Foundation Strategies for an Era of Sub-Par Investment Returns

In my last post I argued that today’s unusually low prospective returns for bonds and near-normal prospective returns for equities will make it very difficult for foundations and endowments to achieve their long-term goals. Here’s our take on the alternative strategies that foundations and endowments should consider.

Seek higher yields from bonds. One common reaction to disappointing bond yields is to take more credit or currency risk. However, doing so may give the bond portfolio an equity-like risk profile. As a result, the 70/30 portfolio could very well end up with the volatility of a 90/10 portfolio—precisely what the board is trying to avoid.

Relax the return objectives. Re-setting the goal to inflation plus 4% may help ensure that the foundation or endowment can meet its current philanthropic needs. It is also likely to keep asset volatility closer to levels that board members, as fiduciaries, feel comfortable with. The drawback? In the median case, this strategy may erode the inflation-adjusted value of portfolio assets a bit.

Fundraise. Boards that lower their return objective to inflation plus 4% could embark on a fundraising campaign aimed at raising 1% of assets per year. If successful, this would help the board maintain its current investment and spending policies without running down assets (and thus sacrificing the entity’s goal of existing in perpetuity).

Turn to active management. The return projections noted above assume index portfolios of stocks and bonds. But if active managers can outperform index returns by 1% after fees, the 70/30 portfolio would become sufficient. Doesn’t seem likely? While most active managers have underperformed in the past few years, their results tend to be cyclical. After periods of poor performance, active managers typically outperform as the markets normalize over the next three to seven years.

Invest in illiquid assets. Historically, investing in a portfolio of illiquid assets, such as private equity or real estate, has added about 1% to returns. Given the so-called liquidity bubble shown by the low yields on US treasury bonds today, we think return premiums for illiquid assets are likely to be higher than normal in the years ahead. This option, however, is only suitable for foundations and endowments that can forgo access to some portion of their capital—and that have sufficient scale to build a diversified portfolio of illiquid assets.

Adopt smoothing rules. Setting spending at 5% of the average trailing five-year account balance can significantly reduce variations in annual spending, enabling the board to meet its near-term charitable commitments. The board would still have to tolerate fluctuations in account values, but the smoothing rule would preserve some capital in bull markets to help sustain spending in bear markets, as we explain in more detail elsewhere.

Even private foundations, which are required by US tax law to spend at least 5% of assets every year, can usually apply a smoothing rule if they have exceeded the 5% spending minimum in the past, as most have.

Of course, the tax, accounting and investment issues are complex and vary by jurisdiction. It is always advisable to seek professional counsel.

The views expressed herein do not constitute and should not be considered to be, legal or tax advice. The tax rules are complicated, and their impact on a particular individual may differ depending on the individual’s specific circumstances. Please consult with your legal or tax advisor regarding your specific situation.

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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