Friday, February 29, 2008

Growing Concern Over New LawsThat Permit Nonprofit Groups to Spend Endowment Gifts

The Chronicle of Philanthropy reports that a "growing numbers of states are passing laws designed to make it easier for nonprofit groups to spend money that donors have pledged to endowments, even if investment losses have caused the value of the donation to drop."  The National Conference of Commissioners on Uniform State Laws (NCCUSL) recommended that states adopt such a law (i.e., The Uniform Prudent Management of Institutional Funds Act ) in 2006.  The law loosens the rules on spending endowment gifts.  The new law provides flexibility because it permits nonprofits to spend money even if the endowment dips below the pledged amount.  An example of how the rule works is provided in the article.  "If a donor pledged $1-million to endow scholarships, for example, no money could be used to pay for scholarships if investment losses pushed the prinicipal in the fund below $1- million."  So far, fourteen states have adopted the new law, and more states are expected to ratify the law in the next few years.  An additional sixteen states have introduced the law since the start of 2008.  The NCCUSL provides a good description of the reasons behind the enactment.

Endowment Spending.  UPMIFA improves the endowment spending rule by eliminating the concept of historic dollar value and providing better guidance regarding the operation of the prudence standard.  Under UMIFA a charity can spend amounts above historic dollar value that the charity determines to be prudent.  The Act directs the charity to focus on the purposes and needs of the charity rather than on the purposes and perpetual nature of the fund.  Amounts below historic dollar value cannot be spent.  The Drafting Committee concluded that this endowment spending rule created numerous problems and that restructuring the rule would benefit charities, their donors, and the public.  The problems include:

1.         Historic dollar value fixes valuation at a moment in time, and that moment is arbitrary.  If a donor provides for a gift in the donor’s will, the date of valuation for the gift will likely be the donor’s date of death.  (UMIFA left uncertain what the appropriate date for valuing a testamentary gift was.)  The determination of historic dollar value can vary significantly depending upon when in the market cycle the donor dies.  In addition, the fund may be below historic dollar value at the time the charity receives the gift if the value of the asset declines between the date of the donor’s death and the date the asset is actually distributed to the charity from the estate. 

2.         After a fund has been in existence for a number of years, historic dollar value may become meaningless.  Assuming reasonable long term investment success, the value of the typical fund will be well above historic dollar value, and historic dollar value will no longer represent the purchasing power of the original gift.  Without better guidance on spending the increase in value of the fund, historic dollar value does not provide adequate protection for the fund.  If a charity views the restriction on spending simply as a direction to preserve historic dollar value, the charity may spend more than it should.

3.         The Act does not provide clear answers to questions a charity faces when the value of an endowment fund drops below historic dollar value.  A fund that is so encumbered is commonly called an “underwater” fund. Conflicting advice regarding whether an organization could spend from an underwater fund has led to difficulties for those managing charities.  If a charity concluded that it could continue to spend trust accounting income until a fund regained its historic dollar value, the charity might invest for income rather than on a total-return basis.  Thus, the historic dollar value rule can cause inappropriate distortions in investment policy and can ultimately lead to a decline in a fund’s real value.  If, instead, a charity with an underwater fund continues to invest for growth, the charity may be unable to spend anything from an underwater endowment fund for several years.  The inability of a charity to spend anything from an endowment is likely to be contrary to donor intent, which is to provide current benefits to the charity.

The Uniform Prudent Management of Institutional Funds Act is the successor to the Uniform Management of Institutional Funds Act of 1972, which was widely adopted among the various states (47).  Both laws, according to NCCUSL, "provide[ ] statutory guidelines for management, investment, and expenditures of endowment funds held by charitable institutions. The new act expressly provides for diversification of assets, pooling of assets, and total return investment, to implement whole portfolio management, bringing the law governing charitable institutions in line with modern investment and expenditure practice."  The legislative history of the act is available on the NCCUSL website.

The article explores the ramifications of this law to charities.  Jack Siegel, a noted tax professional, expressed concern that the new rules make it look like the charity should be spending more money annually from their endowments.  He thinks this is misleading, and especially troublesome during a time when the ranking Senior Republican on the Senate Finance Committee, Senator Charles Grassley, has been urging universities with big endowments to use those endowments to reduce rising tuition costs.

Following the enactment of the new law, the Financial Accounting Standards Board, a private organization, issued standards of financial accounting and reporting that can assist nonprofits comply with the new rules.

Please see full article for a complete story.


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Although UPMIFA, the new law, removes the concept of historic dollar value, the new statute tightens rules on spending from endowment funds by providing better guidance to charities. Under the old rules, if a fund dropped below the $1,000,000 contributed, the charity could not spend appreciation, but the charity could probably (never quite clear, but probably) spend interest and dividend income. Of course, if the $1,000,000 had been contributed in 1950, having a bright-line rule that the charity could not spend below $1,000,000 in 1950 dollars is, in essence, meaningless. The new rules direct the charity to consider foremost the longterm nature of an endowment fund and the intent of donors that the fund continue to be able to spend some amount every year while maintaining the longterm viability of the fund. The new rules protect not just the amount contributed to the endowment fund, but the value of that amount over time.

UPMIFA was introduced in California last week.

Posted by: Susan Gary | Mar 1, 2008 10:42:05 AM

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