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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.

Simple Spending Rate calculation - CFA

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:

Geometric Spending Rule - CFA

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:

Three Year Average Spending Rule - CFA

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