Determining the appropriate required rate of return is just one of many challenges facing an Investment Committee today. Addressing this topic is like a walk in the forest. Questions will require answers, decisions will have repercussions and any number of risks could be around the next turn. Some of these dangers include inflation and market volatility. Understanding these potential hazards allows a Committee to formulate a suitable Investment Policy focusing on the “Three Levers”: Inflows, Outflows and Required Return.
As an Investment Committee begins its walk in the forest, it will likely confront inflation at some point. If inflation is not taken into account, it can be a detriment to your organization’s long-term purchasing power. Not keeping pace with inflation erodes your institution’s purchasing power over time, when the same amount of currency buys fewer goods or services. Since 1914, annual inflation, as measured by the Consumer Price Index, has averaged 3.32%. Simply put, this average inflation level indicates that prices double approximately every 21 years. Historical economic data suggests that rarely is there a time period characterized by low unemployment, increasing asset prices, low interest rates, brisk but steady GDP growth and low inflation. The last time these conditions simultaneously occurred was during 2013 when the S&P 500 rose over 30%. This occurrence is commonly referred to as a “Goldilocks Economy”, an economy that is not so hot that it causes inflation and not so cold that it causes a recession, but just right.
Around the next turn, an Investment Committee may likely encounter market volatility or risk. Identifying the institution’s willingness and ability to assume risk arms the Committee with the necessary clarity to specify the level of risk it can live with. This can often be accomplished by determining the allowable maximum potential drawdown, or losses that would not jeopardize the long-term success of the institution’s mission. Failure to define the organization’s risk tolerance may lead to investment losses greater than the institution can afford during a bear market or insufficient long-term investment earnings to fund spending needs. Ensuring that the institution’s ability to assume risk is compatible with its long-term objectives will aid the Committee in finding a risk tolerance that is neither too aggressive nor too conservative, but just right.
While inflation and market volatility present meaningful pitfalls, the first lever, expected outflows, cannot be overlooked. Future spending commitments or outflows, whether to finance a mission in perpetuity, a specific project over a finite period or simply a “rainy day” fund, are a major consideration in formulating the required return within the overall Investment Policy. Understanding the expected size, predictability, volatility, flexibility and driving factors of spending or outflows is vital to the sustainability of the institution’s long-term mission. Similar details are necessary to establish the second lever, anticipated inflows. The quantity, predictability, volatility, flexibility and driving factors of donations or other expected inflows are vital to discuss. Looking at the inflows and outflows on a net cash flow basis and as a percentage of total assets will quantify the cash flow needed by your organization.
If at the end of your walk through the forest you discover that your institution’s mission is to maintain purchasing power, exist in perpetuity and maintain net cash outflows of 4% per year, the three levers exercise would suggest a required return of at least 7% (3% inflation plus 4% cash flow need) in order to meet long-term objectives. This requirement, of course, must be compatible with your assumed level of volatility, or risk, and your asset allocation. This process will guide you to a responsible Investment Policy, and if you ever wake up to find a bear market in your boardroom, know that you can sleep at night in a bed that is neither too hard nor too soft, but just right.
Please contact any of the professionals at DiMeo Schneider & Associates, L.L.C. to review your three levers and optimal asset allocation.
