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Towers Watson: Optimal Modeling of Risk and Spending Are Critical for Nonprofits

Posted on 20 Sep 2011

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The simultaneous modeling of asset allocation and spending policies can improve the way in which nonprofit organizations manage the risk/reward trade-off in their investment programs, according to a white paper developed by global professional services company Towers Watson.

In its paper, Articulating Risk Helps You Achieve Your Mission, released by Towers Watson Investment Services, the company shows how nonprofits can evaluate and determine the appropriate balance of risks such as asset depletion, spending power erosion and liquidity with expected rewards.

Towers Watson demonstrates a modeling methodology that is tailored to each institution’s objectives, risk tolerances and policies. The approach combines highly technical asset modeling with an institution’s investment beliefs and governance budget, all of which affect how investment committees set and manage spending policy, asset allocation and risk.

“Our aim is to take a very close look into modeling and setting a risk budget, to determine how risks such as solvency, inflation, and asset depletion are affected by a nonprofit’s asset allocation and spending policy,” said Adam Levine, senior consultant, Towers Watson Investment Services. “We’ve found that many institutions make decisions about risk, asset allocation, and spending policy separately. However, making these decisions in isolation is not practical.”

Levine noted that the key components of the model are customized for each study and typically include spending policy, gifting policy, time horizon and risk/reward metrics, all of which are outlined in the Towers Watson paper.

The model also provides insight into:

* Future asset levels
* The probability of achieving a certain asset level over a given time frame
* The probability of assets depleting
* Total spending experienced over a given time frame
* The probability of a forced reduction in spending

“By looking at these elements in an integrated fashion, nonprofits can arrive at a better understanding of what scenarios might unfold, and then set these scenarios against their risk tolerance in a way that reflects reality,” said Levine.

The paper details Towers Watson’s robust, customized modeling, which includes 5,000 stochastic (or randomly generated) simulations of 25 years worth of potential economic scenarios; or whatever time period is important to the organization. These simulations aim to anticipate the likelihood of an endowment running out of assets at some point in the future given its current spending policies.

For instance, in one of the scenarios outlined, if an institution is considering a move from a 4 percent to a 4.5 percent spending policy, it may not be considering a simultaneous change to its asset allocation. However, increased spending under some scenarios could lead to unacceptable levels of asset depletion. The model helps an institution decide if it should consider an allocation that decreases its exposure to certain risks if a change in spending policy is needed.

“In the paper, we have taken a simple approach to spending by defining it as a percentage of current assets indexed to inflation,” Levine said. “But, we can use whatever spending policy the organization actually employs. By understanding and modeling the right spending rule while simultaneously considering an allocation policy, institutions will be better at defining their objectives and therefore better equipped to serve their missions.”