Is your nonprofit’s spending policy still working?
A thoughtful spending policy helps nonprofits balance today’s funding needs with tomorrow’s financial stability. Now is an ideal time to evaluate whether your current approach supports your mission. Here’s a look at common spending policies and what to consider when determining the best fit for your organization.
Review regularly
Your spending policy determines how much of your investment portfolio is tapped each year for expenses such as operating costs and capital projects. Because every nonprofit has different financial needs and objectives, there’s no one-size-fits-all optimal spending policy.
It’s generally advisable to stick with your spending policy once it’s established, but periodic reviews are important. Your board and executive leadership team should regularly evaluate your policy to ensure it continues to align with your nonprofit’s mission, financial goals, liquidity needs and long-term sustainability.
Understand your options
Several common spending policies have emerged, each with its own pros and cons. They include:
Fixed-rate. Also known as the simple spending rule, this approach applies a set spending rate annually to the investment portfolio’s market value at the beginning of the fiscal year. The policy is simple to understand and apply, but it can cause significant spending fluctuations from one year to the next, based solely on the portfolio’s performance the previous year. Over a multiyear period of strong investment performance, the fixed-rate approach can lead to the highest spending increases compared with other techniques. This may reduce the portfolio’s long-term growth potential.
Inflation-based. With this method, the nonprofit sets an initial spending amount, which is then adjusted annually for inflation (sometimes with a cap and a floor based on the beginning market value). This can simplify budgeting and stabilize spending, but annual distributions tend to be smaller than those from other approaches. As a result, this method may help preserve and grow the investment portfolio over time.
On the other hand, the inflation-based method can allow more spending during challenging times than the rolling-average method. (See below.) Of course, this higher spending can also eat into the portfolio. Because inflation can rise or fall significantly over time, organizations using this approach should periodically review whether their assumptions and adjustment methodology remain appropriate.
Rolling-average. Here, the organization applies a spending rate to a moving average of the market value of its investment portfolio, typically calculated over a three-year period. A rolling average generally provides more consistency in spending from year to year but is vulnerable to market volatility. For example, this method could lead to more spending than is wise in a year when the portfolio value has dropped substantially. Conversely, it may produce a spending amount that’s too low when your nonprofit needs additional financial support.
Geometric spending. The formula for geometric spending is complicated, but it reflects both inflation and market movement. Although it can be difficult to calculate, geometric spending reduces year-to-year volatility and can lessen the impact of market declines on spending.
Hybrid. This approach generally considers both inflation and market value. A large portion of annual spending is based on an inflation adjustment to the previous year’s spending. The remainder is based on a fixed rate — for instance, applying a fixed rate to the portfolio’s market value or to a percentage of its rolling average. Hybrid spending policies tend to produce stable spending both in dollar amounts and as a percentage of portfolio value.
Note that each of these policies generally should include a provision allowing spending to exceed the prescribed amount if determined necessary by the board of directors or another authorized party.
The right policy matters
If it’s been several years since your organization last reviewed its spending policy, or if your financial circumstances have changed, now is a good time to take another look. Contact us to evaluate your current spending policy and help ensure it supports your mission for years to come.
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Our team has experience serving a diverse range of tax-exempt organizations, including private and charter schools, churches, environmental organizations, animal shelters, labor unions, and other organizations recognized under Section 501(c) of the Internal Revenue Code. We understand the reporting, governance, and compliance challenges these organizations face and provide the guidance needed to support sound financial stewardship.
We understand the reporting and governance challenges nonprofits face and provide the guidance needed to support sound financial stewardship. Learn more about WCS’s nonprofit services and how our experienced professionals can assist your organization with audit and tax advisory needs. Contact WCS today to discuss how we can support your nonprofit.
