Establishing a foundation can be a great way to pursue charitable objectives, but it often brings a host of fiduciary responsibilities that donors may feel ill-equipped to handle. In this hypothetical case study based on client experiences, a couple of entrepreneurs sought our advice on asset allocation.
Andrew and Jennifer, both 55 years old, found themselves with a large financial windfall a few years ago, when they sold their successful business. Charitably inclined, the couple decided to establish a public foundation with $10 million in capital. They sought to manage the foundation for perpetuity, hoping their children and grandchildren would someday assume stewardship of it.
The couple’s primary question was whether their 60% allocation to stocks and 40% allocation to bonds would allow them to make good on their decision to distribute 5% of the foundation’s value annually, without depleting the portfolio’s inflation-adjusted value over time.
Andrew and Jennifer had been successful in raising about $100,000 (1% of the foundation’s value) each year. They expected to continue doing so. Still, they feared the foundation’s real value would gradually erode, given the lower market returns that are likely in coming years.
Discussion of asset allocation led to another key issue: Were they living up to their fiduciary duty to make prudent investment decisions? If not, their children and grandchildren might be burdened with unwanted fiduciary exposure.
To get a handle on the asset allocation issue, we used our Wealth Forecasting System to model 10-year returns in typical markets for a spectrum of allocations, ranging from 30% to 100% in global stocks, as shown in the Display below. We also estimated how much of the foundation’s principal could be spent each year, above and beyond projected annual inflation. The turquoise section of each bar represents the spending rate that we forecast would allow the foundation to exist in perpetuity with no diminution of its real (inflation-adjusted) value.
The display makes clear that a 60/40 allocation was likely to fall short if the target was 4% net real spending after adjusting for fund-raising. Andrew and Jennifer were right to be concerned about depleting the Foundation’s assets. To meet their spending target, a higher allocation to stocks was needed to fuel growth of the foundation’s assets.
We estimated that 80% in stocks would clear the hurdle in typical markets. Andrew and Jennifer were willing to consider this allocation, but were concerned that such a stock-heavy mix could be very volatile.
Again, they were right to be concerned. We estimated that with an 80/20 portfolio, there was a 71% probability that the foundation’s distributions would decline by at least 20% at some point over the next 10 years. This was troubling to Andrew and Jennifer. They felt that as fiduciaries, they should reduce the risk that volatile distributions would disrupt the programs the foundation was committed to support.
We took our analysis of the foundation to another level by discussing with Andrew and Jennifer three different strategies for mitigating volatility, as shown in the next Display. They could use any or all of them.
Broader investment diversification. The foundation was invested in only stocks and bonds. Allocations to hedge funds, inflation-protected bonds, and real assets would likely reduce portfolio fluctuations, because these investment categories are imperfectly correlated with one another and with stocks and traditional bonds: When one asset loses value, another would likely gain. We estimated that diversifying the portfolio with modest allocations to these investment categories would reduce the risk of a 20% reduction in distributions to 64%.
Smoothing distributions. One of the problems with designating a set percentage of a portfolio’s value for distribution to charity each year is that when the markets drop, the distribution also falls—and when the markets boom, distributions spike.
This volatility can be reduced with a smoothing rule for spending. Instead of basing distributions on the portfolio’s year-end annual value, they could make distributions based on its average value over several prior years, usually three. That makes annual changes in spending more gradual.
If Andrew and Jennifer diversified the portfolio and employed three-year smoothing, we estimated that the odds of a 20% drop in spending could be cut in half—from 71% to 35%.
Matching assets to liabilities through fund-raising. Foundations typically depend in great measure on direct gifts of cash and appreciated securities to support their distributions.That’s fine, up to a point. But direct gifts to charity tend to dry up in difficult markets, when they are needed most. We suggested that the couple ask some donors to contribute via charitable trusts and annuities, in addition to (or instead of) direct gifts.
Vehicles such as charitable remainder trusts, charitable lead trusts, and charitable gift annuities share several characteristics that make them popular with high-net-worth donors: They offer the donor or a beneficiary whom he or she designates either regular income or a remainder payment. They can also help the donor diversify his assets, if he gives highly appreciated stock to a trust. All three also offer valuable tax deductions, though the terms of the deduction (as well as the taxability of any payments to the donor) vary from vehicle to vehicle.
Charitable lead trusts could give the foundation long-term sources of income. Charitable remainder trusts or gift annuities could give them lump sums in the future.
We estimated that if Andrew and Jennifer diversified the foundation’s asset mix, smoothed its distributions, and diversified its long-term funding sources, they would reduce the odds of a 20% drop in distributions to little more than one-in-four. That was a risk Andrew and Jennifer could live with. Andrew and Jennifer decided to adopt this three-pronged approach to maintaining the foundation’s value in perpetuity and reducing fiduciary risk for themselves and their loved ones. And like most of the investors we serve, they were pleased that they had so many levers they could pull to reach their goals.
The Bernstein Wealth Forecasting System uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.