Steady as She Goes: How Smoothing Supports Nonprofit Spending

While nonprofit organizations often hold investment reserves to help sustain their mission, their leadership faces a significant challenge. As they create annual budgets and forecasts, they aim for a reliable and consistent revenue stream from their portfolios. Yet, portfolios designed for long-term growth are bound to encounter bouts of volatility. Even with diversification, the financial seas go through rough stretches.

Compounding the issue, many institutions withdraw a percentage of their portfolio annually to fund operations, leading to maddening fluctuations in available funds to support their operating budget. In turbulent markets, fiduciaries face a difficult choice: scale back operations or continue spending through the downturn, precisely when their services might be needed most.

The Quest for Consistency

Instead of de-risking their investment allocations—which can undermine long-term returns—many nonprofits have adopted a “smoothing” formula in their spending policies. Smoothing involves setting the spending rate as a percentage of the portfolio’s market value, averaged over a multiyear period (typically 12 quarters or three years), rather than just one year. Put simply, think of smoothing as a ship’s bow, cutting through choppy waters.

Let’s look at a historical example that shows how smoothing can cushion the impact of market downturns on distributions. Consider a nonprofit with a $10 million portfolio, distributing 5% per year starting in 2005 (Display 1). The blue line, which reflects distributions without smoothing, started at $500,000 in 2005 and quickly grew to over $600,000 by 2008. Then came the first of two massive declines. Without a smoothing policy, distributions plummeted by 35% to $391,075 in 2009. Then, after a prolonged recovery, the organization faced another sharp drop of 21% in 2022.

How would the organization have fared with a smoothing policy in place? Imagine the nonprofit withdrew 5% annually, using a 3-year smoothing approach. The journey becomes much steadier—the declines and rebounds less pronounced. For instance, in 2009, the smoothed distribution would have decreased by only 7% to $525,830. That’s because smoothing enables the organization to spend more during down markets and less in up markets, providing a more balanced and predictable outlook.

Some fiduciaries might wonder, “Doesn’t this threaten the long-term viability of the portfolio?” In a word, no. Over 30 years, the organization would have withdrawn nearly the same amount: $11.0 million with smoothing versus $11.1 million without (Display 2). And what about the portfolio’s ending value? It would have grown to $13.5 million with smoothing, compared to $13.4 million without. Ultimately, smoothing has little impact on the portfolio’s longevity, while offering a more stable ride along the way.

This approach provides nonprofits with a huge advantage. Reliable budget projections lead to fewer cash flow challenges, minimizing interruptions in mission-driven activities. Not surprisingly, smoothing policies have been widely adopted by large nonprofit institutions. According to the 2023 NACUBO-Commonfund Study of Endowments, 77% of respondents use a percentage of a moving average of their endowment’s market value for spending. And while lengthening the smoothing period tends to enhance the consistency of distributions, we’ve found that three years remains the most popular choice.

What Can Foundations Learn from This?

The role of foundations in philanthropy has grown significantly over the past few decades. In 2023, giving by foundations accounted for 19% of all charitable gifts, a substantial jump from just 6% in 1983.ⁱ For private foundation managers who are concerned about the volatility in their grantmaking budgets from year to year, the concept of “smoothing” may offer a partial solution.

In rising markets, a true smoothing policy would result in distributions falling below the IRS-mandated 5% threshold. This poses a significant problem because private foundations are legally obligated to meet the IRS’s annual distribution requirements, as we pointed out in our blog. But there’s a strategic advantage: if a foundation distributes more than the mandated 5%, the surplus can be carried forward and applied to reduce future distribution requirements for up to five additional tax years. Foundations can effectively implement smoothing by opting to distribute the greater of the IRS-required amount or 5% with 3-year smoothing.

To illustrate how this might work, let’s revisit our previous example, and assume we’re working with a $10 million private foundation. As before, the blue line reflects the foundation’s required 5% distribution without smoothing. But this time, the gold line illustrates a scenario where the foundation distributes either the IRS-required amount or a 5% payout with 3-year smoothing, whichever is higher (Display 3).

Following the market downturns of 2008 and 2022, distributions dropped in both cases. However, the decline was much less severe with a smoothing policy, providing crucial support to grantee organizations when they need it most. Interestingly, cumulative distributions once again remained nearly identical, though the portfolio’s ending value saw a slight decrease from $13.4 million to $13.2 million with smoothing (Display 4). For foundations interested in making multiyear grants but wary of financial commitments during market declines, a smoothing policy may be the answer. 

Optimizing Your Organization’s Financial Future

In the face of market volatility, a smoothing policy can help stabilize annual spending, avoiding the dramatic highs and lows. For directors of public nonprofits and private foundations, maintaining consistent distributions is crucial for supporting their constituents. Even minor tweaks to investment or distribution policies can significantly enhance your ability to fulfill your mission. While some institutions have adopted more complex spending strategies with inflation adjustments, floors, and ceilings, many have found that smoothing offers an optimal solution. If you’d like to explore how changing your organization’s spending policy could impact its financial future, please reach out to your Bernstein advisor.