Executive summary:
- Different economic regimes impact non-profits differently, depending on what the organization supports and its donor base.
- Non-profits should consider how their organizational needs may change during a negative growth or inflation shock and factor this into developing their investment and spending policies.
As non-profit investors set their investment and spending policies, it is important to consider their organizational circumstances during a market shock. Because market declines impact investment strategies, an organization's likely reaction to a drawdown helps determine if more protection during a growth or inflation shock would allow the organization to support its objectives better.
We assume that most organizations aim to support current beneficiaries while maintaining purchasing power in perpetuity for future generations. As discussed in a recent research paper, inflation and growth shocks make achieving a CPI1 + return objective more difficult. Still, different portfolio construction decisions would be made if there is a greater need to protect the asset base during a growth or inflation shock. Coupled with the portfolio construction decision that impacts the magnitude of the market loss in a downturn, the spending policy decision will impact the extent to which that investment loss leads to a reduction in near-term spending or a longer-term impairment of the asset base. This article will explore how organizational circumstances might impact a non-profit's priorities and how understanding this can allow for greater confidence in setting investment and spending policies.
How might an economic downturn impact investment policy? What about by a growth shock?
We typically believe organizations should construct a robust portfolio across different economic regimes. However, if organizational-specific concerns lead a non-profit to be more concerned about maintaining spending during an economic downturn or an inflation shock, this would lead to different investment priorities. For an investor specifically concerned about an unexpected rise in inflation, we generally believe an increased allocation to real assets and inflation-linked bonds and a reduction in duration within nominal fixed income investments2 would be prudent. However, an investor specifically concerned about the impact of a negative growth shock might want to lean into duration within nominal fixed income investments and remove or reduce their allocation to commodities. Certain long volatility and trend strategies can help mitigate downside risk for both investors without altering the expected exposure to inflation shocks.
What is your source of gifts and inflows?
Many non-profits receive gifts and contributions from a variety of sources. The source of these cash inflows will determine how the market environment impacts the gift level. For those who are receiving gifts, the amount of gifts could vary significantly. Here are some key questions for non-profits to consider when receiving gifts:
- Are the gifts from donors in the community?
- If so, are those donors impacted by the overall economic environment? Is there a history of lower gifts in negative economic environments?
- Do the community donors have more concentrated income sources, as might be seen in areas of the country with large oil and gas industries, that could lead to increased gifts during periods of rising price inflation—and a more significant reduction in gifts in periods of declining economic growth?
- Are the gifts primarily received from estates, and, therefore, is there less of a relationship between gifts and the economic environment?
The source of cash inflows can influence the amount of gifts in a market downturn. Although this varies by organization, based on surveys of community foundations in the Council of Foundations annual reports, it appears there is a loose relationship between the economic environment and gifts received by community foundations. Exhibit 1 looks at the rolling two-year return on the Russell 3000 and the proportion of community foundations that stated they experienced an increase or decrease in annual gifts received.
Exhibit 1: Proportion of community foundations that stated an increase or decrease in gifts relative to two-year equity returns3
There are many factors that could impact the sensitivity of gifts to different market environments, whether the primary source of gifts is individual donors, corporations, or the government. The important thing is for the organization to consider which economic environments are likely to make their donors less able to provide ongoing gifts and then incorporate that into any decisions as to which economic environments it is more important to protect the portfolio from adverse results.
Who do you support?
Where the money the organization supports goes is an extremely important differentiator across organizations. If the asset base falls, is there the ability to decrease spending dollars? Or, in reality, will dollars spent need to be maintained—and potentially increased—in a market downturn?
A college endowment is an example of an asset pool that might need to increase spending in a declining economic environment. A recent study from NACUBO4 stated that although in the 1970s, the average level of support of endowments toward the operating budget was just above 4.0%, by the fiscal year 2023, it was an average of 11%. Along with the sticky demands of an operating budget, the same report found that 48% of total spending went toward financial aid. In negative economic environments, there are likely to be more students who qualify for financial aid, leading not just to the inability to decrease spending but likely the need to increase spending in an economic downturn.
Although the need for increased spending may be less mechanical in other cases, it is likely that many non-profits that support vulnerable members in their communities will see an increased need for services in a negative economic environment and would not want to decrease spending through that time. The situation might be very different for a non-profit supporting the arts or the environment. There could be minimal linkage between the needs of the money being spent and the economic environment.
Case study
The impact of rising inflation on the need to increase spending most directly impacts organizations that devote a significant portion of their annual spending on purchasing items or building physical things for which the cost is increasing with short-term price inflation. For organizations aiding vulnerable members of the community, the impact will be different depending on whether rising price inflation is matched with rising wages or not. If salaries for all workers are growing at the pace of inflation, organizations such as food banks may not feel as much pressure to increase spending as they would in a stagflationary environment.
How should spending policy be impacted by circumstances in a downturn?
How the spending policy is formulated has significant implications for adjusting spending as the asset base changes. If, in reality, there is an inability to reduce spending significantly in a downturn, that should be reflected in a spending policy that is less sensitive to changes in the market value of assets. However, as shown in Exhibit 2, a less reactive policy makes it more difficult for the asset base to recover after a downturn.
Exhibit 2: Length of time required to recover nominal asset base from a 10% drawdown
Based on an 80/20 portfolio, from Russell Investments' December 2023 strategic planning forwards forecast assumptions
Ultimately, the higher an organization's spending rate is, and/or the less reactive it is to market returns, the harder it is to recover the asset base after a drawdown.
For those organizations that are more concerned about spending keeping up with inflation, there could be a desire to link inflation directly into the spending policy.
The bottom line
No two organizations are alike. All spending non-profits that are looking to generate real returns in line with inflation plus their spending and expenses must tolerate uncertainty. The specific details regarding the spending and gifts of the organization could lead to a desire to focus on maintaining spending in a negative growth shock, or to heightened concerns about the impact of inflation on the organization's spending. Ultimately, we believe that the most important factor for organizations to consider is what their situation would be in different economic environments. From there, they should ensure their investment and spending policies are best aligned with the needs of the organization.
1 Consumer Price Index (CPI).
2 Assumes that the inflation that the organization is concerned about is highly correlated to broad-market CPI. If an organization is concerned about changes in specific costs that are not highly correlated to broad-market CPI that would change the strategy to build a portfolio that is robust in periods of shocks to that specific cost, if possible and otherwise look for robustness across market environments.
3 Based on Russell 3000 Index returns and the 2014-2022 Council on Foundations – Commonfund Study of Foundations.
4 2023 NACUBO Commonfund Study of Endowments.
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