by Midnight Freemason Contributor
Phillip Welshans
Part 3: Endowments and Spending Rules
So now that we've set the ground rules and are going to think about your lodge as an institutional investor, what next? What kind of institutional investor should your lodge be? The answer is fairly straightforward, in my view: lodges should be managed within the framework of an endowment. This is primarily because the overarching objective of your lodge's investments are exactly the same as a university endowment, even if there are some key differences. But at its heart, your lodge's investment objective is to invest in capital markets to provide both a savings and growth mechanism that will allow your lodge to meet its future obligations into perpetuity. The key aspects, then are:
- Preserving capital while growing assets to meet ongoing obligations
- Investing on a very long, intergenerational timeline
This is a rather long post, but I’ve broken it up into sections. We’ll talk about what endowments are and dispense with some myths about them. We’ll define what spending rules are and why they’re important. And finally, we will look at a hypothetical example of two imaginary lodges that approach their spending very differently to illustrate our points.
Endowments: Myths Dispelled
Universities, hospitals, and other large organizations have used endowments for decades as a means for managing a large pool of money in perpetuity. This is because institutions have found that operating costs often cannot be covered by fees, tuition, or hospital charges alone. However, there are a number of misconceptions about endowments and what they’re for.
First: not all endowments are gargantuan. A pool of money held by an institution need not be the size of, say, the Harvard University endowment ($51 billion as of 2022), in order to be considered an endowment. Broadly speaking, Harvard's endowment fund should be managed with the same general objectives as an endowment for a smaller, less flush school.1 You might not have $51 billion to manage, but you might be surprised to learn that your concerns for your investments are not all that different from Rick Slocum, the Chief Investment Officer of the Harvard Management Company, which manages the endowment funds. His primary focus every day is making sure the endowment can provide the funding Harvard relies on for operations, while also not blowing up the portfolio to do it. This should be your goal as well!
Second: endowments are not hedge funds. Endowments of all sizes are bound by strict regulatory and legal frameworks that define how they should manage their assets and require investment committees to act as a fiduciary.2 This means endowments have established processes and bodies like investment committees in place that meet regularly, discuss investment performance, and assess potential new investments. For the big guys, this means entire staffs of professional managers and analysts and administrators overseeing how money is invested. It's not just one guy with a Bloomberg terminal buying and selling securities. For your lodge, you probably won’t need to hire a staff of managers, but there are important takeaways here for how you might want to think about managing your investments.
Third: endowments are not untapped slush funds, but instead serve important roles in operations. Yes, the size of endowments continues to grow (see Harvard's $50+ billion assets under management (AUM) above), but so too are the spending requirements. At their heart, every endowment is designed to exist forever while also providing some amount of year-to-year boost to an institution's operating budget. Let's use Harvard University's endowment as an example. In 2022, the AUM was about $51 billion, yet the endowment also distributed $2.1 billion to the various schools within the university, and overall, about 36% of Harvard's operating revenues for their fiscal year came from endowment funds.3
Spending Policies
To strike this balance between managing for the distant future while helping to fund today's operations, endowments use clearly defined spending policies. These policies help to determine what sort of expected investment returns they need to achieve in turn.4 We are going to take this basic concept and apply it to lodge investment management.
A straightforward way to craft a spending policy is to reverse engineer it. That is, start with defining what you want the endowment to help pay for, and then settle on a spending policy that gets you there, while preserving the long-term capital of the endowment. Try to answer these two questions5:
A. Will you look to add to the endowment via fundraising or any other routine capital contributions? In other words, are you going to rely just on investment returns, or will you be chipping in from time to time too?
B. What percentage of your lodge's operating budget will the endowment support?
The answer to the first question will vary from lodge to lodge, but basically your spending rule can be adjusted if you think you'll be getting some additional capital each year from contributions. Question B is more pertinent for all lodges. The general rule for this answer is an endowment can pay out between 4% and 6% of its assets per year for this purpose without imperiling the principal. The reason is that all else equal, for every 1% you pay out, you've got to earn 1% in investment gains to replace it. The more you pay out, the higher the required return, every year, needed to maintain the endowment. And since markets can be volatile year to year, while spending and budgets tend to be relatively static or at least slow-changing, this can create a mismatch between the needs of the lodge and the realities of the capital markets. Going back to the Harvard endowment, it’s dispersal of $2.1 billion in 2022 worked out to a roughly 4% spending rule on the total size of the endowment. The absolute number is huge, while the proportional number remains reasonable.
There are a number of basic models for a spending rule, but one of the more popular is what is called a market value spending rule. It pays out a set percentage of the endowment's asset value each year (again, typically between that magic 4-6% range). The asset value used to compute the amount withdrawn for spending is a moving average of the previous three to five years’ market value of the endowment assets. The idea here is that you're trying to smooth out the endowment's value and tamp down any single year's outsized gains or losses. The advantage of this kind of rule is that it is simple and easy to apply. The downside is that it is pro-cyclical, meaning that in periods when markets go up, the dollar amount of the annual payout will go up, and vice versa. That's not necessarily a bad thing, so long as the endowment's contribution to the budget is relatively small. But if that amount is large, then you've got a dilemma: do you stick to your spending rule and potentially draw down the principal of the endowment as a result, or do you pay out what you can without reducing the principal, knowing that your lodge's operating budget will be negatively impacted?
Prudence vs. Charity
Let's end this post with a very basic example that will illustrate the importance of spending rules and considering how your lodge’s assets will be managed and tapped in the years to come.
Say two lodges in town, Prudence #101 and Charity #202, both happen to inherit $100,000 from a wealthy brother's estate (he was a plural member at both lodges) in 2002. Both create an endowment for managing the funds and supplementing their operating budgets. Prudence Lodge wants to use the proceeds to pay for an anticipated new boiler in the next few years, and to sponsor some social programs, including an annual scholarship award. The lodge, under guidance from a few brethren, some of whom work in financial services and some who don’t but who have experience investing and managing their own monies, adopts a market value spending rule with a 5% threshold and a 3-year average market value measurement.
Charity Lodge wants to dramatically increase its charitable activities, both monetary and events. Their lodge has a long history of being generous in the community, sponsoring numerous events and organizations. But due to a combination of overspending on these activities, falling membership rolls, and dues that hadn't gone up in 20 years, Charity's coffers were bare. The lodge also lacked any brethren who had any professional or personal financial expertise. They did not institute a spending rule per se, instead agreeing that the Worshipful Master would have discretion to pull from the funds as needed, and with approval of the lodge. The first year the Master pulled $10,000 and that set a precedent where Masters started assuming $10,000 as a contribution to their annual budgets. Call it a “George Washington 2-terms as President” moment: the first guy took $10,000, so the next several guys did the same thing and soon it was expected.
For the sake of simplicity, let's say both lodges decided to invest 100% of their endowments into an S&P 500 ETF.7 So, both portfolios are getting the same investment returns year after year; the only difference is the spending rule (or lack thereof). And let’s assume both lodges somehow manage to invest their money on the same day, December 31, 2002, so that they have equal track records which begin on January 1, 2003. Here is a table showing Prudence #101's endowment over the proceeding 10 years:
Here you can see the "pro-cyclicality" of the market value spending rule. The run up in US stocks in the years before the global financial crisis in 2008 helped push the absolute dollar amount of the endowment's contribution to an all-time high just as markets were imploding. A tough combination, to be sure. But proportionally, the $7,062 withdrawal in 2008 was still just 5% of the average market value of the preceding three years. And with the recovery in the market in the years after the crisis, by the close of our 10-year sample period, the endowment was a bit over 20% higher than it had been at the beginning; and more than 40% higher from the 2008 nadir. That's the conservativeness of the market value spending rule in action.
By contrast, the more spendthrift approach of Charity Lodge lacked those guardrails of prudential spending amounts and smoothed market values. Here is how those ten years went for that lodge's endowment:
The higher spending rate actually doesn't make that big of a difference for the first few years. It's only when the gravy train of the mid-2000s bull market end suddenly in 2008 that the math starts to conspire against the endowment. The spending rate, which began as the equivalent of 10% of the market value in 2002, decreased to about 8% thanks to good years for the S&P 500 in '03-'07. However, the global financial crisis crushed the endowment and sent the spending rate above 14%, where it stayed the rest of the decade despite the strong post-crisis recovery in stocks. The higher spending demands, with each Worshipful Master taking his $10,000 to make the budget balance and make sure “his” year measured up to his predecessors’, was a millstone around the neck of the portfolio.
To really illustrate the point, if we extend our examples all the way through the end of 2022 using the actual returns for the ETF, Prudence Lodge's endowment would have entered 2023 with a balance of over $257,000. By contrast, Charity Lodge's endowment would have shrunk to a little over $60,000, a decline of almost -40% in 20 years. Now, of course this is a very simple and extreme example that allows for no changes in spending rules in any way, which is unrealistic. It's possible the brothers of Charity Lodge would have turned over management of their portfolio to a financial advisor at some point who would have been able to rein in the spending and rebuild some of the principal capital. Maybe a Master would have ended the $10,000 precedent in the name of saving the endowment. But maybe not! Masonic lodges tend not to be fast-movers and in a situation where money that Masters have been able to count on for decades might need to go away, not every lodge will make the hard choices.
Nonetheless, I think this example is illustrative of the overarching point here: endowment spending rules are your friend when you're managing your lodge investments. Don't make the mistake of tabling that discussion for later, at the risk of letting precedent undermine long-term capital preservation. Maybe 5% spending is too low for your lodge. Maybe you've got a hard dollar amount you want to set. Whatever it might be, make sure it's thought out, debated amongst the brethren, and that it doesn't become a sacred cow of the lodge. A year like 2008 doesn’t happen very often, of course, but a prudent and thoughtful spending rule can be the difference between a portfolio dwindling to nothing, or surviving and even thriving in the years afterward, helping future brethren achieve the missions of the lodge, long after you've gone to the celestial lodge above.
2. Fiduciary duty means that the person managing the assets must act in the best interests of their client at all times. Some financial advisors are not explicitly bound to act as fiduciaries, and this can create all sorts of conflicts of interest that advantages the advisor over their client. A classic example is advisors might invest client money in mutual funds with so-called "load fees" which are fees a fund charges investors either at purchase or sale, a portion of which are then sent to the advisor. It's basically a kickback and it erodes the investor's return over time.
3. Source: https://finance.harvard.edu/endowment%20
4. Endowments also fundraise like crazy and most universities (and colleges and private high schools, etc.) have separated out fundraising from endowment management because while they're both important, they require very different skillsets and professionals to do each one well. If you ever see a portfolio manager presenting at a conference of financial advisors, you will immediately understand why fundraising is a skill.
5. There's actually a third question endowments will need to answer and that is if it or the university will be able to issue debt. Obviously, your lodge is not going to be issuing debt, so I left this one off.
6. This is a very simplified way to think about spending rules and payouts and ignores all manner of considerations, not least of which is inflation. For example, inflation in the U.S. as of the writing of this post is about 5%, depending on your preferred measurement, which has major implications for an endowment's ability to preserve its capital after its spending rule. 7. Here I'm going to use the returns of the SPDR S&P 500 ETF, a large and well-known ETF that follows the S&P 500 Index. And yes, you wouldn't put 100% in just one fund like this, but we'll talk about asset allocation later; it's beside the point of this example. Perhaps we will return to Prudence and Charity Lodges down the road…
~PW
Phillip Welshans is Senior Warden of Palestine Lodge #189 in Catonsville, MD under the Grand Lodge of Maryland A.F. & A.M. He is also a member of the Maryland Masonic Lodge of Research #239, and the Hiram Guild of the Maryland Masonic Academy. As a member of the Ancient and Accepted Scottish Rite, S.J. in the Valley of Baltimore, he has completed the Master Craftsman programs and is a member of the Scottish Rite Research Society. His interests are primarily in Masonic education, particularly the history of the Craft, esotericism, and the philosophy of Masonry.
Phillip Welshans is Senior Warden of Palestine Lodge #189 in Catonsville, MD under the Grand Lodge of Maryland A.F. & A.M. He is also a member of the Maryland Masonic Lodge of Research #239, and the Hiram Guild of the Maryland Masonic Academy. As a member of the Ancient and Accepted Scottish Rite, S.J. in the Valley of Baltimore, he has completed the Master Craftsman programs and is a member of the Scottish Rite Research Society. His interests are primarily in Masonic education, particularly the history of the Craft, esotericism, and the philosophy of Masonry.
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