Every nonprofit organization benefits from endowments. They can provide financial stability and serve as a nest egg of capital to generate income. It’s important to remember that not all endowments are built the same. Managing and spending these funds needs a responsible and strategic approach. A well-defined endowment spending policy dictates how the funds are utilized and should align with the organization’s mission while simultaneously being financially sustainable.
Endowment spending policies guide how organizations, particularly universities, foundations, and nonprofits, manage withdrawals from their endowment funds. These policies aim to balance current spending needs with the long-term growth of the endowment, ensuring sustainability and intergenerational equity
This is often easier said than done. It takes a lot of hard work to make an endowment grow at a sufficient rate so it can be maintained indefinitely. Nonprofit leadership needs to consider spending policies that make sense while remaining tactful enough to appease donors and often public opinion.
First, what are the key elements of a solid endowment spending policy?
We’ll start with an Endowment’s Spending Rate. This is the percentage of the endowment’s market value that is allowed to be spent annually, often adjusted based on a moving average to smooth out market fluctuations. Prior to 2006 when the laws governing endowments were re-written, endowments were required to maintain historical dollar value of the gift which typically meant the nonprofits invested in bonds and used the interest payments as their “spend rate”.
Now, Endowments can invest in equities and bonds so the spend rate is typically based on the total return of the portfolio over a given time period, which in the low-rate environments of the past 25 years, has provided better overall spending for nonprofits as well as growing the principal amounts of most endowments.
Another important element to include in policies is a mechanism for inflation adjustment. The policy needs to address the ability to increase spending over time to account for inflation, so the purchasing power of the endowment remains stable for the nonprofit.
We can’t forget donor intent! This is key to any policy when the donor has put restrictions on the spending. For instance, a donor may require a specific time horizon in which to spend the funds, making that portion of the endowment, a “term endowment”. Or a donor may have specific programs in mind for spending and that also needs to be taken into consideration.
Because donor intent is critical to both informing the spending policies and to following UPMIFA, [link to UPMIFA article] we advise all nonprofits to develop donor acceptance agreements along with Gift Acceptance Policies. These don’t have to be overly complex or long documents, but they do need to spell out donor intent and guide your organization on acceptable gifts that fit both the organization’s mission and your staff resources.
Both Principal Protection and Current Economic Conditions are also key elements in an endowment’s spending policy. Your endowment’s primary goal is to protect the corpus of the initial endowment over the long term while still providing sufficient funds for current programs and operations. In addition, a good policy has flexibility to adjust spending based on market fluctuations and overall economic conditions. If the global economy is in a recession as happened in 2008, your policy should allow for flexibility and UPMIFA supports this as well. If your organization needs to take its regular distribution in a year much like 2008 and it will dip into the Corpus, UPMIFA will allow for this consideration and your policy should reflect that as well.
So how and when does an organization determine the spend? Should it be stated in the policy?
Yes, both the how and when should be stated in the investment policy. When: Depending on your organization’s fiscal year, you may want to have the annual distribution from your endowment coincide with the end of your fiscal year. For example, if your fiscal year is July 1 through June 30th, then your organization may want to take the distribution around July 1st so the funds are available at the start of your new fiscal year.
How Much? Most states follow the same or similar core principles of UPMIFA which outlines that spending must be prudent. In California, anything over 7% is considered imprudent and most California-based nonprofits have spending rates of 5-6% documented in their spending policies. New York’s policy (NYPMIFA) is similar, and spending is deemed imprudent if it exceeds 7% of the endowment’s fair market value over a five-year period. However, the board can appropriate above 7% if they document how they reached that decision.
What formula should nonprofits use to determine the annual spend from the endowment? There can be endless combinations and slight variations, but we’ll focus on 4 different formulas:
- Simple: A nonprofit’s policy can state a spending of 5-6% of the prior calendar year’s market value.
- Moving Average: Spend 5-6% of the prior three years’ average ending market value or the average of the preceding 12 quarters’ ending market value.
- Inflation-based: In year 1, the nonprofit follows a 5% distribution and then in future years, the rate of spending increases by the rate of inflation with a cap of no more than 7% as anything above that would be considered imprudent.
- The Tobin Rule: This policy, named for James Tobin who won the Nobel Prize in Economics in 1981, sets the annual distribution in a particular year through a quantitative formula that has a “stability” term – the prior year’s spending adjusted for inflation – and a “market” term – the long-term sustainable rate of distribution times the market value of the Endowment. By selecting the weightings between these two terms, an organization can determine the pace at which variations in market value are incorporated into spending.
University and hospital endowments which are typically older and more established, may reference The Tobin Rule in their spending policies. Simply put, The Tobin Rule allows for greater balance between funding current operations through a consistent inflation-adjusted increase in spending while also maintaining the long-term purchasing power of the endowment.
MIT changed their spending formula to the Tobin Rule during the market downturn of 2008 in order to meet the needs of current scholars while ensuring the long-term purchasing power of the endowment.
Most importantly, nonprofit organizations need to consider current operating needs or grant-making efforts, preserving intergenerational equity and maintaining stability of the endowment so that purchasing power is not diminished.
This is a tall order, especially as it relates to the intergenerational equity component which means spending neither too much, so the amount left for future generations is substantially diminished nor spending too little such that current needs are being neglected in order to preserve for the future.
The concept of intergenerational equity keeps evolving as well. As an example, with the rise of student debt over the past 25 years, some congressional representatives want to see college and university endowments with over $1 billion in assets to offer coverage for some or a majority of their students tuition. With rules around endowment spending and donor intent, this may not be possible. However, it has sparked a debate as to why some college and university endowment assets are ballooning while the tuition costs keep rising exponentially beyond what working and middle class students can afford.
In the next chapter to our series, we will cover who is responsible for overseeing the endowment.
Fairlight Advisors
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