Prudent Management of Institutional Funds

Over the past few years, nonprofit and charitable organizations faced a multitude of economic challenges.

Endowments and foundations were hit hard by an economic downturn not seen since the 1930s. A decrease in donations and available funds put pressure on spending policy, and a number of investment schemes and scandals cost billions. These events contributed to the increased scrutiny of the management of nonprofit funds and the boards responsible for oversight.

As often is the case during times of uncertainty and challenge, new rules or regulations are introduced to provide clarity and direction. The Uniform Prudent Management of Institutional Funds Act (UPMIFA, 2006) provides specific guidance regarding investment and spending policies. UPMIFA is a result of the merger of two state laws, the Uniform Management of Institutional Funds Act (UMIFA, 1972) and the Uniform Prudent Investor Act (UPIA, 1994). On September 17 of this year, New York became the forty-seventh state to pass UPMIFA legislation; however, each state may have a unique interpretation and requirements.

Where UMIFA did not apply to private foundations, UPMIFA does apply to most private foundations. There is an exception for private foundations that are organized as charitable trusts AND have individual or institutional trustees. These private foundations fall under the UPIA, where adopted. Nevertheless, as most are established to exist in perpetuity, it is strongly recommended that the board of all private foundations (especially those structured as nonprofit corporations) be familiar with UPMIFA and the policies established for endowments.

The key provisions of UPMIFA are as follows:

• allows the delegation of investment management authority;
• defines standard of care and factors to consider when making investment decisions;
• eliminates historical dollar value limitation;
• establishes guidelines for releasing restrictions on assets; and
• establishes a prudent spending amount.

Not only is the delegation of investment management allowed, it is also deemed prudent if the organization does not have a sophisticated investment committee. The board can demonstrate procedural prudence by selecting an agent in good faith, establishing the scope and terms of the delegation and periodically reviewing the agent. Although the board is not responsible for the actions of the agent, it is responsible for establishing guidelines for performance, progress toward goals and objectives, and adherence to the investment policy.

UPMIFA modernizes the rules governing investments and the standard of care for investment decisions. It directs that investments be made “in good faith and with the care an ordinarily prudent person in a like position would exercise under similar circumstances, considering the purposes, terms, distribution requirements, and other circumstances of the institutional fund.” UPMIFA also explicitly provides that, as long as the investment is prudent, the institution may consider any investment for inclusion.

A significant change made by UPMIFA is the elimination of the historical dollar value limitation. Previously, growth or net appreciation could be spent, but the “historical dollar” value of an endowment had to be preserved. Under the new law, institutions are no longer limited in their ability to spend “underwater” endowment funds. Given the market losses of recent years, this is a critical and beneficial change. Boards can now authorize prudent spending of principal of an endowment fund so long as a good faith determination is made that the spending aligns with the “uses, benefits, purpose, and duration for which the fund was originally established.” One caveat is if the donor puts a limit on how much principal can be spent, that limit controls or overrides even a prudent approach.

Recognizing that restrictions may become outdated, wasteful, or at times unworkable, UPMIFA provides rules and/or guidelines for releasing donor restrictions on funds. The most straightforward and often most effective method is to simply seek the permission of the donor to remove the restrictions. Often times the board may offer a modification consistent with the purposes of the gift interest that is as close as possible to the original donor intent. If the attempts to work with the donor fail, the board may seek legal action. The board can petition the courts for approval to either modify or fully release a restriction.

One of the most important considerations for any organization and its board is to develop a well thought, prudent spending policy. UPMIFA spending policy rules promote a total return approach to spending. The goals resemble those of many individual investors. Two key components to both spending and investment policies are to invest at an expected rate of return to preserve purchasing power of the principal over the long term (possibly in perpetuity) and to spend at rates that reflect the donor’s intentions. UPMIFA provides greater flexibility to spending policy. Some states, such as New York and Rhode Island, adopted a rebuttable “presumption of imprudence” for any spending in excess of 7% of the market value of the endowment per year. In determining whether spending is prudent, UPMIFA requires the board to consider the following:

• the duration and preservation of the endowment fund;
• the purposes of the organization and the endowment fund;
• general economic conditions;
• the possible effects of inflation or deflation;
• the expected total return from income and the appreciation of investments;
• other resources of the organization; and
• the investment policy of the organization.

These considerations drive both spending policy and investment decision making. Today’s market realities have shifted priorities from maximizing returns to achieving desired goals, cash flow, and liquidity needs. Although many nonprofits, foundations, and endowments currently have strong investment and spending policies in place, it is advisable and prudent to perform reviews of the current procedures. Advisory boards and investment committees dealing with endowments must adhere to a fiduciary standard of care set forth by UPMIFA. Adherence is not measured in returns but in the prudent process implemented. A uniform fiduciary standard of care provides that boards and investment committees should:

• know the standards, laws and trust provisions;
• diversify assets to the specific risk/return policy of the entity;
• prepare a detailed investment policy statement
• use “prudent experts” (e.g., money managers and consultants) and document the due diligence process;
• control and account for investment expenses (full transparency);
• monitor activities of “prudent experts;” and
• avoid any conflicts of interest and prohibited transactions.