How to Maintain an Endowment’s Value and Generate Annual Income

Non-profit and charitable institutions can reap great benefits if they’re fortunate enough to receive an endowment. With a few key practices, the original fund can remain stable while providing a steady source of spendable income.

Endowments are funds donated to charitable institutions or non-profit organizations to provide for their operational needs or to achieve a specifically set aim. Endowments generally have a usage policy alongside their withdrawal and investment elements. How much can be drawn from this fund, where an endowment manager can invest, and the manner the money may be used in are typically built-in rules that accompany the gift.

Endowments take several forms: restricted, unrestricted, quasi, and term. The expenditure of a restricted endowment is limited by the donor’s wishes, while an unrestricted one may be spent at the recipient’s discretion. Quasi-endowments are funds set aside by an organization’s board to generate investment income. In contrast, term endowments have the proviso that all or part of the principal sum may be used only upon the achievement of a specific goal or the elapsing of a stated time period.

The principal amount of the endowment typically must remain intact in perpetuity with only the income drawn from its investments or interest from the principal’s growth being spent. Beyond this common rule, “best” practices for endowment management are essentially those allowances/restrictions set forth by the donor(s), since their wishes take precedence.

If the donor has not provided a particular set of instructions on how an endowment should be managed, the recipient can then look to the Uniform Prudent Management of Institutional Funds Act (UPMIFA) for secondary guidance (so long as the nature of the endowment is not quasi).

The role of the UPMIFA

The Uniform Prudent Management of Institutional Funds Act was approved in 2006 as an amendment to the more restrictive rules of its predecessor, the Uniform Management of Institutional Funds Act (UMIFA). The UPMIFA has been adopted in all but two states (Pennsylvania and Puerto Rico) and exists to provide organizations with direction on endowment spending and charitable investing.

The latter act improves upon the former by allowing for both total-return investing and the practice of modern portfolio theory. The UPMIFA also removed the “spending floor” limitation, where endowment spending was limited to, and not below, the original gift’s historic dollar value. It now allows institutions to spend appreciation and income in the amount and manner they feel is prudent.

UPMIFA rules can differ between states, such as with New York’s version of the Act—the NYPMIFA—passed in 2010. Like any investment, an endowment portfolio has a duty to diversify and these decisions can be guided by the 7 UPMIFA steps—guidelines which help organizations more accurately define what a prudent endowment expenditure/investment would be.

Breaking down the 7 steps for best endowment management practices

  • Assessment of current economic conditions – A currently strong or weak investment market should be an aid to endowment distribution decisions. A favorable outlook may be a good indicator to proceed. Its opposite could lead to not only loss but diminishing of the principal sum; a shortfall which the recipient would have to make up from their own funds to honor the preservation agreement.
  • Promotion of asset sustainability over time – Since the principal likely must remain whole in perpetuity, long-term sustainability of organizational assets should be a prime factor in endowment spending.
  • Consideration of inflation and deflation – Both the principal and distribution of an endowment are affected by inflation, making this another key consideration. The spending power of an endowment fund is weakened if asset returns do not exceed the spending policy, plus inflation.
  • Shared purpose of the endowment and the institution – Before investing or spending, the recipient should consider if their decision strengthens and reflects the mission of their organization and, if applicable, the wishes of the donor. It will be necessary for a non-profit to prove this on its financial statement (articles 10 and 11c).
  • Expected returns – Endowment returns should exceed the rate of distribution. This requires a thorough consideration of investment risk across the endowment portfolio.
  • The investment policy of the institution – While endowment investing is a separate endeavor from other investment types, the policy and strategy an institution employs here should reflect its overall approach to investing. Restrictions, risk tolerance and other financial factors may vary between organizations, so each recipient must factor in their individual circumstances to arrive at a prudent level of expenditure.
  • Further institutional resources – Endowment recipients should consider which other financial resources they have to draw on aside from the endowment. It may be prudent to prioritize spending from those resources in order to leave the endowment invested and providing returns.

Endowment recipients may also choose to adopt a further sub-section of the UPMIFA as a best practice. The sub-section recommends that annual endowment expenditures not exceed 7 percent of the total value of the principal amount.

Some further considerations on endowment management

Endowments of all sizes require administration and sound financial advice if they’re to prosper. Recipients may have to hire and retain a professional wealth management and investment firm to provide that insight, so payment for these services must be part of the overall calculations. Bank fees are a further consideration if a recipient chooses to manage an endowment alone.

Endowment prudence is a delicate balancing act of maintaining the fixed sum of the principal beside the fluid, flexible nature of the best portfolios over the long term.

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