Information given in the School Endowment example:
1. Annual operating budget of approx. $10m (90% goes to salaries and benefits for teachers and a small admin staff.
2. The school has no debt
3. The school is unlikely to expand in the future.
4. The school has endowment of $30m (composed of $10m for general unrestricted support, $10m for financial aid, $5m small funds with various donor use restrictions and $5m of unrestricted funds functioning as endowment).
Spending Policy for a fiscal year: calculated by adding 70% of prior year spending amount to 30% of endowment MV at the beginning of the prior fiscal year times the policy spending rate of 4.5%.
What I don’t understand is how the following was calculated as part of the solution provided:
i) Risk objectives: Endowment is not a very large part of the school’s annual budget (less than 14% of revenue) – How does one arrive at 14%?
ii) Liquidity: Only a small % of the fund approx 4% or 5 % is spent each year – How does one arrive at 4% to 5%?
Source: CFA Institute Level III 2014 Volume 2 – Example 13
“The City Arts School (CAS) is an independent private school educating 500 children from 9th through 12th grade. Founded in 1920, it is located in a modest- sized city in the northeastern United States with a diverse socioeconomic and racial population. CAS has an outstanding reputation and draws students from the city and surrounding suburban communities. The school has an excellent program in the performing and visual arts; in addition, it offers a broad and innovative curriculum with small class sizes.
CAS has an annual operating budget of approximately $10 million, more than 90 percent of which goes to salaries and benefits for teachers and a small administrative staff. With conservative fiscal management, the school has built” “and maintained a fine campus over the years without the use of debt. Due to the limited availability of adjacent land or other space, the school is unlikely to expand in the foreseeable future. CAS’s inflation rate has averaged 1 percent above that of the economy in general.
CAS has an endowment of $30 million, composed of $10 million for general unrestricted support, $10 million for financial aid, $5 million of small funds with various donor-specified use restrictions, and $5 million of unrestricted funds functioning as endowment.
The CAS board consists of 15 elected directors, each serving three-year terms. In addition, the head of the school serves on the board ex officio. The board delegates responsibility for investing the endowment to an investment committee that includes at least three board members as well as other members of the CAS community who can offer investment expertise and guidance. Investments are monitored and implemented by the school’s business and operations manager.”
Proposed Statement of Endowment Goals
The goal of the CAS Endowment (and funds that the board has designated as endowment) is to provide significant, stable, and sustainable funding to support the school’s annual operating budget and specific donor-designated programs. Endowment funds will be invested with the objective of earning high, long- term returns after inflation without undue risk of permanently impairing the long-term purchasing power of assets or incurring volatile short-term declines in asset values or annual spending flows.”
Spending Policy for Endowment
The goal of the CAS Endowment spending policy is to provide a sustainable, stable annual source of income from the endowment to the operating budget of CAS. The spending policy helps provide financial discipline to the school by providing a clear, unequivocal amount of annual funding from the endowment consistent with sustainable long-term operations.
Spending from the endowment (and funds designated as endowment by the board) shall be determined by a spending rule that smoothes the volatility of spending from year to year using a weighted-average formula. The formula takes into account spending from the prior year as well as the endowment’s current market value. Spending for a fiscal year shall be calculated by adding 70 percent of the prior year’s spending amount to 30 percent of the endowment market value at the beginning of the prior fiscal year times the policy spending rate of 4.5 percent.”
Spending for fiscal year t = 70% × [Spending for fiscal year (t − 1) + 30 % × [ 4 . 5 % × Endowment market value at beginning of fiscal year (t − 1) ]
Adjustments will be made to incorporate the effects of new gifts, additions, or fund decapitalizations. Spending from new gifts or additions to the endowment in their first year shall be at the same rate as other endowment funds adjusted pro rata to reflect the partial year of inclusion in the endowment.
Given these goals for the endowment, specify appropriate objectives and constraints.”
The goal of the CAS Endowment is to provide a significant annual distribution to support the school’s programs while maintaining the fund’s long-term purchasing power. In general, inflation for the school runs about 1 percent above that of the economy. Therefore, in order to maintain the fund’s purchasing power with a 4.5 percent spending rate, net of investment management expenses the portfolio must generate a long-term return greater than 5.5 percent above a broad measure of inflation such as the U.S. CPI.
CAS must address two primary risks in investing its endowment. As discussed above, CAS must protect the endowment’s long-term purchasing power by generating real returns above spending. In the short term, the CAS Endowment should produce a reliable and somewhat stable flow of funding for programs. This short-term risk is tempered by CAS’s spending rule, which smoothes distributions with a geometric moving average spending rate. In addition, endowment spending is not a very large part of the school’s annual budget (less than 14 percent of revenues). Endowment spending could fall by as much as 20 percent and the impact on the budget would be less than 3 percent of revenues. CAS is debt free and has an above-average risk tolerance.” *How do I calculate the endowment spending as part of the school’s annual budget and as a % revenue*?
Only a small percentage of the fund, approximately 4 or 5 percent, is spent each year, and the fund’s historical gift value should remain invested and not spent. A portion of the CAS Endowment pool, however, is composed of funds functioning as endowment. The board, in extraordinary circumstances, may decide to spend the FFE because the monies are not permanently restricted. *How do I calculate the % of fund spent each year as 4% or 5%?*
School’s Annual Budget = $10 mil
The equation for endowment spending,
70% × (Spending for fiscal year (t − 1)) + 30 % × (4 . 5 % × Endowment market value at beginning of fiscal year (t − 1))
We don’t know the spending for the previous year. However,
30% of the equation works out to be $405000. We can do a bit of math and solve for the 70% part of the equation.
405000*0.70/0.30 = 945000. Total Spending = 945000+405000 =$1,350,000
Total Spending as a %age of operating budget works out to be around 13.5% (1,350,000/10,000,000).
If you take the total amount of $1,350,000, it turns out to be around 4.5% of the total endowment value.
But we cannot be sure that the spending value will remain 4.5% each year. The endowment Market Value might change. However, due to the spending equation, there won’t be any major fluctuations in the spending amount as a %age of Endowment. Therefore, we can approximate the spending percentage, which in this case they have mentioned as 4-5%.
As I said, its one of those questions where you need to rack your brains to come up with the solution. But you kind of expect that from the curriculum books. Hope this answers your question, and that I’ve answered it correctly. I would love to know any alternative way of getting the solution.
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