How do foundations set their spending rates?

There are numerous ways to determine the endowment spending rate for a nonprofit. Most nonprofits are familiar with less complex approaches that include spending income, assigning a prespecified percentage of the beginning market value, simply deciding on a spending rate, and using the Internal Revenue Service minimum required payout of 5% for certain private foundations. In practice, there are three primary methods used today.

Moving average methods

One of the most frequently used methods, the moving average method tends to ”smooth” the overall spending rate and reduce the impact of a single year’s increase or decrease in portfolio value. This method involves the application of a spending policy rate (typically 3.5%–5%) to a moving average of beginning-period market values over a defined historical period (typically 3–5 years, or 12–20 quarters).

Inflation-based methods

Inflation-based methods are calculated using previous year’s spending and inflating it by an applicable inflation index, such as one of the Consumer Price Indexes. Depending on preference, some organizations will then impose upper and lower bands on their spending (e.g., a lower band of 3% and an upper band of 6%).

Hybrids

Another way to determine the appropriate spending level for an organization is to adopt a hybrid calculation that uses a weighted average of the inflation-based calculation and the moving average calculation. Spending rates can be expressed as a maximum, a target, or a range.

Read the article “Designing a Spending Policy That Works” and download a sample foundation spending policy >>

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