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Understanding UPMIFA: Important Endowment Concepts
David Wheeler Newman presents a cogent summary of the effects of UPMIFA regulations on managing Endowment funds.
The Uniform Prudent Management of Institutional Funds Act (“UPMIFA” or “the Act”) was adopted in 2006 by the National Conference of Commissioners on Uniform State Laws, as the successor to the Uniform Management of Institutional Funds Act (UMIFA), and has (at 1/1/2017) been enacted in every state except Pennsylvania. UPMIFA provides guidance and authority to charitable organizations concerning the management and investment of charitable funds and for endowment spending.
UPMIFA contains rules and standards for their application across three broad areas of importance to charitable organizations, members of their fiduciary boards, and their advisers, if those organizations hold restricted funds including endowment. This post focuses on endowment, and future posts will address UPMIFA rules for the delegation of management and investment functions, and for the release or modification of restrictions contained in gift instruments.
UPMIFA applies to any institution, which can be a charitable trust or a nonprofit corporation, holding funds for charitable purposes subject to restrictions imposed by a donor in a gift instrument, including endowment funds.
Focus on Endowment Funds
The Act defines an endowment fund as one that, under the terms of a gift instrument, is not wholly expendable by the institution on a current basis. “Gift instrument,” while requiring a writing (in any form, including electronic), is interpreted broadly to give full effect to the intent of the donor. It may consist of more than one document, and may be a will, deed, agreement, memorandum, or even a cancelled check, so long as both the donor and the institution are aware of the terms. The gift instrument may also include documents that have no donative purpose, such as corporate bylaws or a board resolution that provides for a fund with this type of spending restriction. It is even possible for a gift agreement to be solicitation materials, such as a brochure or website informing prospective donors that any contribution made in response to the appeal will be held as an endowment fund.
UPMIFA is similarly expansive in applying a rule of construction to a gift instrument to determine if it creates an endowment fund. If the document authorizes the charity to use only “income,” “interest,” “dividends,” or “rents, issues, or profits” or “to preserve the principal intact,” it is considered to create an endowment fund of permanent duration.
Investing Endowment Funds
For investment of endowment funds, the Act provides guidance informed by modern portfolio theory. A charity is required to make decisions about each asset in the context of the entire portfolio of investments, as part of an overall investment strategy. This means that an asset which in isolation might seem imprudent for a charitable organization to hold because of its risk profile may nevertheless be retained by the charity if it fits into a diversified portfolio comprised of various asset classes. Indeed, another general UPMIFA investment directive is to diversify investments.
This investment guidance, combined with the approach to endowment spending discussed below, encourages institutions to invest for total return including capital appreciation, rather than focusing only on assets which will generate current income such as interest and dividends.
Probably the biggest change made by UPMIFA was doing away with the concept of historic dollar value. Under the predecessor uniform law, a charity could spend amounts above the historic dollar value of a fund, which is the value of the fund at the time its assets are transferred to the institution, but spending could not be approved which would reduce the fund below that value. The old rule created many problems, including variations on spending between old and new funds, held as part of the same endowment investment pool, during periods of market declines. It also had the occasional perverse effect of increasing spending beyond a prudent amount, rather than the opposite, if a charity viewed the restriction on spending simply as a direction to preserve historic dollar value. Without the historic dollar value rule, institutions are no longer required to review the prudence of spending decisions fund-by-fund, to make sure the spending is not taking a fund below its historic dollar value, but instead may determine prudent spending levels across the entire pooled endowment based on seven factors spelled out in UPMIFA:
- the duration and preservation of the endowment fund;
- the purposes of the institution and the endowment fund;
- general economic conditions;
- the possible effect of inflation or deflation;
- the expected total return from income and the appreciation of investments;
- other resources of the institution; and
- the investment policy of the institution.
The Act contains an optional subsection (adopted in many states including California and New York), which provides that the appropriation for expenditure in any year of an amount greater than seven percent of the value of an endowment fund (averaged over at least three years) creates a rebuttable presumption of imprudence. Although very few institutions bump up against this seven percent standard, much less exceed it, the manner in which the rebuttable presumption is expressed provides some insight concerning the way in which endowment spending rates are often set by institutions.
The first of the seven factors looks at the duration of the endowment fund, which in most cases is perpetual. This requires the institution to consider generational equity: an effort is made to ensure that the purchasing power of the endowment fund, after inflation (factor 4) will be maintained for future generations served by the institution. But the spending must also fit within the expected total investment return (factor 5).
This often leads the fiduciaries responsible for setting the endowment spending rate to begin with the expected total investment return. From this is subtracted the projected rate of inflation and the projected investment management expenses of the endowment fund, with all figures expressed as a percentage of the value of endowment fund assets. The concept is that the spending rate should not exceed the results of this equation. For example, if the expected total investment return over the next several years is 7.5%, anticipated inflation is 2% and the investment management expenses are assumed to be 0.5%, the fiduciaries might conclude that the spending rate should not exceed 5%. To smooth fluctuations in asset values, the resulting spending rate is typically applied to the value of the endowment fund averaged over some prescribed time period, frequently three years. As a final check, the fiduciaries consider other resources of the institution. If the institution is a state college, does it receive support from the state that is stable, increasing, or decreasing? If the institution is launching a major fundraising campaign that is likely to substantially increase endowment funds, can this future increase be taken into account in perhaps distributing at a higher spending rate now?
In applying the seven factors in this manner, many institutions end up setting their endowment spending rate between four and five percent of the value of endowment fund assets, averaged over a three year period.
Extra Credit for Serious Students
One of my favorite tax law professors would say, “Why rely on exegesis when one can consult the scripture?” For students of UPMIFA wishing to do so, the text of the uniform act, along with very helpful commentary by the drafting committee, may be found here.
This is the first in a series of posts on UPMIFA. Future posts will address the standards for delegation of management and investment of institutional funds to an external agent such as an out-sourced chief investment officer, and the rules for release or modification of restrictions contained in gift agreements.