Portfolio Design: A Modern Approach to Asset Allocation

DESCRIPTION OF THE SPENDING PLAN

Once the portfolio is chosen and the returns are estimated, the foundation must determine the objective of its spending plan. One natural objective is to set a spending rule that can be sustained in real terms indefinitely. But there are two alternative types of spending rules: (1) absolute rule where spending is set in dollar terms as a percent of today’s endowment, then adjusted each year for inflation, or (2) proportional rule where spending is set as a percent of each year’s endowment.7 If the latter choice is made, then spending could rise or fall depending on the returns experienced.

As will be demonstrated below, making spending rise or fall with the size of the endowment allows higher spending rates than when spending is fixed in dollar terms. The reason is that bad returns generate cutbacks in spending, and this flexibility reduces the chance that the foundation will have to cut back its spending more drastically in the future.

Returns could be bad enough to force the foundation to abandon its spending plan. This would certainly occur if the portfolio were wiped out entirely. Most foundations, however, would abandon the spending plan far short of that threshold. It seems sensible for the foundation to set an upper limit for losses on the portfolio or, equivalently, set a lower bound for the size of the endowment. In the simulations below, we will assume that if the endowment sinks more than 35 percent in real terms, then the foundation ...