Charitable foundations are facing some of the most challenging mandates they’ve ever encountered — and that means they will have to make tough decisions about risk and spending to survive, according to Michael Crook, chief investment officer at investment consulting firm Mill Creek Capital Advisors.
In a research paper titled “Mission Impossible: Foundation Investment Policy in the Post-Covid World,” Crook outlined what the current macroeconomic environment — including inflation and rising interest rates — means for private and community foundations. According to Crook, it’s important to understand that the total return these non-profits need to reach to meet their objectives is about as high as it’s ever been.
“That idea drives the rest of the conclusions because it means that [institutions] are really forced to reconsider whether or not the same objectives that they’ve had historically are even feasible,” Crook said.
In the paper, Crook defines this necessary rate of return — the amount of money institutions need to generate to pay beneficiaries without diminishing their long-term capital holdings — as a combination of a foundation’s targeted distribution rate, which usually falls at about 5 percent, and the expected rate of inflation. For example, if a foundation wants to distribute 5 percent of its assets to beneficiaries and inflation is at 5 percent, the foundation’s portfolio would have to generate a 10 percent return just to break even.
According to Crook, rampant inflation and rising interest rates have driven these return-rate hurdles to an all-time high for private foundations.
So what should they do? One possible solution, according to Crook, is for foundations to reduce their annual distribution targets to achieve a lower target rate of return.
“Many foundations might find that slightly lower spending rates are an acceptable trade off for greater year-to-year certainty around the magnitude of their distribution,” Crook wrote, adding that they could adopt a framework which enables higher spending rates “when market conditions justify such a policy.”
Another potential solution is to increase the amount of risk in their portfolios. Crook suggested that investment committees considering this option devote time to studying the risk profiles of their portfolios, focusing more on the characteristics of these risks, rather than getting caught up in the potential outcomes. Still, he warned that endowments and foundations should avoid taking on too much risk, which could jeopardize the long-term health of their portfolios.
“Foundations seeking to distribute 3 to 6 percent must accept portfolio risk and variability in their distributions, or accept the gradual diminishment of their corpus in real or nominal terms,” Crook concluded.