Spending, flexibility, and dealing with economic downturns

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“Whatever goes up must come down”— a rule as inescapable when it comes to financial markets as it is to balls tossed in the air. As for “up,” we are now in the ninth year of what is already the second longest economic expansion in U.S. history, making it all-too-easy to act as if the growth will continue indefinitely. But it won’t. So, as all leaders in philanthropy and the nonprofit sector should be doing these days, we have been thinking a great deal at the Hewlett Foundation about how to handle the coming downturn, as well as future feast-and-famine cycles.

To do so, we must balance two paramount considerations. On one hand is the welfare of our current grantees, whose work and institutional health will suffer if we abruptly reduce or terminate funding in the face of a downturn. On the other hand is the long-term condition of our endowment, whose spending power will diminish in real terms if payout in grants exceeds what’s necessary to sustain its growth over time— reducing the foundation’s capacity to have impact in the future.

Managing spending for the long term

Before explaining how we plan to square these potentially conflicting priorities, I should say a few words about how we manage spending generally. Bill and Flora Hewlett established their foundation with the expectation that it would exist in perpetuity. They hoped the foundation they created would be around to help later generations as well as the present one, a charge we take seriously.

There is a lively, ongoing debate about the wisdom of this decision, with increasing—though still small—numbers of new philanthropists opting to give their assets away during their lifetimes. Partisans on both sides sometimes talk as if there were only one right answer, when in fact the question whether to spend down depends on a variety of considerations about which people can reasonably disagree. We believe, with our founders, that perpetuity makes sense for the Hewlett Foundation given the kinds of problems it tackles. Efforts to promote deeper learning, preserve biodiversity, mitigate political polarization, nurture performing arts, or enable women to control their reproductive choices (to name only a few of our strategies) are not amenable to quick fixes achieved by large infusions of cash. Progress requires nurturing and becoming part of an ecosystem of grantees, beneficiaries, and other funders whose cumulative efforts pay off slowly, and over time. For this work, qualities like patience, experience, dependability, and the credibility that comes from long-term partnership—that is to say, qualities at odds with a spend-down philosophy—are at a premium.

Operating with long-term goals and a long-term vision calls for a particular form of discipline when it comes to managing an endowment. Just to sustain our spending power, the foundation must earn enough to cover annual grantmaking, including expenses, plus inflation. Critics sometimes grumble that the IRS’s required five percent payout is arbitrarily low, but more than a century of experience supports its propriety. After all, paying out at that rate requires an investment team to generate a long-term annualized return of at least six to eight percent— no mean feat.

Making the task still more challenging, it’s not enough to focus only on generating returns. There is also the matter of volatility. One cannot manage a budget responsibly, much less foster good relationships with grantees, if payout fluctuates wildly from year to year. That’s why organizations that depend entirely on an endowment to support operations never invest all their assets in equities or index funds— over time these may generate the most growth, but only at a cost of large, destabilizing annual fluctuations. Indeed, some volatility is inevitable even when investments are diversified to counterbalance such swings. Hence, most foundations—including Hewlett—also use a “smoothing” rule that determines payout as a percentage of the average value of the endowment over the most recent three years.

This combination of a diversified portfolio plus smoothing is adequate to manage typical year-to-year fluctuations. But what happens when there is a big downturn, as in 2008? Or if returns are negative for several years running? It’s not possible to maintain support for current grantees in such cases without paying out more than five percent, which, over time, unavoidably reduces the foundation’s real spending power. To preserve long-term grantmaking capacity, it seems necessary during a downturn to reduce support for current grantees.

In 2008, when our endowment dropped in value by 23.6 percent, the Hewlett Foundation employed both alternatives. We honored commitments already made—which were considerable given the foundation’s preference for multiyear support—by increasing payout well above five percent. At the same time, we acted to blunt the impact on our future by imposing quite severe, forward-looking cuts in our program budgets. About the only solace we had in making these unhappy choices was that everyone was in roughly the same boat.

Creating flexibility

A lot has changed since the Great Recession. One big shift at Hewlett has been in how we allocate our annual grant budget. As the endowment recovered its value, we did not put all the funds immediately back into programs. Instead, we left a significant portion unallocated. The amount varies from year to year, but today roughly 60 percent of our annual grant budget is automatically committed to programs, with the remaining 40 percent held as what we call “flexible funds.”

We took this step with an eye toward managing several competing objectives: (1) a desire to provide programs with consistent, predictable budgets and to avoid competition for resources among them; (2) a simultaneous wish to encourage program staff to think creatively and propose new ideas; and (3) a parallel ambition to preserve flexibility to experiment with work in new areas and to seize unlooked-for opportunities.

Here is how it works: Each of our core programs—Education, Environment, Global Development and Population, Performing Arts, Philanthropy, and Serving Bay Area Communities—receives a base budget that is stable and predictable and indexes with the endowment. Because our commitment to these programs is long-term and enduring, program staff can count on starting each year with this base amount, which they use to pursue the programs’ ongoing strategies. Flexible funds can then be added to this base if a program obtains approval to pursue a special initiative of some sort. Such initiatives must be time limited, typically running from three to 10 years. During the period of the initiative, the program’s budget is increased, returning to its base size when the initiative ends with no sense among staff of having had their budget cut. In this way, programs can experiment and exercise creativity around their core strategies.

We also use flexible funds to support a small number of initiatives and explorations outside the foundation’s core programs. In the past, these funds supported our Nuclear Security Initiative, as well as the Community Leadership Project. Currently, we are using flexible funds to support our Climate Initiative, Cyber Initiative, and the Madison Initiative, as well as to explore new work on rethinking political economy.

Flexible funds are likewise available for unexpected exigencies and unanticipated one-time opportunities. We used these funds to make grants to help combat the West Africa Ebola outbreak, for example, and to partner with the Edna McConnell Clark Foundation’s PropelNext and Blue Meridian projects, as well as to launch the Open Rivers Fund and 50 Arts Commissions in celebration of our 50th anniversary. The list goes on.

Even with some long-term commitments—our $120 million per year Climate Initiative is already more than a decade old, and the $20 million per year Madison Initiative could last for several decades—we typically begin each calendar year with $60-70 million in flexible funds that are distributed over the course of the year. As the funds are available each year, there is no need for program directors to worry about grabbing them or losing out. Instead, programs seek funds only when they have ideas for new work that meaningfully augments and enriches their ongoing efforts. In most years we have unallocated funds remaining, which we distribute proportionately among the programs to supplement their regular grantmaking activities.

Handling downturns

It’s a highly functional system that significantly enhances the Hewlett Foundation’s strategic capacity and flexibility. Not only that, but as we started thinking about how to handle the next financial downturn, we realized that these flexible funds could also provide a solution to the problem of choosing between current and future priorities. More specifically, we can use the funds as a cushion to absorb reduced payout in a way that permits us both to continue supporting current grantees and to preserve our endowment’s long-term spending power.

To this end, our board recently endorsed the following approach going forward: we will not change an approved budget in the year of a financial downturn (defined as a year in which the endowment’s investment return is negative). In the following year, we will set the payout at 5.1 percent of the new endowment value— abandoning our usual smoothing rule in order to spend at a rate consistent with long-term needs. The associated reduction in the grant budget will come from unallocated funds without any reduction in the budget of our programs or approved initiatives.

We do want to preserve some flexibility, however, so in the case of a severe downturn, we will protect some of these flexible funds by sharing a portion of the burden with our programs and initiatives. According to our calculations, however, we can absorb as much as a single year loss of 20 percent in the endowment’s value (or, what is worse, two consecutive years with five-six percent drops) without needing to make more than very modest, short-term cuts in program and initiative budgets and other expenses.

No one wants to see a downturn. All our work feels essential, especially now. But we know a downturn is coming, and while we hope it doesn’t happen soon, we want to be responsible by planning ahead and being transparent about our plans with our partners and other stakeholders.

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