Endowments and Foundations: Coping with a Budgetary Shortfall

Brian D. Wodar and Ashley E. Velategui

The board of the Midtown Art Museum (MAM) had an unpleasant surprise. Due to federal budget cuts, an expected $1 million grant for the upcoming year was not going to arrive. This was a huge loss for an entity that had just $9 million in assets and $200,000 in annual donations. How could it adjust?

While MAM is fictional, we’ve known a number of real boards that have faced similar predicaments. Many chose to revisit both their investment policy and their spending policy. Here, we’ll use the fictional case of MAM to illustrate how we use the  Bernstein Wealth Forecasting System to help clients evaluate their choices.

MAM has a moderate investment policy. Its portfolio consists of 60% global equities and 40% bonds. It spends 4.5% of its assets annually, and had budgeted $450,000 in spending for the year ahead (4.5% of the anticipated balance of $10 million).

Our Wealth Forecasting System shows that a bond-heavy, preservation-oriented asset allocation could make MAM’s bad situation worse, but that a stock-heavy portfolio could recover the lost ground by year 15 under median market conditions (Display 1).

But what about the spending rate? Raising it to 5% annually would generate greater cumulative distributions for the next 30 years, but not forever. Over the very long term, a 4.5% or 4.75% spending rate would produce greater cumulative distributions.

If perpetuity is part of MAM’s mandate, the board should carefully consider the spending rate. We use total philanthropic value (TPV)—the sum of the present value of an organization’s future distributions and the real value of its remaining portfolio—to measure a nonprofit’s ability to grow its portfolio in perpetuity, after factoring in spending and inflation. As Display 2 indicates, a growth-oriented, 80% stocks/20% bonds allocation would enhance TPV at all spending rates.

Unfortunately, the higher equity allocations that increase TPV tend to decrease stability in payouts. Note the highlighted upper left quadrant of Display 3, below—the area corresponding to high TPV and high stability in payouts. It’s empty! This means that there’s no combination of investment policy and spending policy that can compensate completely for the loss of the million-dollar grant.

After reviewing these conclusions, MAM’s board might reasonably decide to:

  • Increase the expected return (and risk) in the portfolio by changing the investment allocation from 60% stocks/40% bonds to 70% stocks/30% bonds
  • Increase the spending rate from 4.5% to 4.75%, effectively cutting its budget this year from $450,000 to $427,500
  • Allow the investment policy to play itself out for the next two to three years
  • Redouble development efforts in hopes of counteracting the loss of government help.

The Bernstein Wealth Forecasting SystemSM uses a Monte Carlo model to simulate 10,000 plausible paths of return for each asset class and inflation, producing a probability distribution of outcomes. It projects forward-looking market scenarios, integrated with an investor’s unique circumstances and taking the prevailing market conditions at the beginning of the analysis into account. The forecasts are based on the building blocks of asset returns, such as yield spreads, stock earnings and price multiples. These incorporate the linkages that exist among the returns of the various asset classes and factor in a reasonable degree of randomness and unpredictability.

Brian D. Wodar is National Director of Bernstein Nonprofit Advisory Services and Ashley E. Velategui, CFA, is a Senior Investment Planning Analyst, both at Bernstein Global Wealth Management, a unit of AllianceBernstein.

Brian D. Wodar

Brian D. Wodar is Director—Wealth Management Research

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3 thoughts on “Tax Cliff Enhances Potential Benefit of Roth IRA Conversion

  1. Presupposing the purpose of a retirement account is for use during your retirement years, I do not understand you analysis.
    A 65-year-old waiting to use the funds for 20 years would not have access until the age of 85. Are you imagining a life expectancy of 10 or 20 years beyond that. If not, you need to present a more practical model.

    • We agree that this stategy would not be suitable for a 65-year-old who is planning to live on the assets in his or her IRA. As we noted in the article, this strategy could be advantageous for investors who do not need their IRA assets for at least two decades, such as wealthy individuals who seek to build the Roth IRA as nest eggs for their children that grows tax-free and can be withdrawn from tax-free.

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