The Law of Endowments – Things Have Changed

The declining market has caused nonprofits to fret about the value of their portfolios and the appropriateness of their spending rates. Most, if not all, endowment funds created in the past six years are “underwater”—a phrase used to indicate that the fair value of the investments in the fund are less than the gift that created that fund. Many older funds may also be approaching that condition. This article addresses the impact of the declines on endowments, and how a new law, the Uniform Prudent Management of Institutional Funds Act (UPMIFA) and a new Financial Accounting Standards Board (FASB) standard may help you respond.

The old law, the Uniform Management of Institutional Funds Act (UMIFA) provides rules regarding how much of an endowment a nonprofit could spend, for what purpose, and how the nonprofit should invest the endowment funds. The old law was out-of-date, particularly as to management, investment, and spending issues. This was especially exposed as the “down” market resulted in many “underwater” endowments.

Under the new law, the Uniform Prudent Management of Institutional Funds Act (UPMIFA), a nonprofit can continue to spend from underwater endowment funds, as long as the Board determines that is a prudent thing to do. Under the old law, spending was limited to income and net appreciation of the endowment’s investment- dividends, interest, etc. Historic dollar value—defined as the sum of the original gift, any subsequent gifts added to the fund, and any accumulations added to the fund pursuant to the gift instrument—had to be maintained inviolate under the old law. The new law (UPMIFA) eliminates the historic dollar value limitation, thereby increasing an organization’s ability to apply a total-return spending rate to its funds. UPMIFA replaces historic dollar value with a new standard of prudence.

“Subject to the intent of a donor expressed in the gift instrument, an institution may appropriate for expenditure or accumulate so much of an endowment fund as the institution determines is prudent for the uses, benefits, purposes, and duration for which the endowment fund is established.”

The intent is not to allow an organization to totally spend the fund, but rather to be responsive to spending needs during market declines while encouraging the organization to preserve the purchasing power of the endowment fund. Acting prudently and in good faith, the organization must consider a list of defined factors and decide how much to spend from an endowment fund. UPMIFA does not have an explicit requirement to preserve the purchasing power or to permanently retain any amount.

The old law provided a standard of care in investing comparable to a ordinary and business care and prudence that applies to investments and distribution decisions. The new law, UPMIFA, also articulates a general standard of care for both managing and investing an endowment. It requires the Board (and others responsible for managing and investing) to act in good faith and with the care of an ordinary prudent person. It takes the experience from UMIFA portfolio management and provides standards and guidelines the experience told us are most appropriate. The nonprofit must consider:

General economic conditions;
Effects of inflation and deflation;
Tax consequences;
The role of each investment in the overall portfolio;
Expected total return from income and appreciation;
The nonprofit’s other resources, and
The needs of the nonprofit and the funds to make distributions and preserve capital.

UPMIFA provides that an individual investment must be analyzed in the context of the total portfolio and the overall risk-reward objectives, and that a nonprofit can invest in any kind of property that is not inconsistent with the standard of care.

Illinois UPMIFA Law – Modification of Restriction on Charitable Funds
Under Illinois’ UPMIFA law, if a nonprofit determines that a restriction contained in a gift instrument on the management, investment, or purpose of an institutional fund is unlawful, impracticable, impossible to achieve, or wasteful, the nonprofit organization, 60 days after notification to the Attorney General, may release or modify the restriction, in whole or part if:

The institutional fund subject to the restriction has a total value of less than $50,000;
More than 20 years have elapsed since the fund was established; and
The nonprofit uses the property in a manner consistent with the charitable purposes expressed in the gift instrument.

By permitting the nonprofit to make appropriate modifications in connection with such old and small funds, the expense of a court proceeding, which is often prohibitive as to such small funds, is avoided. Note: the donor, even if available, need not be given notification in the case of such a modification of an old and small fund.

The Accounting Standards
Because UPMIFA allows an organization to spend from an endowment fund without distinctions between permanent and expendable resources, the Financial Accounting Standards Board (FASB) needed to clarify whether any portion of a donor-restricted endowment fund of perpetual duration could be classified as permanently restricted. FASB did this by issuing FSP FAS 117-1, Endowments of Not-for-Profit Organizations: Net Asset Classification of Funds Subject to an Enacted Version of the Uniform Prudent Management of Institutional Funds Act, and Enhanced Disclosures for All Endowment Funds.

FSP FAS 117-1 builds upon existing standards when it states that an “organization that is subject to an enacted version of UPMIFA shall classify a portion of a donor-restricted endowment fund of perpetual duration as permanently restricted net assets.” The amount classified as permanently restricted is “the amount of the fund that must be retained permanently in accordance with explicit donor stipulations or that, in the absence of such stipulations, the organization’s governing board determines must be retained (preserved) permanently consistent with the relevant law.”

FASB determined that the more robust guidelines for appropriation for expenditure in UPMIFA-based law create a time restriction. FSP FAS 117-1 states that for each donor-restricted endowment fund, a nonprofit under the old law “shall classify the portion of the fund that is not classified as permanently restricted net assets as temporarily restricted net assets (time restricted) until appropriated for expenditure by the organization.” In states where UPMIFA has not been adopted yet, the act of appropriation has no effect on the classification of net assets.

In states, like Illinois, with a UPMIFA-based law, however, the appropriation releases the time restriction on the net assets and, in the absence of purpose restrictions, results in a reclassification of the appropriated amount to unrestricted net assets. If an endowment fund is subject to a purpose restriction, the reclassification of the appropriated amount does not occur until the purpose restriction also has been met.

FSP FAS 117-1 also states that, consistent with existing standards, “the portion of a donor-restricted endowment fund that is classified as permanently restricted net assets is not reduced by losses on the investments of the fund, except to the extent required by the donor. Likewise, the amount of permanently restricted net assets is not reduced by an organization’s appropriations from the fund.”

New Disclosures
FASB also used FSP FAS 117-1 as an opportunity to improve disclosures about endowments for all organizations whether under UMIFA or UPMIFA law. FSP FAS 117-1 requires all organizations with endowment funds (both donor-restricted and board-designated) to make additional disclosures in four areas.

Net Asset Classification. Organizations will be required to disclose their interpretation of the law(s) underlying the net asset classification of donor-restricted endowment funds.
Spending Policies. Organizations will be required to disclose their policies for making appropriations for expenditures from endowment funds.
Investment Policies. Organizations will be required to describe their investment policies for endowment funds, including matters such as return objectives and risk parameters for the funds, how those objectives relate to the spending policies for the funds, and the strategies employed for achieving the objectives.
Net Asset Composition and Changes in Net Assets. Organizations will be required to provide:

The composition of the organization’s endowment by net asset class at the end of the period, in total and by type of endowment fund, showing donor-restricted endowment funds separately from board-designated endowment funds.
A reconciliation of the beginning and ending balances of endowment funds in total and by net asset class. This reconciliation must include, at a minimum, the following line items, as applicable: investment return separated into investment income (e.g., interest, dividends, and rents) and net appreciation or depreciation of investments; contributions; amounts appropriated for expenditures; reclassifications; and other changes.

Conclusions
UPMIFA and FSP FAS 117-1 are a dramatic change in endowment management and reporting. By placing more importance on prudence and the legal significance of appropriation, they create temporarily restricted net assets from unrestricted net assets and change the manner in which those restrictions are fulfilled. FSP FAS 117-1 will likely result in possibly sizable reclassifications from unrestricted net assets to temporarily restricted net assets in many nonprofit organizations.

These changes are likely to surprise and confuse many people. It took Dugan & Lopatka’s team of nonprofit experts a couple of readings and a seminar or two to get our arms around the new rules and their implications for our clients. If you need help, give us a call.