What It Takes to Manage an Endowment

Every not-for-profit dreams of receiving a large endowment that will keep it financially worry-free in the future and allow it to fulfill its mission with ease. But, in the real world, endowments also carry serious responsibilities, created by the Uniform Prudent Management of Institutional Funds Act (UPMIFA). When managing endowments, not-for-profit leaders must keep the following realities in mind. 

An investment policy drives fund management

Every endowment should have a comprehensive investment policy that drives the management of the fund. According to UPMIFA, investment decisions must be made in relation to the not-for-profit’s overall resources and purposes. And the endowment investment policy should be different from the policy for other investments of the organization. 

“Prudent” investment decisions must consider the entire portfolio and be made as part of an investment strategy with risk and return objectives reasonably suited to the fund and the organization. UPMIFA also permits “only investment costs that are appropriate and reasonable.” (UPMIFA applies only to “true” endowments funded by donors, not “quasi” endowments created by boards.)

The endowment’s objectives should guide its investments and management. For this reason, it’s important not to simply adopt a generic objective but to articulate an objective that reflects the organization’s own circumstances. For many not-for-profits, the primary goal is to preserve and grow funds for the organization’s long-term stability while providing a predictable contribution to support current activities. As a living document, the investment policy can change over time as objectives or other factors change.

Asset allocation is key

The investment policy will include an optimal asset allocation. The not-for-profit’s investment committee must analyze the risk and return of potential investments (including stocks, bonds and alternative investments such as hedge funds and private equity) to determine the best mix and to obtain the total desired return. To maintain flexibility for responding to changes in the investment environment, it’s best to establish ranges for each asset class instead of set percentages. The investment committee should review performance quarterly and adjust the allocations accordingly.

Your spending policy: A crucial component

The investment policy should include a spending policy for the endowment, setting a percentage that can be spent annually. The spending policy will impact the performance of the fund, as well as its ability to fulfill the donor’s intent.

UPMIFA sets standards for endowment fund spending. It provides that an organization can spend as much of a fund as it determines to be prudent for the “uses, benefits, purposes and duration” for which the fund is established. 

UPMIFA’s seven criteria to guide annual spending decisions are: 1) duration and preservation of the endowment, 2) the purposes of the organization and the fund, 3) general economic conditions, 4) effects of inflation/deflation, 5) expected total return from income and appreciation, 6) the organization’s other resources, and 7) the organization’s investment policy.

Unlike its predecessor, the Uniform Management of Institutional Funds Act, UPMIFA allows not-for-profits to adopt a “total return” strategy that bases the spending rate on the endowment’s total value (including appreciation) rather than on only income. To ensure reasonably consistent cash flows, many organizations using a total return spending policy apply “smoothing” mechanisms to minimize the effect of market volatility. An organization might, for example, use a three- or five-year rolling average calculation.

Benchmarks gauge performance 

The investment policy should include benchmarks for evaluating the performance of investments and managers, too. Performance should be assessed over both full market cycles (seven to ten years) and the shorter time periods that compose them. 

An investment committee can meet quarterly to review performance, consider recommendations for changes to the investment strategy and rebalance asset allocation as necessary.

GAAP requires disclosures

Whether or not it’s covered by UPMIFA, every endowment must make certain financial statement disclosures under Generally Accepted Accounting Principles (GAAP). Among these are descriptions of the organization’s endowment spending — and investment — policies, and of the nature and types of permanent or temporary restrictions on the endowment net assets. You also must report:

• The governing board’s interpretation of the law(s) underlying the organization’s net asset classification of donor-restricted funds, 
• The composition of the endowment by net asset class at the end of the period, in total and by type of endowment fund, with donor-restricted funds shown separately from board-designated endowment funds, and
• The aggregate amount of the deficiencies for all donor-restricted endowment funds where the fair value of the assets at the reporting date is less than the level required by donor stipulations or law.

Finally, be sure to include a reconciliation of beginning and ending endowments, in total and by net asset class.

Not just a dream

One of the most important roles of your board of directors is managing your endowment funds. Guided by good stewardship, the endowment will contribute to your not-for-profit’s financial health and stability — no longer a dream, but a reality.

© 2016