Recently, I have received a number of questions relative to the law and accounting for endowment funds. I interpret this as a good sign for charitable organizations as the creation and maintenance of an endowment fund can be the cornerstone of a strong financial foundation for any organization.

In the old days of endowment management, it was generally held that institutions could spend the annual income generated by a fund – the interest and dividends received – and retain the net capital gains to provide for endowment growth. That policy of endowment management had a potentially negative impact on an organization’s investment strategy as the need for income had to be balanced with the availability of growth-oriented investments.

In the mid 1970’s most states passed the Uniform Management of Institutional Funds Act (UMIFA) that required institutions to invest endowment assets on a total return basis. That is, maximizing the total return (interest, dividends and net capital gains) was to be the objective and preference was not to be given to interest or dividend paying investments when income was needed. This law also required a different way of determining annual spendable endowment funds since the receipt of interest and dividends may be substantially reduced in favor of total return investment strategies. As a result, the concept of spending policy income was born.

The spending policy is simply a percentage of the total endowment fund’s value; e.g. 4% of market value. Once this policy is established the amount of annual spending is the mathematical answer after applying the percentage times the market value. All of the earnings above the spending policy amount are retained for endowment growth.

Generally accepted accounting principles (GAAP) require that the spending policy amount be determined prior to or at the very beginning of the fiscal year. It is inconsistent with GAAP to calculate the annual spending amount after seeing how the financial picture for the year is shaping up. Likewise, it is inappropriate to specify a spending policy range – e.g. between 3% and 5% - and then select a specific spending policy amount within the range after seeing the results of operations.

In 2009, the UMIFA laws were updated into the UPMIFA laws. The Uniform Prudent Management of Institutional Funds Act (UPMIFA) updated UMIFA and added clarity to the spending policy concepts. I will write more on UPMIFA in a future post.

Although not required by either Act, I typically have a few general recommendations regarding spending policy. First, if a board wants to create a policy that the annual spending policy amount will fall within a range, that is OK. However, that does not constitute the spending policy; rather that is a policy established for creating a spending policy. The organization still needs to establish a single percentage rate that is to be applied to the endowment’s market value to determine the annual spending amount.

Our second, the spending policy figure should be applied to an average of endowment market values rather than the single market value at a single point in time. This will have the impact of reducing wide variances in spending amounts as endowment market values fluctuate. For example; a spending policy of 4% of the average endowment quarterly market value over the past 12 quarters will result in an annual spending amount that moves up or down slowly even though individual quarterly market values over that time period may move drastically.

The third recommendation is a further refinement our second suggestion. We recommend that the endowment spending calculation be performed based on average endowment quarterly market values determined 6 or 9 months prior to the beginning of the fiscal year in which the spending will occur. For example: a calendar year organization whose spending policy is 4% of the average endowment quarterly market value over the 12 quarters ending on March 31st of the previous year will result in the organization being able to determine endowment spending at least 8 months prior to the beginning of the year and allows them to easily move this figure into their annual budget process.

Let us know what you would like to read more about below in the comments section. Do you have more questions about endowments? Contact any member of the not-for-profit services team at 888-KLR-8557.

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