Question: A friend of mine is on the Board of Trustees for a charitable organization and he says that I should use the endowment model of investing for my portfolio. What is it?
Answer: Public charities such as those affiliated with non-profit organizations, colleges, and universities solicit and collect money from donors. Donors can state their intent for the money and give instructions to spend the money within a specific period of time or preserve the principal and spend the earnings in perpetuity.
When a donor’s intent is to preserve the money in perpetuity and to use the earnings to fund a program the donor wants to support, the donor’s gift is referred to as an endowment. When a foundation collects and accumulates donations that are not designated by the donor for a specific purpose, the foundation’s Board of Trustees might designate those funds as a board-designated endowment. Technically, a donor-designated endowment is considered to be a “true” endowment and a board-designated endowment is considered to be a quasi-endowment. Both types of endowments are managed to last forever and provide annual withdrawals to spend on grants, research, scholarships, or other programs pursuant to an approved spending policy.
The Foundation’s Board of Trustees has the fiduciary responsibility to manage the endowment money prudently, following guidance established by the Uniform Law Commission in 1972 when they published the Uniform Management of Institutional Funds Act (UMIFA). The Commission updated the guidance in 2006 when they promulgated the new Uniform Prudent Management of Institutional Funds Act (UPMIFA). UPMIFA is now law in 49 states, with Pennsylvania the only holdout.
The old guidance centered on preserving principal and only spending interest and dividends. Foundations felt constrained to invest in bonds and high-dividend stocks. UPMIFA introduced concepts of Modern Portfolio Theory, brought endowment investing into the 21st century, and freed endowments to invest for total return, which includes gains in principal along with interest and dividends.
Endowments generally aim for returns of at least 5% above inflation in order to meet spending requirements and still grow. The endowment model recognizes that without investment risk there is little return and some risks can be reduced or avoided by diversification. Endowments need investment growth to preserve their spending rate as prices rise with inflation. This means that endowments must hold more equities and fewer bonds.
Smaller endowments and individual investors use mutual funds and exchange-traded funds to diversify, whereas large endowments with large investment staffs have direct access to investments in companies, real assets and private equity. Real assets protect against inflation and include treasury inflation-protected securities (TIPS), real estate, timber, and oil and gas.
Private equity includes leveraged buyouts and venture capital bets on private companies with IPO (initial public offering) potential. Many of these alternative investments are illiquid, and in exchange for accepting that illiquidity, the endowment hopes to realize a significant return.
By now you should see a similarity in your goals to those of an endowment. You want your portfolio to grow to keep up with inflation and provide you with annual income to maintain your lifestyle throughout your golden years. It follows that the endowment model of investing using inexpensive ETFs and/or mutual funds would be prudent and appropriate for you.
Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment advisor and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning. Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA93940 or email them to firstname.lastname@example.org.