Strategies for a Low-Return Investment Environment

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1 Summer 2013 Global Wealth Management BERNSTEIN NONPROFIT ADVISORY SERVICES MissionPossible Strategies for a Low-Return Investment Environment Low-return investment markets are a challenge for most endowments and foundations: When returns are subpar, normal spending will likely eat into principal. If this continues long enough, it can jeopardize a nonprofit s mission of perpetuity. Given current economic and capital market conditions, we project bond returns well below normal and stock returns slightly below normal over the next 20 years. Display 1 shows the likely impact on sustainable spending levels. Display 1 Portfolios Are Unlikely to Support Normal Spending Levels Sustainable Unitrust Distribution 20 Years* Median, Inflation-Adjusted 4.1% 4.8% 5.4% 4.2% Normal 3.3% 3.3% 1.2% 2.3% Current 20%/80% 40%/60% Stocks/Bonds 60%/40% 80%/20% *Sustainable unitrust distribution calculated at 50% level of confidence of maintaining inflation-adjusted portfolio value over 20 years. Stocks modeled as 21% US diversified, 21% US value, 21% US growth, 7% US small/mid-cap, 22.5% developed international and 7.5% emerging markets. Bonds modeled as intermediate-term global taxables. Based on Bernstein s estimates of the range of returns for the applicable capital markets over the next 20 years. Data do not represent past performance and are not a promise of actual future results or a range of future results. See Notes on Wealth Forecasting System on the last page for further details. Bernstein does not provide tax, legal, or accounting advice. In considering this material, you should discuss your individual circumstances with professionals in those areas before making any decisions.

2 Asset allocation involves balancing short-term and longterm risks. There is no risk-free option. A bond-heavy 20% stock/80% bond portfolio that would normally support spending at the 3.3% level will now support only 1.2% in annual spending. With a 60/40 portfolio, the normal level is 4.8% and the current level 3.3%. Organizations that exceed sustainable levels run the risk of depleting their capital over time. More Return-Seeking Assets? There are a number of strategies for meeting this challenge. Shifting to a more aggressive asset allocation could help, but this decision must be made with care. Foundations and endowments have to strike a balance between two countervailing risks: Increasing their allocation to equities will reduce the likelihood of depleting their capital over the long term, but it will also increase the odds of a steep short-term peak-to-trough portfolio loss. As Display 2 demonstrates, the greater this short-term risk, the smaller the long-term risk. There is no risk-free option here. After carefully considering both risks, leaders have to choose a point along the spectrum that they can live with. Display 2 Investors Should Weigh Two Different Kinds of Risk Short-Term Risk Probability of Peak-to-Trough Loss of 20%* Stocks/Bonds Long-Term Risk Probability of Depleting 20% of Principal 4% 20%/80% 45% 12% 40%/60% 25% 36% 60%/40% 18% 61% 80%/20% 15% *Projections indicate the probability of a peak-to-trough decline in pretax, pre-cash-flow cumulative returns of 20% over the next 20 years. Because the Wealth Forecasting System uses annual capital market returns, the probability of peak-to-trough losses measured on a more frequent basis (such as daily or monthly) may be understated. The probabilities depicted above include an upward adjustment intended to account for the incidence of peak-to-trough losses that do not last an exact number of years. See Display 1 footnote for information on asset allocation. Represents the probability of depleting 20% of the nominal portfolio value over 20 years, assuming a 5% unitrust distribution. Based on Bernstein s estimates of the range of returns for the applicable capital markets over the next 20 years. Data do not represent past performance and are not a promise of actual future results or a range of future results. See Notes on Wealth Forecasting System on the last page for further details. 2 Bernstein Global Wealth Management MissionPossible

3 Greater Diversification? Investing in a broader set of assets may also help: Introducing allocations to inflation-sensitive investments (such as real estate) and hedge funds could reduce the odds of an uncomfortably large short-term loss. As shown in Display 3, these added sources of diversification in a 60/40 portfolio could bring the probability of a 20% loss quite close to the level under normal conditions. Display 3 Additional Sources of Diversification Could Reduce Odds of Big Losses A board s choices include cutting spending somewhat, investing more aggressively, and accepting somewhat higher odds that assets will erode over time. Probability of Peak-to-Trough Loss of 20% Within the Next 20 Years* 36% 29% 23% 20% 60% Stocks/ 40% Bonds + Inflation-Sensitive Investments + Inflation-Sensitive and Hedge Funds 60% Stocks/ 40% Bonds Normal *Projections indicate the probability of a peak-to-trough decline in pretax, pre-cash-flow cumulative returns of 20% over the next 20 years. Because the Wealth Forecasting System uses annual capital market returns, the probability of peak-to-trough losses measured on a more frequent basis (such as daily or monthly) may be understated. The probabilities depicted above include an upward adjustment intended to account for the incidence of peak-to-trough losses that do not last an exact number of years. 60/40 + Inflation-Sensitive modeled as 52/40/8 (stocks/bonds/reits); 60/40 + Inflation-Sensitive and Hedge Funds modeled as 44.5/34.5/7/14 (stocks/bonds/reits/hedge funds). See Display 1 footnote for further information on asset allocation. Bonds for inflation-sensitive allocations modeled as 75% global taxables and 25% intermediate-term TIPS. Based on Bernstein s estimates of the range of returns for the applicable capital markets over the next 20 years. Data do not represent past performance and are not a promise of actual future results or a range of future results. See Notes on Wealth Forecasting System on the last page for further details. A Range of Options The wise course, we think, is to explore what combination of actions makes sense for a particular foundation or endowment. The menu includes cutting spending somewhat; investing more aggressively (and living with somewhat higher risk of a large short-term drawdown); and accepting somewhat higher odds that assets will erode over time. On the following pages, we discuss another key option on this menu: more extensive and effective fund-raising. MissionPossible Bernstein Global Wealth Management 3

4 Fund-raising can play a key role in keeping a foundation or endowment on a sustainable course. Fund-Raising Can Make the Difference When investment policy can t keep pace with spending plus inflation, foundations generally turn to fund-raising. Those that can raise enough to close this gap can go far toward assuring their continued survival because every dollar added to or maintained in an organization s portfolio can continue to earn investment returns into the future. But how much fund-raising is required, and how much is feasible? Display 4 shows fund-raising needs for foundations and endowments with a variety of asset allocation strategies and a range of spending levels. We ve shown the projected results for the 50th and 90th percentiles the 50th because it represents a likely outcome, and the 90th because it s close to a worst-case scenario. Both numbers are useful for planning purposes. Foundations and endowments that require a high level of certainty will be inclined to use the 90th percentile number. Those that can (or must) tolerate a greater level of risk will focus on the 50th percentile or something between the two. Display 4 More Fund-Raising Can Be the Critical Solution At the 50th Percentile of Confidence Stocks/Bonds (%) 20%/80% 40%/60% 60%/40% 80%/20% 10-Year Compound Real Return (No Spending) 0.9% 2.0% 3.0% 4.0% Additional Funds/Year ($000) Required for a $10 Million Foundation to Break Even Assuming a 4% Spending Rate* $310 $200 $100 * Breaking even is defined as earning a 0% return after inflation and spending. The amounts of funds raised shown here are for Year 1 and increase annually with the inflation rate. Using projected pretax 10-year compound annual growth rates. See Display 1 footnote for information on asset allocation. Fund-raising amounts are calculated as percentages of the initial portfolio value and then increased each year by the rate of inflation. Based on Bernstein s estimates of the range of returns for the applicable capital markets over the periods analyzed. Data do not represent past performance and are not a promise of actual future results. See Notes on Wealth Forecasting System on the last page for additional information. At the 90th Percentile of Confidence Stocks/Bonds (%) 20%/80% 40%/60% 60%/40% 80%/20% 10-Year Compound Real Return (No Spending) Additional Funds/Year ($000) Required for a $10 Million Foundation to Break Even Assuming a 4% Spending Rate* (1.8)% (1.4)% (1.2)% (1.2)% $580 $540 $0 $520 $520 4 Bernstein Global Wealth Management MissionPossible

5 We ve shown the results for a $10 million foundation with a 60/40 investment portfolio and a spending level of 4%. If the combination of returns and inflation is in the median range, the foundation will need to raise $100,000 a year, grown with inflation, to keep pace. With poor returns and high inflation, that figure rises to $520,000 a year. Why is the difference between these numbers so large? The answer is apparent in the rows marked 10-Year Compound Real Return. In the median situation, the 60/40 portfolio outpaces inflation by 3%, but in the dismal situation, it trails inflation by 1.2%. This may seem extreme, but it can occur when low returns coincide with high inflation. Results this poor have occurred in the past, but rarely. In fact, of the year periods from January 1926 through December 2012 that we studied, just five had real returns of (1.2)% or less. But with interest rates as low as they currently are, we find that the likelihood of such disappointing returns is substantially greater today than it has been historically. In the current environment, many organizations (and individuals) want to plan for just such a catastrophic set of long-term real investment returns. In combination with asset allocation changes and the acceptance of greater risks, fund-raising can play a key role in keeping foundations and endowments on a sustainable course. Bernstein Nonprofit Advisory Services Can Help New fund-raising targets often call for new fund-raising strategies. Bernstein supports fund-raising drives through services offered gratis to both organizations and donors. We help development officers reach and motivate donors, and we provide research-based insight into various giving techniques. We also educate donors on the basic economics of charitable giving and stress-test specific giving opportunities they are considering. For further information, please contact: Brian Wodar, National Director, Nonprofit Advisory Services Bernstein Global Wealth Management Brian.Wodar@Bernstein.com Events Bernstein Global Wealth Management Nonprofit Panel Discussion Making and Inspiring Large Gifts: An Insider s Perspective June 6, 2013 San Diego, CA Brian Wodar, National Director Bernstein Nonprofit Advisory Services Alan Sorkin, Past President Social Venture Partners International Gerald McFadden, President and CEO Volunteers of America, Southwest California Division Irma Cota, President and CEO North County Health Services Mark Stuart, President Foundation of the Zoological Society of San Diego Bernstein Global Wealth Management and Kiva New Trends in Philanthropy July 11, 2013 San Francisco, CA Premal Shah, Co-Founder and President Kiva Steve Schilling, Director Bernstein Global Wealth Management Chicago Council on Planned Giving Smarter Ways to Give: Maximizing Donor Impact in an Era of Higher Taxes and Lower Investment Returns September 10, 2013 Chicago, IL Brian Wodar, National Director Bernstein Nonprofit Advisory Services Clare Golla, Vice President Bernstein Global Wealth Management MissionPossible Bernstein Global Wealth Management 5

6 Notes on Wealth Forecasting System The Bernstein Wealth Forecasting System SM (WFS) is designed to assist investors in making a range of key decisions, including setting their long-term allocation of financial assets. The WFS consists of a four-step process: (1) Client Profile Input: the client s current assets, income, expenses, cash withdrawals, tax rate, risk-tolerance, goals, and other factors; (2) Client Scenarios: in effect, questions the client would like our guidance on, which may touch on issues such as which vehicles are best for intergenerational and philanthropic giving, what his/her cash-flow stream is likely to be, whether his/her portfolio can beat inflation long term, when to retire, and how different asset allocations might impact his/her long-term security; (3) The Capital Markets Engine: our proprietary model that uses our research and historical data to create a vast range of market returns, taking into account the linkages within and among the capital markets (based on indexes, not Bernstein portfolios), as well as their unpredictability; and (4) A Probability Distribution of Outcomes: based on the assets invested pursuant to the stated asset allocation, 90% of the estimated returns and asset values the client could expect to experience, represented within a range established by the 5th and 95th percentiles of probability. However, outcomes outside this range are expected to occur 10% of the time; thus, the range does not establish the boundaries for all outcomes. Further, we often focus on the 10th, 50th, and 90th percentiles to represent the upside, median, and downside cases. Asset-class projections used in this paper reflect initial market conditions as of December 31, They include the following median forecasts of 30-year compound rates of return: US diversified stocks (represented by the S&P 500 Index), 8.1%; US value stocks (represented by the S&P/Barra Value Index), 8.3%; US growth stocks (represented by the S&P/Barra Growth Index), 7.9%; developed international stocks (represented by the Morgan Stanley Capital International [MSCI] EAFE Index of major markets in Europe, Australasia and the Far East, with countries weighted by market capitalization and currency positions unhedged), 8.6%; emerging markets stocks (represented by the MSCI Emerging Markets Index), 6.9%; US small-cap and mid-cap stocks (represented by the Russell 2500 Index), 8.3%; taxable bonds (represented by diversified securities with seven-year maturities), 3.8%; and inflation (represented by the Consumer Price Index), 3.0%. Expected total returns on bonds are derived taking into account yield and other criteria. Globally diversified equity portfolios comprise an annually rebalanced mix of 21% US diversified stocks, 21% US value stocks, 21% US growth stocks, 22.5% developed international stocks, 7.5% emerging markets stocks, and 7% US small-cap and mid-cap stocks. Bonds are modeled as intermediate-term global taxables. An important assumption is that stocks will, over time, outperform long-term bonds by a reasonable amount, although this is by no means a certainty. Moreover, actual future results may not be consonant with Bernstein s estimates of the range of market returns, as these returns are subject to a variety of economic, market, and other variables. Accordingly, this analysis should not be construed as a promise of actual future results, the actual range of future results, or the actual probability that these results will be realized. Bernstein Global Wealth Management is a unit of AllianceBernstein L.P. AllianceBernstein and the AB logo are registered trademarks and service marks used by permission of the owner, AllianceBernstein L.P AllianceBernstein L.P. Global Wealth Management A unit of AllianceBernstein L.P Avenue of the Americas, New York, NY I I BER