Endowment funds 101: What is an endowment fund, UPMIFA, spending policy and more

Answers to common endowment questions

Endowments are a powerful tool for non-profits, donors and fundraisers to magnify their social impact. Even experienced endowment fiduciaries and fundraisers often benefit from improving their understanding about what endowments are and are not, how to guide donors around unintended consequences, and how to frame a win-win-win value proposition for donors. In this article, we’ll focus on helping you answer some of the critical questions related to your endowment.

What is an endowment fund?

An endowment fund is generally a pool of assets donated to a non-profit organization, with the expectation that the funds will last into perpetuity while providing a stream of spending to support the non-profit’s mission. The non-profit must invest the money prudently and develop an appropriate spending method in order to respect the donor’s intent and maintain the inflation- and cost-adjusted principal (known as the “corpus”) over a reasonable period of time.

To the surprise of some endowment fiduciaries, not all endowment-like entities are actually endowments. Funds that do not have such donor-imposed restrictions are generally not endowments, and as a result, are not subject to all of the same rules as true endowments.

Is your endowment fund truly an endowment?

While asking whether or not your endowment fund is truly an endowment may seem odd, it is a fundamental first question for endowment fiduciaries because the answers determine the rules and regulations to which your fund is subject. These rules will guide how your fund should be managed to achieve your goals and be in compliance with the Uniform Prudent Management of Institutional Funds Act (UPMIFA), if required.  It may also raise more questions:

• Is your fund subject to UPMIFA?
• Is your fund required to have a spending policy?
• How do you prudently determine spending policy for your fund?
• Is your investment policy appropriately linked to spending policy?

When is spending restricted vs. unrestricted?

Funds donated as true endowment funds are subject to prudent spending restrictions.  In contrast, funds donated with unrestricted spending do not require a spending policy. A non-profit may choose to spend such funds over the time frame of its choosing, which includes the option of designating such funds as temporarily or permanently “Board-endowed”, aka “quasi-endowed,” following an endowment-like investment and spending policy approach.

Donors may also establish spending restrictions as temporary, and may establish other types of restrictions. The non-profit has the right to decline donations that come with restrictions or intent that is not consistent with the non-profit’s mission, or that are not sufficiently operationally feasible.

It is advisable for non-profits to carefully draft a donor gift form to clarify expectations for both the donor and non-profit, and to encourage the donor to understand and avoid applying spending or other restrictions that might unintentionally be inconsistent with the non-profit’s mission and modern best practices.

For example, income-only spending restrictions may lead to unintended negative consequences, relative to the use of a total-return and prudent spending policy approach. Similarly, establishing specific investment restrictions may have the effect of reducing diversification, and lead to a sub-optimal overall risk/reward profile.

Note:  A non-profit may commingle both restricted and unrestricted assets for investment purposes, while using appropriate accounting methods to ensure that any restrictions are properly respected.

What is UPMIFA?

UPMIFA is the Uniform Prudent Management of Institutional Funds Act, enacted in 2006, and adopted by the vast majority of US states, including California. It is a uniform law that provides guidance on investment decisions and endowment expenditures for nonprofit organizations. UPMIFA replaced UMIFA (the Uniform Management of Institutional Funds Act of 1972).

What are UPMIFA’s three guideline levels?

Most non-profit entities and their endowment funds are subject to one or more of the guidelines of UPMIFA. However, whether or not an organization or funds are subject to the three different levels of UPMIFA guidelines varies based on which definitions are met:

1. Institutions

Most non-profit organizations, and some corporate and governmental entities qualify as “institutions” under UPMIFA. UPMIFA “institutions” are generally defined as entities with charitable purposes.

2. Institutional funds

“Institutional funds” under UPMIFA are investment assets held by an institution exclusively for charitable purposes, and must follow UPMIFA guidelines regarding prudent management. Excluded from this definition are “program-related assets” held by an institution primarily to accomplish a charitable purpose of the institution and not primarily for investment.

3. Endowment funds

Under UPMIFA, “endowment funds” are a subset within “institutional funds” that, or any part thereof, fall under the terms of a gift instrument not wholly expendable by the institution on a current basis. Endowed fund status triggers spending rule requirements.

UPMIFA rules and restrictions

Funds that are not wholly expendable have spending restrictions, and spending must or should rely on prudent spending policy methods, for the purpose of long-term sustainability (avoidance of inflation-adjusted and cost-adjusted corpus erosion) and meeting the donor’s intent.

When funds are “institutional funds” but not technically “endowment funds,” but are treated as a “quasi-endowment,” it is generally advisable to use UPMIFA guidelines for endowed funds as a best practice regarding prudent spending policy. In addition, quasi-endowment fiduciaries should be careful not to label their quasi-endowment as an “endowment” because it may trigger the UPMIFA endowed funds requirements.

Private endowments, unless explicitly stated otherwise, may also be subject to UPMIFA “endowment fund” rules and have minimum spending requirements. Conversely, a fund held by an individual to benefit a charity, a fund held by a for-profit company for charitable purposes are not “institutional funds” under UPMIFA, and therefore, are not governed by UPMIFA. Funds subject to the oversight and special requirements of certain industry-specific regulatory bodies may be subject to UPMIFA “institutional funds” requirements, but may not be subject to UPMIFA “endowment fund” requirements, even if they are endowment-like. That said, where some or all UPMIFA guidelines do not apply, following UPMIFA, where relevant, is generally a best-practice.

Additionally, the definition of an endowment under UPMIFA is or may be different than the definition for accounting purposes. For example, an operating bank account, a development fund to pay for a new facility, and an endowment are all considered “institutional funds” under UPMIFA.

How is a UPMIFA’s prudent spending policy or rule developed?

Where spending rules are required, UPMIFA contains a set of seven factors that must be considered when developing spending policy, including:

1. preservation of the fund,
2. purpose,
3. expected return,
4. inflation,
5. general economic conditions,
6. the charity’s other resources, and
7. investment policy.

Without carefully considering these factors, the organization’s spending and mission may be under-achieved by underspending, or damaged through corpus erosion from overspending.

When developing a spending policy, two common methods include the “implied spending policy” and “required return” approaches. The expected returns of an investment portfolio, as well as inflation, cost projections and other factors should be considered towards developing a spending rate that avoids corpus erosion, where required or desired.

When capital markets produce higher or lower levels of returns or inflation for an extended period of time relative to projected returns and inflation, spending policy may merit careful temporary adjustments.

Endowment fund benefits

Endowments, whether true or quasi-endowments, present a powerful opportunity to make a valuable social impact. When non-profits and their donors accomplish their missions, the organization, contributor and community all win.

Endowment unfamiliarity

If you are an endowment fiduciary and these topics are not entirely familiar to you, you are not alone. Endowments often start small with well-meaning philanthropically-minded people who may not have expertise in the regulatory or best practices related to endowments. As endowments grow, there are few natural or trigger events that systematically lead to an awareness of the regulatory dynamics, and many fiduciaries rely on investment advisors who may be well-versed in the investment process, but who may be equally unfamiliar with UPMIFA and endowment best-practices.

Expert endowment investing and consulting fiduciary support

With so much to know and consider about endowments, endowment fiduciaries can benefit greatly from having an experienced, qualified advisor to guide them. At The Advisory Group, we specialize in helping fiduciaries, namely in California, create effective spending policy and investment policy processes and implement consistent with the guidelines of UPMIFA. This assistance frees up endowment fiduciaries to focus on their mission, reduce complexity and improve perception and engagement with their donor community.  If you’re interested in having a conversation about your endowment or endowment-like fund, please reach out.  It would be an honor to guide you in support of your mission.

This article is intended as a general overview regarding endowments and endowment-like funds, and does not intend to be a comprehensive summary. Appropriate investment, spending-policy, legal, accounting and other support expertise should be obtained to address each non-profit’s goals and circumstances.