How much can charities withdraw from their endowment to spend on good works, while leaving the remaining endowment protected from the effects of inflation?
A key question facing trustees of long-term charitable endowments is ‘what is a sustainable withdrawal rate?’. Newton first published work on this topic in 2013, using historical analysis from a period of over 100 years to conclude that 3.5%-4% a year would have been a reasonable level of sustainable distribution for charities, if one had wished to protect capital against inflation and market loss, and avoid excessive volatility in distributions. However, the conditions of ‘financial repression’ (by which governments essentially channel funds from the private sector to pay off public debt, and suppress interest rates) in place in 2013, and lower expected returns, led us to suggest that a sustainable level of spending for charities would be closer to 3%, especially if charities wanted to adopt the ‘traditional’ approach of spending only income received.
We believe several factors make a further visit to this topic worthwhile now. Bond yields and interest rates have trended lower in the years since the 2008 global financial crisis, while dividend payments have been materially disrupted by the economic challenges of the Covid-19 pandemic. At the same time, a long period of above-trend investment returns from most asset classes has given many trustee boards a ‘surplus return’ to think about, while in a rather more current context, the rate of inflation that we will be protecting against is again under much discussion.
Our updated analysis suggests that if 3% was the ‘sustainable’ withdrawal rate in 2017, the rate now looks more like 2.8%, partly owing to inflating asset prices in the last few years.
We have also explored how trustee decisions may have fared over previous time frames. While history does not repeat itself (reliably at least), taking an example or two of how decisions and their timing may have played out in the past can offer relevant perspectives for today’s trustee. Having identified a balanced portfolio with a track record going back to 1986, which encompasses multiple periods of market feast and famine, we have applied different withdrawal rates and strategies, as well as examining the impact of investing at different starting points.
Our findings confirm that trustees cannot set a withdrawal rate with certain knowledge that they will protect the long-term spending power of the underlying endowment over ten-year periods. However, over longer time frames, in each of our illustrated cases the value of the endowment has ultimately been protected from the effects of inflation.
Our findings highlight the importance of keeping to a long-term strategy and permitting trustees to make genuinely long-term investment decisions. Over-optimistic distribution of surplus return, or equally unfortunate (perhaps de-risking) investment decisions when the strategy is most challenged, risk damaging the long-term health of the endowment.
Although moves towards total-return investment are understandable when income yields are low and thought insufficient to service a realistic withdrawal, we recognise the importance of predictable income flows to finance charitable spending. Where a charity’s withdrawals are funded by sensibly derived income, short-term capital values may be thought to matter less (as capital is not being sold to fund activity). Where income is disregarded and withdrawals are made from capital gain, sequencing risk (the timing of withdrawals from an endowment) becomes much more relevant.
As investment managers for charity clients, we regard our purpose as being to give our charity clients the best chance to fulfil theirs. Ultimately, we believe that investment managers working with trustees to set realistic and appropriate (to the charity) withdrawal rates, and to set an investment target and strategy accordingly, remains key.
You can read our full paper at https://www.newtonim.com/sustainable-withdrawals-aco/
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