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We speak of a sponsor™s endowment fund as if that sponsor were the sole
owner. That™s true in one sense, but it™s a little more complicated than that.
There are two basic kinds of money in the endowment fund.

Donor Designated

Board Designated

Donor Designated endowment is money that was designated by the con-
tributor for the purpose of endowment. Legally, that is the only true en-
dowment. To keep faith with its contributors, and the law, the sponsor
should withdraw no more than annual income; the sponsor may not with-
draw principal. Under most endowment statutes, Imputed Income meets
this requirement of not withdrawing more than annual income, provided
the de¬nition of Imputed Income has been established rationally. In fact, I
would contend that the Imputed Income approach meets the intent of en-
dowment statutes far better than the traditional de¬nition of income (inter-
est and dividends, etc.).

Ibid., p. 38.
“Owners” of the Endowment Fund

Board Designated money is money the sponsor™s board of directors
chose to treat as endowment. It is not legally endowment, and future
boards may at any time withdraw the entire principal if they so choose,
since one board cannot bind a future board in this regard. But the sponsor
has every reason to treat Board Designated endowment as true endow-
ment, investing it with a long-term approach in the hope and assumption
that future boards will treat it similarly.
Why would a sponsor™s board choose to designate new contributions
as endowment?

Many sponsors encourage their supporters to include the sponsor in

their wills. Bequests are a wonderful support for any sponsor. But be-
quests come in lumpy fashion”a whole lot one year, very little the
next, with no way of predicting the pattern. Few bequests are desig-
nated by the donor speci¬cally for endowment. But bequests should
generally not be put into the operating budget, since they can™t be bud-
geted for. Hence many sponsors have a standing board resolution that
all bequests are automatically to go into endowment.
Sponsors receive other unexpected gifts during the year, such as gifts in

memory of a supporter who has just died. These also are best shunted
directly to endowment.
If the sponsor is fortunate to end a year with a budget surplus, one of

the things the sponsor might consider doing with the surplus is direct-
ing it to endowment, where it can bene¬t the sponsor for years to
come rather than arti¬cially easing the sponsor™s operating budget for
just the coming year.

Use-Restricted Endowment
Many donors restrict their contributions to particular uses that are impor-
tant to them. For example, a sponsor might receive two large contribu-
tions”one simply restricted to Program X, and the other designated for
endowment and also restricted to Program X.
The sponsor would now have four endowment fund “owners”:

1. Donor Designated, Restricted to Program X: The donor designated
the gift to endowment and restricted it to Program X.

2. Donor Designated, Unrestricted: The donor designated the gift to en-
dowment but didn™t restrict its use to any particular program.
3. Board Designated, Restricted to Program X: The donor restricted
the gift to Program X but the board, not the donor, designated it to
4. Board Designated, Unrestricted: The donor didn™t restrict the gift
to any program, and the board, not the donor, designated it to

A large sponsor, such as a university, could conceivably have dozens
of restricted endowments, some of them Donor Designated, and some
Board Designated. Each of these endowments must be accounted for
separately, so that the income from each can be used for its particular
If we have a dozen such endowments, we can invest each separately,
receiving from our custodian a separate statement on each. Or we can do
things a simpler way, a way that both saves cost and leads to better invest-
ment returns: We can coinvest all such endowments as a single endow-
ment fund.
But then how do we keep each endowment separate? Through unit ac-
counting, just like a mutual fund. That means we must unitize our endow-
ment fund. Each of the “owners” of the endowment fund is credited with
units every time a contribution is made for that owner, just as we are cred-
ited with shares every time we buy a mutual fund, and vice versa for with-
drawals. That way, the value of the endowment fund held for each
“owner” is kept distinct regardless of how diverse the contributions and
withdrawals on behalf of each “owner”.


An endowment fund is intended to provide perpetual annual income to

its sponsor. That annual income should be reasonably predictable and
over the long term should at least maintain its buying power.
Our endowment fund can best meet these objectives if annual income

is calculated under the Total Return, or Imputed Income, approach”
such as a reasonable percentage of the fund™s average market value
over the last ¬ve years.
Appendix 9: The Total Return or Imputed Income Method

The Total Return or Imputed Income Method

1. For any ¬scal year, Imputed Income equal to 5% of the Base Market
Value of the Endowment Fund shall be withdrawn and realized as in-
come for that year.
2. The Base Market Value shall be the average market value of the En-
dowment Fund on December 31 of the last ¬ve calendar years. The
market value at prior year-ends, however, shall be increased for contri-
butions (or decreased for withdrawals, if any, other than withdrawals
of Imputed Income) made subsequent to those years according to the
following procedure: A contribution (or special withdrawal other than
Imputed Income) shall be valued at 95% for the ¬rst year-end prior to
the contribution (or special withdrawal); 90% for the second prior
year-end; 85% for the third prior year-end; and 80% for the fourth
prior year-end.3
3. The timing of withdrawals of Imputed Income during each ¬scal year
shall be at the discretion of the Finance Committee. At the time an Im-
puted Income withdrawal is to be made, the Investment Committee
shall decide from which investment manager(s) the withdrawal shall
be made. If a separately managed account does not hold enough cash
to meet the withdrawal, the manager of that account shall sell assets
suf¬cient to meet the withdrawal.
4. Withdrawals of Imputed Income shall be allocated to the accounts
of the various owners of the endowment fund4 on the basis of the
relative market values of those owners™ accounts as of the latest

On the following page is a sample Imputed Income worksheet.

If we don™t adjust prior yearend market values for subsequent contributions,
the effect would be to take only 1% (1/5 — 5%) of a new contribution in year
one, because the latest year-end market value determines only one-¬fth of
Base Market Value. Similarly the effect would be 2% in year two, 3% in year
three, etc.
Such as “Donor Designated, Restricted to Program X,” or “Board Designated,

Sample Imputed Income Worksheet
- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -Adjusted Year-End Market Values - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
Market Net Imputed
Date Entry Value Contributions 12/31/96 12/31/97 12/31/98 12/31/99 12/31/00 12/31/01 12/31/02 12/31/03 12/31/04 12/31/05 5-Yr. Total Income

12/31/99 MV 0 0 0 0 0
Year ™00 C 100,000 80,000 85,000 90,000 95,000
12/31/00 MV 100,000 80,000 85,000 90,000 95,000 100,000 450,000 4,500
Year ™01 C 56,500 45,200 48,025 50,850 53,675
12/31/01 MV 165,816 130,200 138,025 145,850 153,675 165,816 733,566 7,336
Year ™02 C 550,000 440,000 467,500 495,000 522,500
12/31/02 MV 800,000 578,025 613,350 648,675 688,316 800,000 3,328,366 33,284
Year ™03 C 300,000 240,000 255,000 270,000 285,000
12/31/03 MV 1,210,000 853,350 903,675 958,316 1,085,000 1,210,000 5,010,341 50,103
Year ™04 C 8,000 6,400 6,800 7,200 7,600
12/31/04 MV 1,210,000 910,075 965,116 1,092,200 1,217,600 1,210,000 5,394,991 53,950
Year ™05 C 12,000 9,600 10,200 10,800 11,400
12/31/05 MV 1,390,000 974,716 1,102,400 1,228,400 1,221,400 1,390,000 5,916,916 59,169

C = Net Contributions (net of any withdrawals other than of Imputed Income)
MV = Market Value
Last column = 1/5 of 5-Yr. Total, times 5%

What™s Different
about Pension Funds?

Preface: “Pension plan,” as used in this chapter, will refer only to
de¬ned-bene¬t pension plans, not de¬ned-contribution pension
A de¬ned-bene¬t plan is a traditional pension plan, where the
bene¬t is de¬ned as an annuity”$X a month for the rest of our
life”or a cash balance pension plan, where the bene¬t is de¬ned
as a lump sum. In either case, the plan sponsor bears the entire
risk or opportunity of investment results. The employee is entirely
A de¬ned contribution plan, such as a 401(k) plan, is one
where the employee bears the entire risk or opportunity of invest-
ment results. Within the investment options provided by the plan,
the employee decides how his particular account will be invested.

First, what™s similar about pension funds and endowments? Most things.
They both want the highest long-term return they can achieve within
an acceptable level of risk. The process of developing their investment pol-
icy and asset allocation, and hiring and monitoring managers, is essentially
the same, and so are the principles of governance. In fact, almost everything
written in the ¬rst eight chapters of this book applies to pension funds as
well as endowment funds.
So what™s different (besides the fact that private pension plans are gov-
erned by ERISA)? A pension plan™s de¬nition of risk should be different.
For the endowment fund, risk is the volatility in the market value of its


portfolio. For pension funds, risk is the possibility that the plan won™t be
able to pay all promised pension bene¬ts to retirees. As long as the plan
sponsor remains solvent, that™s not much of a risk, because if pension as-
sets fall short of pension liabilities, the plan sponsor must make higher
contributions to the pension fund. So risk for the plan sponsor is just
that”the possibility of the sponsor having to make greater contributions
to the pension fund, perhaps suddenly much higher.1
A measure of risk for the pension plan therefore is its funding ratio”
the ratio of the market value of plan assets to the present value of the
plan™s liabilities, and both change from year to year. That™s because a de-
clining funding ratio means the plan sponsor will have to come up with
higher contributions to the plan.


In truth, the promises the pension plan has made to its participants don™t
really change much from year to year. They change only by the amount
of additional bene¬ts employees have accrued each year. What changes
is the present value of those promises. What do we mean by present
If we promise to pay someone $1,000 ten years from now, what is our
liability today? Certainly not $1,000. We could put a lesser amount in the
bank today, and that would grow into the $1,000 we need 10 years from
now. That lesser amount, realistically, is our liability today. The amount we
need today”the present value”depends on what rate of interest we expect
we can earn. And reasonable people can™t agree on what rate of interest we
should assume.
Financial accounting standards say the interest rate assumption should
vary each year depending on the change in the prevailing interest rate on
corporate bonds. That™s the interest assumption that determines the pre-
sent value of pension liabilities shown in a company™s annual report. The
Pension Bene¬t Guarantee Corporation, as an insurance company, uses an
interest rate more closely related to the interest rate on long government

If pension assets fall short and the sponsor becomes insolvent, then the risk falls
upon the insurer”the federally chartered Pension Bene¬t Guarantee Corporation.
Investment Implications

bonds. That results in a much higher present value of pension liabilities.
For other purposes, other interest assumptions are made.
The key point is that pension liabilities change each year with interest
rates. As interest rates go down, liabilities go up. And vice versa. So trying
to maintain a level funding ratio”the ratio of assets to liabilities”is a
moving target. The market value of assets may have risen nicely last year,
but our plan™s funding ratio might be down if interest rates have dropped
sharply at the same time.


What does this mean for the investment of a pension portfolio? It means
that risk is not just the volatility in the market values of assets but also in
the volatility in interest rates. A nice safe T-bill may be anything but safe
for a pension plan, because its future value is quite unpredictable relative
to the present value of pension liabilities.
What™s the safest asset for a pension plan relative to the plan™s liabili-
ties? It™s a very long-term government bond, whose market value is ex-
tremely volatile. But the volatility of its market value moves in synch with
the volatility in plan liabilities.
Given this complication, how do we develop the Policy Asset Alloca-
tion for our pension plan? The best way is to do an asset/liability study.
This study requires the same set of assumptions we discussed in Chapter
4 for an Ef¬cient Frontier. The study also includes a projection of plan
liabilities. It uses 500 or more Monte Carlo simulations to project the
range of probabilities for funding ratios, future contributions, and the
present value of all future contributions. Based on these de¬nitions of
risk, the study also indicates an Ef¬cient Frontier for each set of assump-
tions, and it also provides useful probabilities of unhappy results from
any given asset allocation.
Asset/liability studies are much more complex and expensive than sim-
ple Ef¬cient Frontier studies, and modest-size pension plans may feel they
can™t afford one. What are the main differences in the output?
The asset/liability study will recommend that all traditional ¬xed in-
come be allocated to very long durations, but in other ways its recom-
mended asset allocations are often not greatly different from those
indicated by a simple Ef¬cient Frontier study. The amount and duration
of the allocation to long-term ¬xed income will depend on the nature of

liabilities. If the pension plan is for a younger work force, the duration
of liabilities will be very long, and so might be the allocation to bonds. If
the plan is largely for older or retired employees, duration will not be
quite as long.


The sole purpose of a pension fund is to pay promised pension bene-

¬ts. Those promised bene¬ts are its liabilities.
We can best decide the Policy Asset Allocation of our pension fund

with the help of an asset/liability study.
Such a study will typically show that the least risky asset class for our

pension fund is not cash, but high-quality bonds of very long duration.

Once Again

embers of an investment committee need not be experts, but they
M should have some familiarity with investments. They should have open
minds and be willing to learn. They should make a commitment to attend
all meetings they possibly can and to review carefully any materials distrib-
uted in preparation for those meetings. The committee chairman should be
a strong leader who is focused, able to keep discussion on track, and can
bring committee members to ¬nal resolution on issues.

We committee members devote a relatively few hours per year to the
fund™s investments and should not try to go it alone. We need an adviser.
We should hire a chief investment of¬cer and staff, if the fund is large
enough to afford it, or else hire a consultant on whom we can rely for ed-
ucation, recommendations, and reporting performance. If the fund is too
small to afford a consultant, we should recruit a committee member with
experience in portfolio management who will serve the function of a

We should ¬rst establish a written Operating Policy, covering the commit-
tee™s procedures and responsibilities. We should also appoint a custodian
(usually a trust company) that will hold all of the fund™s assets and provide
timely reports on the fund™s market values.

Our most important task is to establish a written Investment Policy. This
statement should include a Policy Asset Allocation and benchmarks for
each asset class included in that Policy Asset Allocation. Our asset alloca-
tion will have far more impact on the fund™s future investment returns than
any other action we will take, including the selection of investment man-
agers. The range of asset classes we should include in that Policy Asset Al-
location far exceeds traditional ones of domestic stocks, bonds, and cash.


To the extent that we make use of all attractive asset classes we can, the ad-
ditional diversi¬cation can meaningfully reduce the fund™s volatility and
even ratchet up its expected return.

It is okay to be aware of conventional investment wisdom”what our peer
endowment or pension funds are doing. But let™s not become prisoners of
their investment objectives and constraints, or use them as our principal
benchmarks. Let™s do our own independent thinking as we set our Invest-
ment Policies and select our investment managers.

Only after deciding on our Policy Asset Allocation should we consider
who will be our investment managers. Our objective should be to hire
the best possible manager(s) for each asset class. Rarely does an invest-
ment ¬rm qualify as the best possible manager in more than one asset
class, so we should be prepared to hire multiple managers (or invest in
multiple investment funds), often more than a dozen, even for a very
small fund.

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