How does the total return spending approach work for endowments?

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AcadiFi · Accepted Answer

The total return spending approach treats the endowment as one integrated pool and defines spending as a percentage of a smoothed market value, regardless of whether the source is dividends, interest, or capital appreciation. This contrasts with the income-yield approach, which spends only current dividends and interest.

Implementation typically uses a smoothing formula to dampen spending volatility. The most common is the Yale/Stanford-style weighted average: Spending_t = w x (Spending_{t-1} x (1 + inflation)) + (1 - w) x (target spending rate x MV_{t-1}), with w often 0.70 to 0.80. Alternatively, a rolling-3-year or rolling-12-quarter average of market values is used: Spending_t = target rate x (average MV over last 12 quarters).

Worked example: Cedarvale College Endowment had $2.4B at year-end, with a target 4.5% spending rate. A simple 12-quarter average MV of $2.35B yields $105.75M in FY spending. Under a Yale-style rule with w = 0.75, spending of $100M last year, 2.5% inflation, and target 4.5% on $2.4B: Spending = 0.75 x ($100M x 1.025) + 0.25 x (0.045 x $2.4B) = $76.875M + $27M = $103.875M.

Advantages: smooths operating budgets, avoids procyclical spending cuts, and integrates with total return investing. Disadvantages: complex to explain, can overspend after prolonged bull markets and underspend after crashes (though smoothing partially offsets this).

UPMIFA governs these rules in most US states and permits spending from underwater funds with prudence.

How does the total return spending approach work for endowments?

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