Let’s say a community health clinic receives a $1 million donation to establish a permanent endowment fund specifically for providing free vaccinations to underserved populations. Ideally this gift would give the organization the ability to navigate financial uncertainties with confidence, ensuring it delivers on the mission to provide vaccines through economic highs and lows. For nonprofits managed over 20 years ago, this wasn’t necessarily the case. Back then, regulations would have restricted the health clinic’s ability to manage the endowment should health care prices skyrocket, for example or if it wanted to invest in a new, more effective way to deliver vaccinations.
For many years, nonprofits were required to maintain the “historic dollar value” of their endowments, meaning they couldn’t spend below the original value of contributions. This often led to overly conservative investment strategies focused on preserving principal rather than achieving growth.
Enter the Uniform Prudent Management of Institutional Funds Act or UPMIFA. UPMIFA, introduced in 2006, was legislation that allowed nonprofits to invest more strategically to better support their missions over the long term. UPMIFA provides nonprofits with legal guidance on endowment investment and spending decisions in 49 states and Washington, D.C. This transformative regulation empowered institutions to make more suitable investment choices, adapt to changing market conditions, and maximize their impact.
There are three key provisions of UPMIFA.
- The Donor’s Guidelines Are Fundamental
Spending and investment guidelines dictated by the donor are the most important goals of any endowment and supersede any standards outlined in UPMIFA.
- Spending Policies Must Be Established
Spending policies to fulfill the endowment’s philanthropic mission are established to ensure the original intent of the donation is maintained.
If the donor is silent on how much of the endowment to spend every year, your state’s UPMIFA will stipulate what is considered imprudent. For example, in CA spending over 7% of the value of the endowment every year is considered imprudent unless the organization can demonstrate that excess spending is acceptable. Most nonprofits spend about 5% of the value of their endowment every year. Private foundations are required to spend at least 5%. Minimum spending and payouts are required to ensure the endowment is using funds toward a philanthropic purpose and not just holding onto gifts.
- Prudent Investment Management
The organization must use prudence in managing and monitoring the endowment fund as it pertains to investing, spending, and selecting investment professionals.
Seven Factors of Prudence
Prudence is perhaps the most important element of UPMIFA and requires policies, procedures, and resources to comply properly. From a legal perspective, prudence refers to the exercise of sound judgment, caution, and foresight when making decisions or taking actions. It involves acting with a reasonable standard of care based on what was known or should have been known at the time. UPMIFA stipulates seven factors which we will break down. Many of the factors are interrelated.
- Assets and distributions should be managed in such a way as to promote the sustainability of the assets over time.The investments and annual spending toward the philanthropic mission must be crafted so the endowment is maintained over its lifetime, as stipulated by the donor. For example, if the endowment is meant to be maintained for 30 years, the investments and spending must be managed in order that the endowment does not run out of money in under 30 years.
- Spending and distribution policies should be designed to support the mission. This factor simply instructs that all payouts from the endowment must be spent only on the endowment’s mission.
- General economic conditions must be taken into account when determining the annual distribution. Spending from the endowment must consider prevailing interest rates, unemployment, business cycles, and other factors that determine the health of a country’s economy.
- Spending policy should always account for the effects of inflation or deflation. Similar to the above factor that requires economic conditions to be considered, the fourth factor emphasizes the need for endowment spending to consider the rate at which prices are increasing or decreasing in the economy. This is important because the prices for the goods and services the endowment supports may change drastically from year to year. It may pay for much more one year and then far less the next.
- In crafting a spending policy, an institution should consider what returns are realistic relative to the return, risk, and liquidity profile of the portfolio.An endowment’s investment strategy must support an annual payout to support the mission. In other words, it can’t be too speculative, characteristic of investments that have a substantial risk of losing value in the expectation of outsized gains. Exuberance over a particular investment, like cryptocurrency, can lead to devastating losses. It also can’t be too conservative where there is no expectation of growth, and the portfolio will not keep up with rising prices. For example, a downturn in the economy can bring about so much fear in leadership that they move all endowment assets to cash, thereby missing a recovery in stock and bond markets.
Achieving a sound investment strategy requires diversification across several investment types for the endowment to be viable through many market and economic conditions. It also should adhere to the basic tenets of risk management. Crafting a sound investment strategy to achieve your nonprofit’s endowment spending policy often requires the assistance of an investment professional.
- When determining a spending policy, it is important to consider the other financial resources. As we all know, investment markets and the economy don’t always behave the way we’d like them to. For this reason, UPMIFA allows the nonprofit to spend an amount that reduces the endowment to a value below the original gift value or its “corpus”. In other words, it is permitted to spend an amount that leaves the endowment with less than what the donor gave. This is a major improvement over UMIFA, which we mentioned before did not allow spending more than the donor contributions. With UPMIFA nonprofits have flexibility in how they decide to maintain appropriate spending no matter the strength of the economy. In some years, nonprofits can decide to allow investments to grow rather than spend. In other years, nonprofits may decide spending is the prudent thing to do, even if the endowment investments have not shown a positive return.
- The investment policy needs to be flexible enough to establish sustainable spending. The investment strategy chosen to fulfill the endowment’s mission must be governed by a set of guidelines that is relevant and adaptable in most situations. This means that the policy need not be updated frequently based on changes within the organization and the prevailing economy.
Why is it important for a nonprofit with an endowment to take UPMIFA seriously? Donors and important stakeholders can file a complaint with that nonprofit’s state attorney general if they believe that the board of directors is mismanaging the funds of the endowment. While rare, a state’s Attorney General can bring an action to enforce the terms of a restricted gift.
Not every endowment should be governed by UPMIFA so contact Fairlight or a nonprofit professional to determine whether UPMIFA applies for your specific example. Board-advised funds and quasi-endowments are not governed by UPMIFA, but the guidelines still can help to instill discipline in every step of the process.
In the next chapter in our series, we cover the key elements of an Investment Policy Statement and how it applies to your organization.
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