A disciplined approach to investing and spending is vital to all nonprofit organizations. But what’s the best policy for your current circumstances? Are you setting reasonable long-term goals for both your organization and its investments? Let’s take a look.
Revisit and revise as needed
Your spending policy is essentially the formula used to determine how much of the value of your investments will be tapped each year for expenses such as operating costs and capital projects. Unfortunately for leaders who prefer to focus on their missions rather than their finances, there’s no one-size-fits-all optimal spending policy.
It’s generally advisable to stick with your spending policy once it’s established, but circumstances can arise that support review and potential revision. Every few years, revisit your spending approach and consider whether changes are warranted.
Choose your policy
Generally, five types of spending policies have emerged, each of which has pros and cons. They include:
1. Fixed-rate. Also known as the simple spending rule, this approach specifies a spending rate that’s applied annually to the beginning-period market value of the investment portfolio. It’s simple to understand and apply, but can result in big swings in spending from one year to the next based solely on the investment portfolio’s performance the previous year. In a multiyear period of strong investment performance, the fixed-rate approach can lead to the highest spending increases compared with alternative techniques. This may undermine the portfolio’s optimal growth.
2. Inflation-based. With this method, the nonprofit sets an initial dollar amount for spending, which is then adjusted annually for inflation (sometimes with a cap and a floor based on beginning market value). It can simplify budgeting, stabilize spending and help grow the investment portfolio because the spending amounts tend to be smaller.
On the other hand, the inflation-based method can facilitate more spending in challenging times when compared with the rolling-average method. (See below.) Of course, higher spending also can eat into the portfolio. And this method doesn’t take into account the portfolio’s market value.
3. Rolling-average. Here the organization applies a spending rate to a moving market value average of its investment portfolio, usually determined over a three-year period. A rolling average generally ensures more consistency in spending from year to year but is vulnerable to market volatility. For example, this method could dictate more spending than would be wise in a year when the portfolio value has dropped substantially. Or it may produce a low spending amount when your nonprofit needs extra financial support.
4. Geometric spending. The formula for geometric spending is complicated, but it reflects movement in both inflation and the market. Although it can be difficult to calculate, geometric spending reduces volatility between years and can lessen the impact of market declines on spending.
5. Hybrid. This approach generally considers both inflation and market value. A large chunk of annual spending is based on an inflation adjustment to the previous year’s spending. The remainder is based on, for instance, the application of a fixed rate to the portfolio’s market value or a percentage of the rolling average. Hybrid spending policies tend to result in stable spending in terms of both dollar amounts and the percentage of portfolio value.
Note that each of these policies generally should include a provision allowing spending to exceed the prescribed amount if determined necessary by the board of directors or another authorized party.
Invest in success
Well-managed investments play a critical role in the success of every nonprofit. Contact Hood & Strong to discuss whether your organization’s spending policy is the right fit.
