The decade following the financial crisis (2010-2019) was great to investors, as markets generated both strong absolute and risk-adjusted returns. However, the next decade is likely to look much different, as investors face one of, if not the most, muted forward-looking return environments for a traditional stock and bond portfolio. As we entered the new decade, interest rates were at historically low levels (the 10-year Treasury yield was about 1.9%) and U.S. equity valuation levels were at historically high levels (the Shiller CAPE 10 was about 30, putting it at the 96th percentile of all levels since 1871).

While the crisis caused by the coronavirus did lower equity valuations (the CAPE 10 had fallen to about 25 by the end of March), interest rates fell sharply, offsetting that benefit. Since yields and valuations are the best predictors of future returns, going forward we are likely to experience low real fixed income and equity returns. With a real expected return for stocks of about 4%, and with TIPS yields below zero at the end of the first quarter, a typical 60/40 portfolio has a real expected return of only about 2%.

For foundation and endowment managers, this has implications not only in terms of asset allocation but also on spending policy, which determines the amount of funds that are distributed annually to support the institution’s mission and operations. With lower future expected returns on the horizon, endowment managers are questioning whether standard annual spending rates – which typically fall between 3 to 5% of endowment value – will be sustainable going forward and whether certain spending formulas might be better suited for the muted forward-looking environment investors currently face.

A focus on total return

Endowment management changed drastically in the late 1960s after the Ford Foundation released pioneering research suggesting endowments should focus on “total return” as opposed to just income. The foundation illustrated that over the long term, an endowment focused on total return – including both capital appreciation and income – would generate significantly more investment growth and thus provide larger payouts to beneficiaries. Before the release of this research, most endowments took a more conservative approach – only distributing interest and dividend income. As a result, endowments tended to allocate mostly to fixed income investments.

It wasn’t until 1972 when the National Conference of Commissioners on Uniform State Laws developed a model statute on endowment management called the Uniform Management of Institutional Funds Act (UMIFA), which encouraged a total-return approach, that equity allocations became more prevalent in endowment allocations. UMIFA was adopted by most states and later revised in July 2006 by the National Conference of Commissioners – the revised statute, the Uniform Prudent Management of Institutional Funds Act (UPMIFA), is now the statute currently adopted by most states.