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Financial Planning > Charitable Giving > Donor Advised Funds

No Portfolio Is an Island, Especially an Endowment

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What You Need to Know

  • For a few charities, the endowment is going to be the primary source of funding.
  • The lower the donation risk, the higher the risk capacity of the endowment.
  • Endowment considerations can also apply to households, which typically have a lot more flexibility when it comes to portfolio withdrawals.

No portfolio is an island. In other words, a portfolio is typically only one of many “assets” that can be used to fund some type of financial goal.

For example, for a household, while the 401(k) is important, it is typically used in combination with other assets and income sources to fund retirement consumption, such as Social Security retirement benefits, home equity, etc.

The risk of these non-portfolio (i.e., nonfinancial) assets should impact how a portfolio is invested, but in reality, they often are ignored. I’ve covered this topic in a variety of past research papers, this one in particular, and this concept is especially relevant for endowments today, given relatively low returns expectations and high fixed spending levels (e.g., 5% of assets).

Donation Risk

The role of an endowment varies by charity. For a few (generally very large) charities, the endowment is going to be the primary source of funding, where donations are not necessarily important. For most charities, though, donations represent the vast majority of funding and therefore effectively represent the largest “asset” of the charity.

While donations are obviously an intangible asset, they represent a funding source, similar to an endowment, and should be thought of in a similar light.

Additionally, they should be considered when determining how to invest an endowment, a concept I refer to as “donation risk” in a paper I co-authored awhile back in the Journal of Portfolio Management.

Long story short, the optimal endowment allocation differs significantly across charities given the varying risks associated with donation levels. Certain charities, such as churches, have historically had relatively “safe” (or constant) donation levels, while other charities, such as the arts, have exhibited significantly higher levels of volatility.

The lower the donation risk the higher the risk capacity of the endowment. In other words, charities with lots of safe donations have the capacity to take on more risk in the endowment, but may not choose to do. Charities with relatively risky donations, have less risk capacity, but this may be offset to some extent by their risk preference (i.e., desire to invest in riskier assets).

Expected Returns

Allocation decisions for endowments today are increasingly being determined in light of expected market returns, i.e., capital market assumptions (CMAs).

Virtually all investment managers expect returns in the near future to be well below historical long-term averages, largely due to today’s low bond yield environment.  For example, PGIM’s Q3 2021 10-year geometric expected CMAs for aggregate bonds are 2.16% and are 5.23% for US equities.

When faced with these lower returns, especially in light of a 5% target withdrawal rate, the endowment investment committee may seek to allocate more to riskier asset classes that have higher expected returns in order for the portfolio to have a higher probability of returning more than the target withdrawal rate (5%).

While this is certainly a reasonable perspective, especially given the fact endowments typically expect to exist in perpetuity, the correlation between market drops and potential donation levels (i.e., donation risk) needs to be considered as well.

A charity with a relatively safe level of donations is going to be able to withstand a market drop better and likely can invest the endowment more aggressively if it wishes to try and earn a higher return.

However, a charity where donations are more likely to move with market returns (e.g., if a lot of donors work in the investment management field) may be better served not increasing the risk of the portfolio because the impact of a market drop would be magnified given the non-portfolio implications (again … donation risk).

For example, if the endowment is invested aggressively, and it drops 20% (when the market drops) and the drop is accompanied by an even larger decline in donations, the financial implications for the charity could be disastrous, prompting further withdrawals from the endowment (depending on spending restrictions).

While some might suggest that by not investing the portfolio in higher returning assets the endowment is “surrendering” to declining in value, a different perspective would be that the endowment is simply taking the returns available today (which are unfortunately very low).

Ideally, return expectations will improve in the future; however, if they do not, a more sustainable lever to adjust would likely be the spending level versus the risk level.

Remember, there’s no free lunch when it comes to investing (other than perhaps diversification, which endowments are already generally quite good at). While riskier (i.e., equities) have outperformed safer (i.e., bonds) over longer periods historically, and are expected to continue doing so, there have been (and are likely to be) prolonged periods where this has not been the case.

Therefore, while increasing the risk of a portfolio might make things look better in a projection, doing so could also result in a (significantly) faster depletion rate of the portfolio, especially to the extent donations are correlated to market returns.

Household Impact

The considerations outlined about endowments also clearly affect households; however, households typically have a lot more flexibility when it comes to portfolio withdrawals (even RMDs don’t technically have to spent, just withdrawn from the qualified account) and surveys suggest more retirees actually plan on growing savings versus spending them down.

In other words, investors who are faced with fixed, relatively high spending levels are especially vulnerable to today’s lower expected returns.

There is no easy answer here, but before simply moving into a more aggressive portfolio, the investment committee needs to better understand the implications of doing so, especially when considering how donations may change if the endowment declines in value.

David Blanchett is managing director and head of retirement research at PGIM DC Solutions. PGIM is the $1.5 trillion global investment management business of Prudential Financial. He can be reached at [email protected].