A nonprofit with a few years under its belt will eventually ask itself, “Should we have an endowment?” And while this is not a straightforward decision, on balance, the answer is yes. From a fundraising perspective, a nonprofit endowment demonstrates to prospective donors that this is an organization that has meaningful financial support to fulfill its philanthropic mission. However, managing an endowment requires significant time and dedication from the board and staff to establish the objectives of the endowment and manage and monitor the investment performance.
Restricted endowments, where spending is restricted to a particular use by a donor, are regulated by the Uniform Prudent Management of Institutional Funds Act or “UPMIFA”. A Uniform Act is a legal template that allows states to customize laws as they see fit. UPMIFA provides nonprofits with legal guidance on endowment investment and spending decisions in 49 states and Washington, D.C.
There are three key provisions of UPMIFA.
One: The Donor’s Guidelines Are Fundamental
Spending and investment guidelines dictated by the donor are the most important goal of any endowment and supersede any standards set forth in UPMIFA.
Two: 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.
Three: 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.
Demonstrating prudence is perhaps the most involved and requires policies, procedures and resources to comply properly. The law stipulates seven factors which we will break down. Many of the factors are interrelated.
1. 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.
2. 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.
3. 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.
4. Spending policy should always account for the effects of inflation or deflation.
Similar to the above factor that requires economic conditions 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.
5. 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 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.
To achieve a sound investment strategy requires diversification across several investment types in order that the endowment 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’s spending policy often requires the assistance of an investment professional.
6. 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 means that 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.
7. 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. For 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.
If your nonprofit is seriously considering launching an endowment or has just received a large gift and is uncertain how and where to start, please consult with an investment professional focused on nonprofits as well as a nonprofit attorney. With some understanding of the requirements, planning, careful implementation, and regular monitoring, your endowment can be an effective tool to build a strong foundation for your organization and grow well into the future.
For more information on UPMIFA, refer to these sources.
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