A friend who serves on a nonprofit board asked me whether her organization was drawing enough from its endowment each year. “Probably not,” I answered. Then she described her organization’s endowment spending policies. I was right.
Endowment spending policies are often discussed at board meetings, but rarely questioned. And the amount taken annually from the endowment in most cases is too little.
To understand what’s going on, we have to look at the social and power dynamics.
The people who serve on a nonprofit’s investment committee are typically highly credentialed, authoritative, and (without meaning to be) somewhat intimidating. They are conversant with the ins and outs of investing, while the rest of the board usually doesn’t feel the same degree of comfort with the terminology. (“Basis points”? “Non-correlated fixed-rate investments”?) Consequently, board members have a tendency to nod passively and approve whatever recommendation the investment committee brings to the table.
Meanwhile, the size and growth of the endowment has taken on an undeserved importance at most nonprofits. Part of the reason is that endowments, unlike program impact and quality, are easy to measure and compare. The size of the endowment is a simple and readily available (if often misleading) reflection of organizational success. If your organization has a large endowment – or, if you’re the CEO and the endowment has grown under your tenure – that’s seen as a big deal, an indication of good leadership.
Consequently, the conversation at the board table rarely focuses on the core philosophical choice of endowment spending policies, which is: “How much of our endowment are we devoting to current purposes, and how much are we leaving invested for future use?” Instead, most conversations about endowments center around the performance and fees of the investment managers, the allocation of the money in various asset classes, and how to maximize returns safely. And, without explicitly saying so, many boards take the approach that growth of the endowment is more important than using an appropriate portion today to ensure program quality.
So what should lay board members know so they can get involved productively in the conversation about endowment policies? How can they weigh in so that the right questions get asked and considered? And how can they be sure that the endowment policies do not sacrifice current mission for future growth?
First, they need to understand that the law pertaining to endowment management and spending policies is known as the Uniform Prudent Management of Institutional Funds Act (UPMIFA). UPMIFA has been enacted in 49 states (all but Pennsylvania) and requires nonprofits to manage their endowments in a prudent manner while at the same time providing discretion and flexibility to nonprofit boards in deciding the spending level appropriate for the organization.
Second, board members need to understand that in managing endowments nonprofits almost universally rely on a “total return” investment approach. That is, rather than relying only on the income derived from bond interest and stock dividends, nonprofits put their money in a full array of investments, including stock whose primary attraction is the potential growth in its share price.
Third, each nonprofit sets its own “spending rate.” That’s the percentage of the value of the endowment that is taken annually for use by the organization. Under UPMIFA the spending rate is then applied using a mechanism called a “trailing average.” That means that the organization goes back a certain number of years, calculates the average market value of the endowment during that period, and applies a fixed percentage of that amount for use in the next year’s budget. So if the spending rate is 5% of a 20-quarter trailing average, that means the organization adds up the endowment’s total market value at the end of each quarter for the last five years, divides that number by 20 (to get the average), and multiplies that average by 5%. The resulting dollar amount is how much the organization will budget for that year’s use.
This kind of spending rate based on a trailing average is nicely self-regulating. In a falling market, the amount taken each year is not too little; in a rising market, the amount taken is not too much. And the change from year to year is not extreme. It’s a clever and elegant mechanism.
But the key question is: What’s an appropriate percentage for the spending rate? In the wake of the Great Recession, many organizations dropped their spending rate, undoubtedly to help their endowments recover after the 2008-9 crash. Many have kept spending rates at those low levels. Now it’s common for nonprofits to budget 4% of a 5-year trailing average. Assuming that markets are rising (as they have been over recent years), that really amounts to only about 3.5% of the current market value. For most organizations, that’s too little. Nonprofits are starving themselves today in the name of building a big endowment for tomorrow.
Why is this a problem? Boards, prompted by their investment committees, tend to take what they think is the fiscally prudent stance: to use a minimal amount of the endowment now, so as to build up the assets for the future. But with rising demand and increasingly unreliable funding, nonprofits are under great pressure. Nonprofit boards need to remember that managing an endowment is not like an individual putting away money for retirement. When workers are able to save for retirement, they do so because they don’t need those funds now, and they know they’ll need them in the future. Nonprofits, by contrast, do need the funds now – to feed children, house families, educate students, promote public art – in short, to fulfill their missions. Every dollar unnecessarily locked up in the endowment is not helping them achieve good things today.
Which is not to say that nonprofits can or should be profligate with the endowments. In fact, in many states nonprofits are prohibited by a specific section of UPMIFA from spending more than 7% of the trailing average in a given year: spending at that level is deemed to be imprudent. But UPMIFA does not dictate that nonprofits reinvest all they can in the endowment while ignoring current needs. In fact, one of UPMIFA’s stipulations is that nonprofit boards consider “the needs of the institution and the fund to make distributions and to preserve capital.” In other words, it’s about balancing current and future needs in a prudent manner.
So I will go back to my friend who first posed this question and suggest that she ask her institution to calculate what is not being funded and who is not being helped by the decision to use so little of the endowment each year. She should ask if the institution is trying to preserve endowment capital (a good thing) or expand it at the expense of the mission (which I would argue is inappropriate). She should call into question whether the value of the endowment in and of itself is taking on an outsized importance in the calculation of the spending rate. And she should encourage the institution to change its model: rather than taking as little as possible for current use, the organization should take as much as possible from the endowment each year without undermining the long-term preservation of capital.
The end result of a more generous spending rate would admittedly be a somewhat smaller endowment twenty or fifty years from now. But the organization will have accomplished a great deal more good in the meantime. And that, I argue, would be the prudent, pragmatic, and ethical path to follow.
Copyright Alan Cantor 2016. All rights reserved.
Hey Al! Great post. I hope you take on university endowments and the people who continue to donate to institutions such as Harvard when clearly there are so many other worthy causes and Harvard clearly does not really need it! We had an intern with us last year from Harvard who went on an ALL expanse paid trip to Hawaii to visit some volcanoes as part of his geography class only because they needed to spend some money donated by a wealthy alum.
Well, yes. In this post I talk generically about endowment spending policies. There are the larger issues, which you raise here, about which organizations get the big gifts. Given that Harvard recently completed a $7 billion+ capital campaign; that they renamed their schools of public health and engineering in exchange for endowment gifts of $350 million and $400 million respectively; and that they’ve even endowed the salaries and benefits of 17 of their varsity coaches (huh?!) — yes, they’re a rich target for us all. Why do people give to Harvard? Coals to Newcastle, right? I don’t get it, though the lure of prestige is very strong.
But, related directly to this piece, it’s worth looking at how Harvard et al. use their enormous endowments.
It’s interesting to note that a study of university endowments — see http://www.chronicle.com/article/How-Endowment-Hoarding-Hurts/145343 — showed that in the Great Recession none of the largest 200 endowments raised their spending rates, and many of them closed the spigot a bit. So at exactly the time when universities were hurting because annual donations were down and the ability of students to pay tuition was down, instead of increasing the spending rate and alleviating the pain, many schools actually reduced the spending rate. The universities clearly cared more for the size of their endowments than the quality of the education.
This connects to the old line that the big universities are actually large hedge funds with educational services attached. That’s more accurate than not. When push came to shove, they opted to build the endowment rather than ensure educational quality.