Portfolio Design: A Modern Approach to Asset Allocation

SPENDING RULES

If a foundation wants to keep its programs running for an indefinite period, it should consider adopting a spending rule, a rate of spending that can be sustained through time. Sometimes foundations base their spending on the income from their bonds and stocks. They choose their portfolios so as to maximize the coupons from their bond portfolios and dividends from their stock portfolios. This strategy may or may not be ideal as an investment strategy, but it should not be the basis of a spending rule. Foundations should be willing to use both income and principal from their portfolios if the spending can be sustained.

To see why bond coupons or stock dividends may be the wrong basis for spending out of a portfolio, consider a simple example. Suppose that the foundation with a $10 million endowment puts the entire portfolio in long-term government bonds. Would it be safe to spend the coupons on these bonds? In answering this question, we will establish an important principal: the spending rule must be based on the real, or inflation-adjusted, return on the portfolio.

Let’s examine the spending rule for an all-bond portfolio under a simplifying assumption: There is no inflation risk. We know for certain that inflation will be only 2.5 percent per year for the next 30 years. This is a totally unrealistic assumption, but it will help us to analyze the bond portfolio. Suppose that the foundation invests its entire $10 million portfolio in 30-year Treasury bonds that have ...