual spending rate for foundations with long-term objectives. (1) (2)In the course of the debate on the Charitable Giving Act of 2003, a number of articles appeared in the media advocating annual payout requirements of 7 percent or more. Yet, as the first figure shows, an imbalance between the real return (after inflation) and a required payout of that magnitude would steadily corrode the asset base of a foundation, with negative consequences for all aspects of its work. A foundation endowment of $500 million and generating a payout of $35 million in 2004, for example, would be reduced, in real terms, to $357 million in 2023. Its inflation-adjusted payout would be reduced to $25 million — a drop of almost 30 percent. The road to extinction would still be a long one, but the continued loss of purchasing power would fairly quickly move the foundation out of the league of institutions able to operate effectively in any major public policy arena.
Further, because of the effects of compounding returns on a stable capital base, spending at 5 percent actually enables a foundation to generate a larger flow of dollars over the long term than it could by spending at a higher rate. As illustrated in the second figure, the annual expenditures of foundation A (experiencing 3 percent inflation, earning 8.4 percent each year, and paying out 7 percent of its endowment annually) would initially exceed the expenditures of foundation B (paying out 5.4 percent annually) by $8 million. By 2020, however, the annual expenditures of the two foundations would be equal; thereafter, the foundation with the lower payout rate would expend more each year than the foundation with the higher rate as a result of the depletion of the latter's capital base. In terms of the discounted present value of cumulative expenditures, the expenditures of the two foundations would be the same over a 56-year period, but the annual outlays of the foundation with the lower annual payout rate would thereafter be more than twice as high as those of the foundation with the higher rate.
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