Cash may not be king for nonprofits looking to build wealth and make an impact

Erika Murphy is a portfolio manager on a team that manages multi-asset class portfolios on behalf of institutions, including endowments and foundations (E&Fs) and pension plans. Here she shares her insights on why nonprofits may want to consider investing their funds in capital markets rather than hold cash. She also looks at the negative implications of an all-cash portfolio over the long-term.

Sitting on cash vs. investing in markets

For new or very risk-averse nonprofit organizations, we often hear these clients and prospects hesitate to invest endowed assets for fear of market-driven losses. What is more, many of these organizations have been taking comfort in the level of returns offered by cash and short-term bonds of late. Some might ask what could go wrong with just holding these low-risk investments when they offered near 5% annual yields as of mid-March 2024.

Our research shows that there are two probable negative outcomes for endowments when strategically holding a significant cash position:

1. Inflation can erode the real wealth of any portfolio over time, especially for a portfolio that is heavily invested in cash.

2. Annual spending naturally erodes endowed assets (and the level of future spending) unless portfolio returns exceed the nonprofit's spending rate. We do not expect cash rates will persist at current elevated rates, and therefore an all-cash portfolio is unlikely to generate sufficient returns to offset nonprofits' typical 4%—5% annual spending over the long term.

The inflation conundrum

It is common knowledge that inflation drives up the costs of goods and services over time. For nonprofits to have a consistent level of impact, endowment assets and grants need to keep up with inflation. Exhibit 1 highlights the changes in college and health care costs over the last two decades. In 2004, for example, an endowment with $10 million invested in short-term Treasury bonds and a 5% annual spending policy (approximately $500,000 in year one) would have been able to send approximately 100 students to an in-state college. Fast forward to 2024, and the same endowment would only be able to send about 50 students to an in-state college.

Why is this? Over the last 20 years, short-term Treasury bills have only returned 1.5% per annum, while annual spending has persisted (in this case at 5%) and the cost of in-state college tuition has grown by 4.9% per year, resulting in tuition rates more than doubling over this period (Exhibit 1).

Exhibit 1: The costs that many nonprofits aim to subsidize can grow materially each year. For example, college costs and total national health care spending have been on an uptrend over the last 20 years.

Source: U.S. News & World Report, as of September 22, 2023; KFF analysis of National Health Expenditure (NHE) data, by Matthew McGough, Aubrey Winger, Shameek Rakshit, and Krutika Amin, "How has U.S. spending on healthcare changed over time?", Peterson-KFF Health System Tracker. ^* NHE data as of 2022.

Because investment returns from cash or short-term Treasury bills were not high enough to offset both the 5% spending rate and the higher costs of education, the nonprofit organization illustrated above would have been forced to accept a lesser impact of their annual spending (sending fewer students to college), or dip into their endowed capital to maintain their level of impact in the short-term (assuming a constant spending rate).

The long-term risk of cash

Given the mission-orientation of nonprofits, maintaining the level of impact is paramount. However, by dipping into endowed funds to offset rising costs, nonprofit organizations effectively shrink their long-term wealth. This has a knock-on effect and could mean smaller charitable gifts in subsequent years. To illustrate this, we have created a model that shows the real wealth of a hypothetical $10 million nonprofit that has a 5% annual spending policy, based on a 5-year moving average asset value. We show two hypothetical investment portfolios: a). 100% cash portfolio, and b). 70% global equity/30% core bond portfolio (Exhibit 2).

The analysis shows that a 100% cash portfolio could lose more than 30% of its real value over 10 years and 60% of its real value over 20 years. But by investing in a 70% global equity/30% core bond portfolio, endowments and foundations could capture market returns which over time will help better offset inflation and the 5% spending rate. While real wealth in the 70/30 portfolio is still likely to erode over time, the portfolio is likely to still preserve 90% of its wealth over 10 years and over 80% of its real wealth over 20 years.

Comparing the two options, even though cash may seem less risky—due to inflation, annual spending needs, and relatively low expected cash returns—an endowment's real wealth is likely to decline much faster when investing in a 100% cash portfolio compared to a more risk-seeking portfolio such as the 70% equity/30% bond portfolio.

Exhibit 2: Nonprofits' real wealth is eroded much faster when invested in a 100% cash portfolio compared to a 70% equity/30% bond portfolio.

Simulated Real Wealth Over Time

Note: Assumes a $10 million starting value with a 5% annual spending rate based on a 5-year rolling market value and a 2.6% constant inflation rate. Projections are hypothetical in nature, have inherent limitations, do not reflect actual results, and given that market conditions may vary, are not guarantees of future results. Based on a Monte Carlo simulation analysis using Fidelity Global Institutional Solutions' capital market assumptions. Real wealth growth shown represents the median of the simulation. For illustrative purposes only to depict the probability and range of results based on Fidelity's simulations, historical analysis, and research. This is not meant to be exhaustive of all possible options or analysis an institution may wish to consider and will not necessarily come to pass. The hypothetical portfolios are comprised of 100% cash and 70% global equities and 30% U.S. aggregate bonds; Inflation measured by year-end annual headline CPI inflation. Sources: Fidelity Investments, MSCI Inc., Bloomberg Finance L.P., Bureau of Labor Statistics, as of December 31, 2023.

What does this mean in terms of charitable donations?

Declines in real wealth are critical to avoid, as they are very likely to result in declines in charitable giving over time. Based on our modeling, we show that a $10 million nonprofit with a 5% annual spending policy would have a much greater charitable impact over time if it were to invest in a 70% equity/30% bond portfolio (Exhibit 3). If the organization invested in a 100% cash portfolio, we estimate the $10 million (nominal) nonprofit with a 5% annual spending rate would decline to a $6.6 million nonprofit in 20 years; and the annual spending impact would decline from $500,000 per year to about $350,000 per year. Conversely, by investing in a 70% equity/30% bond portfolio, the $10 million nonprofit would grow to $13.8 million over 20 years in nominal terms and would be able to grow annual spending from $500,000 during the first year to over $665,000 in 20 years. Notably, in both the 100% cash and 70% equities/30% bond portfolios, wealth and spending impact would be lower in real terms after 20 years (much more for the 100% cash portfolio).

Exhibit 3: Our modeling shows nonprofits could have a larger charitable impact over time if they invested in a diversified portfolio.

Nominal Annual Spending ($)
($10M starting endowment value, 5% annual spending rate)

Note: Assumes a $10 million starting value with a 5% annual spending rate based on a 5-year rolling market value and a 2.6% constant inflation rate. Projections are hypothetical in nature, have inherent limitations, do not reflect actual results, and given that market conditions may vary, are not guarantees of future results. Based on a Monte Carlo simulation analysis using Fidelity Global Institutional Solutions' capital market assumptions. Real wealth growth shown represents the median of the simulation. For illustrative purposes only to depict the probability and range of results based on Fidelity's simulations, historical analysis, and research. This is not meant to be exhaustive of all possible options or analysis an institution may wish to consider and will not necessarily come to pass. The hypothetical portfolios are comprised of 100% cash and 70% global equities and 30% U.S. aggregate bonds; Inflation measured by year-end annual headline CPI inflation. Sources: Fidelity Investments, MSCI Inc., Bloomberg Finance L.P., Bureau of Labor Statistics, as of December 31, 2023.

Conclusion

Although cash does have appeal given its high current return and limited drawdown profile, we do not expect these levels of return to persist. In addition, we do not expect cash returns will be able to offset both inflation and nonprofit spending rates over the long term. Rather, our analysis shows that the long-term expected outcomes of an entirely cash portfolio include lower real wealth, lower annual spending abilities, and in turn, lesser charitable impacts. By taking more risk in capital markets, we expect nonprofit portfolios can better offset the long-term impacts of inflation and annual spending.