1 Which Spending Policy is Best for Your Endowment or Foundation January 19, 2011

2 Today’s Presenters Lancaster Pollard Investment Advisory Group 65 East State Street, 16 th Floor | Columbus, OH | (614) Visit to sign up to receive investment research. William M. Courson President Adam J. Smith, CFA, CAIA Investment Strategist During the Webinar, Send Questions To: Information in this webinar has been obtained from sources believed to be accurate and reliable. However, we do not guarantee the accuracy, adequacy or completeness of any information and are not responsible for any errors or omissions or for the results obtained from the use of such information. It is not intended to be a complete analysis nor to provide any specific advice or recommendation. See additional disclosures at the end of the presentation.

3 Agenda  Define endowment goals  Review various spending rules:  Broad types  Commonly used  Alternatives  Analyze the effectiveness of each rule  Discuss important considerations

4 Endowment Goals Asset Preservation Intergenerational Equity Budgetary Stability Endowment Goals

5 Asset Preservation Intergenerational Equity Budgetary Stability No spending rule can simultaneously achieve all three goals Endowment Goals

6 Understand Tradeoffs Endowments must prioritize the most important goal and select the appropriate spending rule The primary tradeoffs of any spending rule are: Endowment Goals

7 Types of Spending Rules Adaptive Rules Emphasize total utility at the expense of higher volatility in annual spending (i.e. balance spending & portfolio growth) Stable Rules Emphasize budgetary stability at the expense of portfolio growth (i.e. focus on spending in lieu of portfolio growth) Hybrid Rules can combine any rule, either Stable or Adaptive, into a single spending rule Spending Rules

8 UMIFA Rule (Uniform Management of Institutional Funds Act) An Adaptive Rule That:Spending Calculation Spends a set percentage of the endowment each year based on most recent portfolio value (i.e. Yearly Spending) S T = E T-1 * R E T-1 = Endowment Value (prior year end) R = Target Spending Rate (%) Pros  Simple to implement  Accounts for volatility in portfolio value Cons  Entirely market driven  Can result in significant budgetary volatility Spending Rules

9 UPMIFA Rule (Uniform Prudent Management of Institutional Funds Act) A Stable Rule That:Spending Calculation Spends a set percentage of the endowment’s average value over the trailing twelve quarters S T = [(E 1 + E 2 +…+ E 12 ) / 12] * R E t = Endowment Value (end of prior 12 quarters) R = Target Spending Rate (%) Spending Rules Pros  Provides stable year-to-year spending  Accounts for volatility in portfolio value Cons  Slow to adapt to portfolio volatility (up/down)  Anomalous returns can impact for up to 3 years

10 Inflation-Linked Rule A Stable Rule Where:Spending Calculation Previous year’s spending is increased by inflation:  Consumer Price Index (CPI)  Higher Education Price Index (HEPI) S T = (1 + ℓ) * S T-1 ℓ = Previous Year Inflation S T-1 = Previous Year Spending Pros  Provides stable year-to-year spending  Builds endowment value over time Cons  Fails to account for portfolio volatility  Initial spending rate is highly influential  Poor job of maximizing spending Spending Rules

11 Alpha/Beta Rule An Adaptive Rule That:Spending Calculation Categorizes the portfolio into two “separate” funds:  Endowment Fund: inflation-adjusted corpus (lower spending rate)  Stabilization Fund: assets in excess of Endowment Fund (higher spending rate) S T = (α * E T-1 ) + (β * F T-1 ) α = Lower Spending Rate β = Higher Spending Rate E T-1 = Endowment Fund F T-1 = Stabilization Fund Pros  Maximizes total utility in real terms  Effective in all types of markets  Achieves intergenerational equity Cons  Highly sensitive to market volatility  Spending volatility is linked directly to market volatility Spending Rules

12 Milevsky-Browne Rule An Adaptive Rule That:Spending Calculation Seeks to set a spending rate that results in some ending portfolio value  Factor 1: Probability of reaching goal  Factor 2: Length of time to reach the goal Weighted & combined with the Inflation-Linked Rule to determine the spending rate Pros  Protects endowment’s real value  Works well in good & average markets Cons  Complex to calculate; reliant on assumptions  Increased volatility in annual spending  Long-term horizon required to be effective  Portfolio value decline can lead to significant spending declines Spending Rules

13 Yale Rule A Hybrid Rule:Spending Calculation Developed and currently used by Yale University. It has two components:  Prior year’s spending adjusted for inflation  Set percentage of portfolio’s market value S T = (w * S T-1 ) + [(1 – w) * R * E T-1 ] w = Weighting (%) S T-1 = Prior Year Spending Adjusted for Inflation R = Target Spending Rate (%) E T-1 = Endowment Value (year end) Pros  Stable year-to-year spending  Adapts to the market but protects against wild swings  Used by many large endowments Cons  Dependent upon the weighting assigned to each component  Often fails to maximize any of the three goals Spending Rules

14 Yale & Alpha/Beta Hybrid Rule A Hybrid Rule:Spending Calculation Based on:  Prior year’s spending adjusted for inflation (Yale)  Alpha/Beta Rule S T = (w * S T-1 ) + [(1 – w) * {(α * E T-1 ) + (β * F T-1 )}] w = Weighting (%) S T-1 = Prior Year Spending Adjusted for Inflation α = Lower Spending Rate (%) E T-1 = Endowment Fund (year end) β = Higher Spending Rate (%) F T-1 = Stabilization Fund (year end) Pros  Somewhat stable year-to-year spending  Adapts to market but protects against wild swings  Good job of maximizing utility Cons  Dependent upon the weighting assigned to each component  Trades some of the value of the Alpha/Beta Rule for the stability of the Yale Rule Spending Rules

15 How do the Rules Stack Up?  Analysis Assumptions  $10 million portfolio as of Jan. 1, 1973  60/40 allocation to U.S. Stocks & U.S. Bonds (index returns, rebalanced annually)  Consumer Price Index (CPI) to adjust for inflation  Spending calculated at calendar year end and spent quarterly in equal amounts over the following year Analysis of the Rules

16 Analysis: Total Utility in Real Dollars Analysis of the Rules UMIFAUPMIFA Inflation Alpha/Beta Milevsky/Browne Yale Yale + A/B

17 Analysis: Nominal Ending Value Analysis of the Rules UMIFAUPMIFAInflation Alpha/Beta Milevsky/Browne Yale Yale + A/B

18 Analysis: Nominal 2009 Spending Analysis of the Rules UMIFAUPMIFA Inflation Alpha/Beta Milevsky/Browne Yale Yale + A/B

19 Analysis: Spending Volatility Analysis of the Rules

20 Important Considerations  The appropriate rule depends on the goal:  Utility Maximization: A/B and Yale + A/B  Budget Stability: Yale Rule  Corpus Protection: Milevsky-Browne  Budget Stability: UPMIFA or Inflation-Linked  Spending and/or inflation bands can further reduce spending volatility Important Considerations

21 Important Considerations

22 Summary  The right Spending Policy matches an endowment’s function and purpose  Spending Policies should be reviewed when the organization’s situation changes  Discuss your specific situation with a qualified investment consultant

23 Today’s Presenters Lancaster Pollard Investment Advisory Group 65 East State Street, 16 th Floor | Columbus, OH | (614) Visit to sign up to receive investment research. William M. Courson President Adam J. Smith, CFA, CAIA Investment Strategist

24 Disclosure This presentation has been prepared by Lancaster Pollard Investment Advisory Group. This presentation is for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any particular investment strategy. The information provided is not intended to be a complete analysis of every material fact respecting any strategy and has been presented for educational purposes only. The information herein has been obtained from sources believed to be accurate and reliable; however, we do not guarantee the accuracy, adequacy or completeness of any information and are not responsible for any errors or omissions or for the results obtained from the use of such information. Opinions and data provided in this report are subject to change without notice. Rates of return for periods exceeding one year are annualized. Past performance is not indicative of future results. Any modeling or back testing data contained in this presentation is not intended to be a statement as to future performance. The strategies presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy. Strategies discussed herein are rebalanced monthly using monthly index total return data. Indexes are unmanaged. Return numbers for the indexes include the reinvestment of dividends but do not reflect the deduction of any fees or expenses which would reduce returns. Investors cannot invest directly in indexes. There are risks involved with investing, including possible loss of principal. Neither Lancaster Pollard Investment Advisory Group, nor any officer or employee thereof, accepts any liability whatsoever for any direct or consequential losses arising from any use of this presentation or the information contained herein, or out of the use of or reliance on any information or data set out herein. Additional information is available upon request. Sources: Bloomberg, Merrill Lynch, MSCI Barra, Standard & Poor’s, Barclays Capital, Russell Investments, informa Investment Solutions