A Close Look at the Law Governing Endowment Funds

The Uniform Prudent Management of Institutional Funds Act, or UPMIFA, is a complex law that holds sway in almost every state in the nation. It covers how charitable institutions are to administer donor-permanently-restricted gifts. This law only applies to permanently restricted gifts made by donors to charitable institutions. It does not apply to charitable trusts or donor advised funds. It also does not apply to endowment funds established by a charitable institution itself from previously unrestricted funds.

For background, see my last post, "The Surprisingly Complex ABCs of Endowment Funds." This new post follows up on that discussion with a closer look at UPMIFA. 

The first principle that the UPMIFA law recognizes is that there are institution-created endowment funds and permanently-restricted endowment funds created by donor gifts. If you look at the dictionary definition of "endowment," however, you would think that all endowment funds are the samea fund that is permanently restricted to provide ongoing support for the charity. But the UPMIFA law only applies to funds given to a charity by a donor who has specified that the funds be permanently restricted.

However, when an institution establishes an endowment fund from unrestricted resources and refers to that fund as an endowment or as a fund-functioning-as-an-endowment or as a quasi-endowment fund, this author believes that the charity should also follow the UPMIFA law when administering those funds. Isn’t it only logical that a fund that functions as an endowment must follow the law of endowments? If an institution has created a fund that does not follow the UPMIFA law, then it should not refer to that fund as an endowment of any type.

The second concept that the UPMIFA law addresses is that endowment investments must be invested with the goal of maximizing total return. Using modern investment portfolio theory, the investment policy should be such that the charity is investing in a diversified portfolio that aims to maximize the total return from interest, dividends and net capital gains. Therefore, it would be inappropriate for an institution to invest its endowment assets all in one investment vehicle, such as bank certificates of deposit, common stocks, or corporate bonds. Rather, the institution should diversify its investments consistent with modern portfolio theory.

The next UPMIFA concept is that the permanently restricted endowment should provide the charity with annual financial support. Each year, the institution should receive some financial support from the endowment. Merely investing the funds without providing current support is inappropriate. In order to provide annual financial support, the charity must establish a spending policy. A spending policy will specify what percentage of the fund’s market value is appropriated for spending.

A typical spending policy for a charitable institution, one with a fiscal year end of June 30, will read something like this: The institution will appropriate for spending four percent of the 12-quarter average market value of the fund measured as of the previous December 31. Such a policy allows the institution to calculate (sometime during the first quarter of the year when the December 31 balances are available) the amount available for spending during the fiscal year beginning July 1. In addition, using a three-year (or 12-quarter) average market value insulates the institution from unusual market value highs or lows that might appear at a specific date in time. In this manner, the spending amount will rise or fall as the market value of the fund increases or decreases but the change in spending amount will be more gradual than the potential change in the fund’s current market value.

The amount that is appropriated for spending is considered current income for the charity. If the amount appropriated is not physically spent by the charity, it is no longer considered part of the permanently restricted endowment fund. It is now part of the unrestricted surplus. Even if the appropriated amount is not physically removed from the investment fund, it is still no longer categorized as endowment and must be categorized as unrestricted funds.

This can be very confusing to people. Accounting is a science that identifies funds according to financial accounting concepts. The UPMIFA law has identified some of the financial accounting concepts in the endowment area. The UPMIFA law determines when funds are categorized as permanently restricted and when they must be categorized as unrestricted. This categorization follows the concept regardless of the physical location or flow of the funds, even if they remain in the investment account.

The investment total return is therefore split between (1) the spending amount and (2) the remainder which is retained by the endowment fund. The amount that is specified for appropriation by the spending policy (and by default, the amount retained by the fund) must be determined in recognition of another UPMIFA concept. This one is called generational equity. A fund that is supposed to provide support for a charity permanently, i.e. forever, must take steps to assure that the amount of support provided by the fund a number of years from now will be as valuable as the amount of support provided today. In other words, the amount of support provided in the next generation should be as valuable as the amount of support provided to this generation—generational equity.

One easy way to understand generational equity is to consider a permanently restricted gift whose income is restricted to purchasing books for the library. If a donor gave a $50,000 gift and the spending policy was to spend 4 percent of the fund’s balance, in the first year, $2,000 would be available to purchase library books. If books cost an average of $100 each, this $2,000 would purchase 20 books. Generational equity means that 50 years from now, the charity should still be able to purchase 20 books per year. If we assume that inflation will average 2 percent per year, than in 50 years, the price of a library book will be $264. At that price, in order to purchase 20 books, the endowment principal will have to generate $5,280. With a 4 percent spending policy, the principal of the fund will have to have grown to $132,000 in order to generate $5,280 of annual spending.

In order to accomplish this, the $50,000 fund will have to grow by 2 percent per year. Since the spending policy calls for using 4 percent for annual appropriations, the investment policy needs to have an objective of producing a total return of at least 6 percent net of all other costs and fees. You can now see how the charity’s investment and spending policy work hand-in-hand to assure generational equity. The charity should monitor the balances each year to see if any adjustments are needed to either the investment or spending policy (or both) to assure generational equity. However, it is generally considered inappropriate to appropriate nothing in order to re-build the fund’s balance.

Development directors should be familiar with their institutions spending policy before speaking with potential donors about an endowment gift. It is important to be sure that the donor realizes the amount of annual support that his or her endowment gift will provide. This is especially important when the donor is making an endowment gift where the annual support is restricted to a specific purpose.

These are the basic concepts that have been enacted into law by the various state statutes. There are many minor complexities that deal with short-term fluctuations in the investment markets and other situations and provide charitable institutions with guidance for a variety of issues.