Inflation Plus 5%: Still a Reasonable Goal?

Many US endowments and foundations plan to give 5% of assets annually, while seeking to preserve the inflation-adjusted value of their assets. That’s become a very challenging goal.

In a recent survey by the the Association of Small Foundations, 76% of foundations stated that they “were formed to exist in perpetuity and operate that way now.” The survey also noted that the typical foundation has 70% of its assets in equities or alternatives and 30% in fixed income or cash.

Historically, that portfolio mix was likely to achieve inflation plus 5%. But today’s conditions are far from typical.

The key difference is that given current yields, we project that annual bond returns are likely to be inflation minus 0.5% over the next 10 years, in the median case, as the far left bar of the Display shows. That’s far lower than normal. We project nearly normal stock returns of inflation plus 5.5%, as the far right bar in the Display shows.

The Amount You Can Spend Each Year Without Eroding Principal

When we put these stock and bond projections together, we find that a foundation would have to allocate 90%—not 70%—of assets to equities to have a 50/50 chance of achieving its goal of inflation plus 5% returns over the coming decade.

That’s quite a risky proposition. Even if market volatility declines from current high levels, a 90% equity allocation is virtually certain to lead to substantial variability in asset values. And trustees have become far less comfortable in recent years about risking foundation or endowment assets.

Furthermore, this analysis doesn’t even account for administrative expenses, which would raise the bar for returns even higher.

In our analysis, that means foundations and endowments will need to consider some new strategies. I’ll review the alternatives in my next blog post.

The projections cited above are based on the Bernstein Wealth Forecasting System, driven by the Capital Markets Engine, which uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.

Daniel B. Eagan is Head of the Wealth Management Group at Bernstein Global Wealth Management, a unit of AllianceBernstein.

Daniel B. Eagan

Daniel B. Eagan is a Managing Director and the Head of Bernstein’s Wealth Management Group; he assumed his current role in 2011. A member of the Private Client Investment Policy Group, Eagan joined Bernstein in 2001 as a senior portfolio Manager; in 2003 he assumed the leadership of Bernstein’s private client practice in the Northwest. Prior to joining the firm, Eagan was a senior portfolio manager and managing director with BlackRock for seven years. From 1986 to 1994, he worked in investment consulting, most recently with Mercer Investment Consultants. Eagan earned a BS in finance from the University of Illinois and an MBA with distinction from DePaul University.

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