Several discussion meetings have provided the following information about one of your firm's new advisory clients, a charitable endowment fund recently created by means of a one-time $10 million gift:
Objectives
Return requirement. Planning is based on a minimum total return of 8% per year, including an initial current income component of $500,000 (5% on beginning capital). Realizing this current income target is the endowment fund's primary return goal.
Constraints
Time horizon. Perpetuity, except for requirement to make an $8,500,000 cash distribution on June 30, 2017.
Liquidity needs. None of a day-to-day nature until 2017. Income is distributed annually after year-end.
Tax considerations. None; this endowment fund is exempt from taxes.
Legal and regulatory considerations. Minimal, but the prudent investor rule applies to all investment actions.
Unique needs, circumstances, and preferences. The endowment fund must pay out to another tax-exempt entity the sum of $8,500,000 in cash on June 30, 2017. The assets remaining after this distribution will be retained by the fund in perpetuity. The endowment fund has adopted a "spending rule" requiring a first-year current income payout of $500,000; thereafter, the annual payout is to rise by 3% in real terms. Until 2017, annual income in excess of that required by the spending rule is to be reinvested. After 2017, the spending rate will be reset at 5% of the then-existing capital. With this information and information found in this chapter, do the following:
a. Formulate an appropriate investment policy statement for the endowment fund.
b. Identify and briefly explain three major ways in which your firm's initial asset allocation decisions for the endowment fund will be affected by the circumstances of the account.