Two questions nonprofit leaders constantly ask us are:
- What should we do with our nonprofit reserves? and
- Should we have an endowment?
Neither question has a straightforward answer. There are so many variables that influence a reserves or endowment strategy.
For that reason, we created this overview to help nonprofit board members, executives and major donors understand some general factors and considerations that are critical to understanding your reserving and endowment strategy. This is an introduction and will require further discussions with leadership, the board of directors and legal and financial professionals.
There are four basic ways an organization might choose to use accumulated reserves.
- First, to smooth income or manage fluctuations in the timing of donations or grants to
effectively pay for fixed monthly expenses, such as rent and salaries. - Second, to pay for an unexpected emergency, such us an operational mishap or a sustained downturn due to an external event.
- Third, to make a strategic purchase of say, a building or other capital asset.
- Fourth, to make a long-term investment toward the expansion of the organization’s programs.
The strategy to invest and manage accumulated reserves is based upon several factors that are inherent to the
targeted use of the funds. We will focus on three important ones here.
Liquidity
Liquidity is the ease at which an asset can be converted to cash. Savings accounts, money market accounts and short-term Treasury securities are examples of very liquid investments. Illiquid assets are those that cannot be quickly converted to cash. Examples include real estate, equipment or collectibles.
Volatility
Volatility describes the amount of change a price experiences over time, typically measured by standard deviation. An asset whose prices swings widely, rising and falling over a sustained period, is said to be volatile. Low volatility assets exhibit more stable and steady price changes over time.
Time Horizon
Time Horizon is the time interval from when funds are invested to when the funds are used for their intended purpose. Funds to be used within two years is typically said to be short-term. Medium term is considered between two years and ten years and long-term is a period of over ten years.
These three factors—liquidity, volatility and time horizon—are interrelated and critical in determining the appropriate investment strategy for the organization’s strategic goal. Let’s look at our four uses of funds and their corresponding investment strategies. The following are for educational purposes only and are not specific investment instructions.
Income Smoothing
If the timing of donations and grants are not perfectly timed with expenses, the funds need to be
readily available to pay for income gaps until funds are available. These funds need to be available as soon as possible, highly liquid and value of the funds largely predictable.
Appropriate investments for income smoothing could be a savings or checking account, a money market fund or maybe a short-term CD, if the exact timing of the expense need is known.
Unexpected Emergency
If the objective for reserves is restore the organization after an unexpected emergency, the funds should also be liquid, relatively stable and short-term, particularly for incidents that are very likely to occur within a 12-month cycle.
Some emergencies, on the other hand, might occur every other year or maybe once every five years. Organizations should have funds available for these less frequent incidents as well, but funds could be invested in less liquid and/or more volatile assets that are more likely to grow in value than ultra liquid, ultra stable assets. A short-term bond fund might give the organization sufficient liquidity as well as some value growth to keep up with inflation.
Strategic Purchase
Now let’s consider the organization that is making a strategic purchase, perhaps a major
renovation or new building, or needed equipment and must accumulate funds over a few years to afford the purchase. The organization may decide that keeping the funds in a highly liquid, very low volatility investment might not appreciate enough to afford the purchase in the medium term. In that case, the investment can be less liquid and more volatile to attempt to grow the value of the account to keep up with the price of the asset.
But there is risk with this approach. For example, if the price of the real estate or whatever the planned purchase is,
increases faster than the value of the funds saved to purchase it, the organization must have a plan to make up that gap.
Program Expansion/Innovation
If the organization has funds for ongoing support and innovation in the form of a restricted endowment or an unrestricted board-designated fund, investments should be diversified across the spectrum of the three factors—liquidity, volatility and time horizon—to ensure the funds have a chance to grow with investments that are typically less liquid like riskier stocks, but are also fortified with against downturns in the economy with more stable priced and more liquid investments, like bonds.
Endowment Basics
Let’s turn to the basics of endowments, as it’s the most recognized strategy an organization uses to invest large
amounts of money.
- Endowment is for either a medium-term specific purchase or it could be for long-term, ongoing support.
- The funds in an endowment can be restricted by a donor, considered a true endowment, or unrestricted as with a board-designated fund or quasi-endowment.
- The original invested value or “principal” must be maintained over the life of the endowment, but the earnings
on the endowment, in the form of income and value appreciation, are typically unrestricted. - A true endowment restricted by a donor is governed by an Investment Policy Statement and UPMIFA.
When establishing an endowment, it is critical that the board, in its role as a fiduciary execute an Investment
Policy Statement to establish clear objectives and management policies. The Investment Policy Statement can be broken into two major parts.
The first part is the Introduction, which spells out the purpose of the endowment, the roles, responsibilities and standards of conduct expected of the board and any hired investment professionals. The introduction also sets out the investment goals and the return expectations of endowment.
The second part goes into the details of the endowment’s investment management principles. These principles include how much risk the endowment will accept, what investment are permitted and how these principles will be monitored.
In essence, the Investment Policy Statement sets out standards for the endowment that are maintained throughout the life of the endowment, keeping fiduciaries accountable for its supervision.
If the endowment is funded by donor-restricted gifts, the fiduciaries are required to adhere to the Uniform
Prudent Management of Institutional Funds Act or simply, UPMIFA.
Uniform Prudent Management of Institutional Funds Act
UPMIFA is the law in 49 states including California, Washington D.C. and the Virgin Islands.
There are three key provisions of UPMIFA.
- Spending and investment guidelines dictated by the donor supersede any standards set forth in UPMIFA.
- The board must use prudence in selecting an investment professional, establishing investment guidelines
reviewing performance. - Spending policies are established to ensure the original intent of the donation is maintained. In CA, spending over 7% of the value of the endowment is considered imprudent unless the organization can demonstrate that excess spending is acceptable.
Prudent Spending Under UPMIFA
What does prudent spending look like under UPMIFA? Let’s look at the seven factors.
- Assets and distributions should be managed in such a way as to promote the
sustainability of the assets over time. - Spending and distribution policies should be designed to support the mission.
- General economic conditions must be taken into account when determining the annual distribution.
- Spending policy should always account for the effects of inflation or deflation.
- In crafting a spending policy, an institution should consider what returns are realistic relative to the return, risk, and liquidity profile of the portfolio.
- When determining a spending policy, it is important to consider the other financial resources.
- The investment policy needs to be flexible enough to establish sustainable spending.
Not every endowment should be governed by UPMIFA. If you are uncertain, contact a legal professional. Even if you are not required to follow UPMIFA, its guidelines can help to instill discipline in every step of the process, including portfolio construction, scheduled distributions, and ongoing strategic reviews.
With some understanding of the requirements, planning, careful implementation and regular monitoring, your reserves can be an effective tool to build a strong foundation for your organization and grow well into the future.
Talk to the financial experts at Fairlight Advisors to learn more about managing your nonprofit’s investments. Schedule a free consultation today!
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