## Calculate and Interpret Spending Rules for Endowments & Foundations

If you think back to our calculation for the return requirement for many institutional investors, it is driven by three things: the spending rate, inflation, and management fees.

The spending rate we usually see on the Level 3 exam is usually given as a % of assets that a foundation or endowment must spend the following year. If the spending rate is 5% and the asset base being used is $200 million, the institution must spend $10 million the following year.

## What are spending rules used for and how do you calculate them?

**Spending rules** are formulas used to calculate the asset base that then drives the spending rate.

It should be obvious that this makes them a primary component of an institution's return objective. They could also be important for a CFA exam question asking you to calculate the $ amount an institution must spend in the following year.

Bottom line: You may need to know each of these equations in order to calculate the relevant or correct return for a specific endowment depending on what spending rule they use.

Now each of the following equations is fairly simpleand there's a chance you might need to actually calculate the spending rate, however, **it is far more likely that you will need to interpret how using a different spending rate impacts the overall return objective. **

Let's cover the equations and then talk about their implications.

### Calculating the Simple Spending Rule

The first and easiest of the three spending rules is the simple spending rate.

As you can see the simple spending rate is simply a function of last year's market value. Because it only takes the most recent time period into question the simple spending rate can be subject to a lot of volatility. Huge portfolio returns one year would greatly increase the amount the foundation or endowment would have to spend the next year. The same is true in reverse: large down years would decrease the spending rate the following year.

**This volatility increases risk and increases liquidity as compared to both the geometric and three year average spending rule.**

### Interpreting the Geometric Spending Rule

The second spending approach is the Geometric Spending Rule:

The geometric spending rule takes last year's beginning portfolio value and applies some decay rate to that value. Hence it's a declining average of trailing endowment values. This approach is *less volatile *than the simple spending rule but emphasizes recent returns more than the three year weighted average approach.

### Understanding the Three Year Average Spending Rule

With this approach the spending rate is taken from the average market value over the last three years:

### How Spending Rules Get Tested on the CFA L3 Exam

- Conceptual understanding is more likely to be tested than the calculations themselves
- The use of either the geometric or weighted average approach will
**decrease**volatility and thus**increase**risk tolerance. The simple spending rule leads to the lowest risk tolerance - The geometric approach emphasizes more recent values more than the three year weighted average approach