Endowments and foundations are generally established to support the mission of nonprofit organizations. The mechanism to calculate the amount of annual support is usually established through a spending or distribution policy.
Consequently, an investment program’s success is commonly measured by its ability to support its spending or distribution policy while preserving purchasing power and allowing for the modest growth of real wealth.
In this paper, we will focus on how the UPMIFA, which has been adopted by many states and can apply to the board of trustees or board of directors of an organization, creates structural requirements around spending policy development and implementation. For more information on UPMIFA and how it applies to board governance in general, please see our white paper, Good Nonprofit Governance Starts with the Board.
Spending Policy Construction: Hypothetical Examples
Before we address the UPMIFA guidance on spending policy construction, we will start by laying out three hypothetical examples of spending policy constructs below. For more information on the considerations for creating a spending policy, please see our January 2018 white paper, Spending Policy: Development and Implementation.
Sample Spending Policies
[Simple Spending Rule]
The long-term annual spending and distributions from the fund are targeted to average _______ (xx%) of the beginning period market value of the fund. However, spending and distributions may occasionally exceed this amount as necessary as determined by [__________________________].
[Rolling Three-Year Average Spending Rule]
While the long-term annual spending and distributions from the fund are targeted to average _______ (xx%) of a moving 12-quarter market value average of the fund, spending and distributions in any one fiscal year may range between a minimum of ____ (xx%) and a maximum of ____ (xx%). However, spending and distributions may occasionally exceed this amount as necessary as determined by [__________________________].
[Geometric Spending Rule]
The long-term annual spending and distributions from the fund are targeted to average _____ (xx%). Spending in the current period is equal to: a) previous year’s distribution adjusted for inflation times a smoothing rate of [______], plus b) the beginning market value of the portfolio times the spending rate and the residual of the smoothing rate [______]. However, spending and distributions may occasionally exceed this amount as necessary as determined by [___________________________].
UPMIFA: Seven Factors for Spending Policy Construction
UPMIFA, as a successor to the Uniform Management of Institutional Funds Act, “provides better guidance on prudence and makes the need for a floor on spending unnecessary.” The reasoning behind this centers on seven factors that UPMIFA requires an institution to consider in the prudent expenditure of both appreciation and income (as opposed to older trust law that allowed only the spending of income).
Each of the three spending policies above is perhaps suited to different objectives, situations, or goals; however, as outlined in the UPMIFA policies, the methodology behind choosing which one (and the particular details) is appropriate for a given institution should be the same. According to UPMIFA, that methodology should be based on seven factors:
- The duration and preservation of the endowment fund: Most nonprofit institutions are intended to last in perpetuity; as such, the assets and distributions should be managed in such a way as to promote the sustainability of the assets over time.
- The purposes of the institution and the endowment fund: This factor is fairly straightforward: The spending/distribution policy should be designed to support the mission or goal of the institution and/or the specific assets for which it is assigned.
- General economic conditions: This factor can be especially important to preserving the principal of the institution’s assets: If general economic conditions are favorable, the assets and spending policy can perhaps support a greater distribution; however, if economic conditions are not favorable, the spending policy should allow for taking this into account when determining the annual distribution.
- The possible effects of inflation or deflation: A spending policy should always account for the effects of inflation or deflation, both on the distribution and on the principal of the fund. As a hypothetical example, if the return on the assets does not exceed the spending policy plus inflation in an inflationary environment, the purchasing power of the assets becomes impaired and subsequent distributions will have lost their purchasing power.
- The expected total return from income and appreciation of investments: Over the last 10 years, our capital market expectations have been in a declining trend for both equities and fixed income, with much of this decline concentrated in the past five years. For a spending policy not to cause impairment on the principal or purchasing power of the assets, the total return on the assets (net of fees and accounting for inflation) must be greater than the effective distribution rate. In crafting a spending policy, an institution should consider what returns are realistic relative to the return, risk, and liquidity profile of the portfolio.
- Other resources of the institution: When determining a spending policy, it is important to consider the other, perhaps shorter-term assets of the institution: Generally, endowed funds are long term in nature, meaning that it is often better to leave them invested and hopefully compounding returns, especially if it is not necessary to sell them for liquidity/distribution purposes.
- The investment policy of the institution: Similar to factor number five above, investment policy has a measurable effect on the expected total return of the portfolio and thus plays an important role in determining the sustainable distribution rate for the assets. As a hypothetical example, if an organization has a restrictive investment policy statement (IPS) that, as a hypothetical example, limits the equity asset allocation to a relatively low target level; restricts fixed income to high-grade, short duration securities; and does not allow for alternative investments, it would not likely be possible for that investment program to support an 8% spending policy (that is, a relatively high objective) over the long term.
It is important to remember that UPMIFA does not apply to every nonprofit organization and situation.
For example, when a donor expresses intent clearly in a written gift instrument, UPMIFA requires that the charity follow the donor’s instructions. In addition, UPMIFA does not apply to private foundations held by individual trustees or commercial trustees, such as banks or trust companies, even if the sole beneficiary is a charity. Such trusts are instead governed by the instruments establishing them and applicable state trust law.
To determine if UPMIFA applies to your organization, we recommend consulting a legal services firm experienced in nonprofit law in your state.
The development and implementation of a well-reasoned, well-documented spending policy is an important task for the prudent management of the long-term assets of nonprofit institutions. While UPMIFA has different levels of required adoption in different states, the underlying spirit, especially as it relates to spending policy and distribution, can be highly beneficial in providing structure to institutional investment programs. We highly recommend documenting your organization’s spending policy in the IPS. This can help to instill discipline in every step of the process, including portfolio construction, scheduled distributions, and ongoing strategic reviews.
For more information, please contact your PNC Investment Advisor.