New State Laws Give Charities More Wiggle Room on Endowment Spending

Charities reeling from investment losses are turning to new state laws giving them more leeway to tap into endowments severely shaken by the stock market.

The laws, passed by 43 states since 2006 — including 17 so far this year — replace strict rules that had prohibited nonprofit groups from taking out money from endowments whose market value had dipped below the original value of the gifts in the fund.

The old restrictions were designed in part to make sure charities preserved those gifts even when finances were tight.

While charities have more flexibility now, “it’s not a free run to overturn donor intent or waste principal resources,” says Kevin Sullivan, head of the Children’s Museum, in West Hartford, Conn., which saw its endowment’s value plummet by 40 percent over the past year, to 20 percent below the original value of the donations to it. “It’s recognition that there ought to be more latitude given to manage accounts in extreme economic circumstances.”

Indeed, the laws have moved into the spotlight as charity assets have been decimated by stock-market declines and organizations search for ways to salvage their 2009 and 2010 budgets. Thousands of charities rely on distributions from their endowments each year to help pay for operating expenses, scholarships, or programs to carry out their missions.

Turning off that spigot during tough financial times, supporters of the new laws say, would create undue hardship, especially as other sources of revenue, like donations, have waned.

But some charity experts worry that the new laws give nonprofit groups too much discretion and that spending decisions could deplete endowments and fail to honor donors’ wishes to have their gifts grow over time.

“The biggest danger is that you dip into endowments and then you’re not able to recover,” says Woods Bowman, an associate professor of public service at DePaul University, in Chicago. “It’s a vicious cycle when you remove assets.”

State laws that guide charities on the management, investment, and spending of endowments are all based on a model statute, called the Uniform Prudent Management of Institutional Funds Act, recommended by a national commission that encourages consistency among state laws.

The act, known as Upmifa, was introduced in 2006 and includes provisions that allow charities in difficult circumstances to dip into “underwater” endowments — funds worth less than the value of the original gifts.

The new statute allows groups to spend the amount they deem prudent after considering donors’ wishes, the purposes of the fund, and relevant economic conditions.

The rules apply to gifts considered to be permanently restricted, meaning a donor expected the contribution to be invested to provide a continuing source of income.

They do not apply to gifts for which donors set specific spending instructions, such as a prohibition against spending from the principal amount. In those cases, the donor agreement prevails.

The Urban Institute, in Washington, estimates that 20,000 nonprofit organizations hold endowments that would be subject to the new laws. And, based on assumptions about charity-held assets and stock-market performance, thousands of those groups, the institute’s researchers estimate, have funds that are not worth as much as the amount donors originally contributed.

Educational institutions, which invest millions of endowment dollars to help pay for scholarships, and charities with relatively new endowments — containing gifts that had not had the chance to mature greatly before the recession — are among those most likely to be grappling with tough spending decisions.

Tough Decisions

The Greater Worcester Community Foundation, in Massachusetts, for example, saw its endowment drop by nearly 30 percent, and many of the funds within the endowment are no longer worth as much as the donors initially contributed.

To make up for a shortfall in its budget for college scholarships, the foundation persuaded several of its endowment donors to release the organization, at least temporarily, from spending restrictions, and it solicited others to give additional cash donations to cover costs. (Massachusetts adopted an Upmifa statute last month, but it was too late to resuscitate this year’s scholarship budget.)

The effort meant the foundation was able to award more than $500,000 in financial aid this year, only $63,000 less than it would have if the law to loosen endowment restrictions had passed sooner.

But foundation officials say they are looking forward to the flexibility the new law will offer in the future.

“We are sophisticated enough to spend a prudent amount that balances the obligations of stewardship with present needs,” says Ann T. Lisi, Greater Worcester’s executive director. “We have plenty of factors to consider that will bring us to the best handling of our assets, and we are relieved to be free of any additional, unnecessary constraints.”

Legality Questioned

Experts, however, urge caution as organizations dip into endowment funds to pay for pressing needs.

David Bass, director of foundation programs and research at the Association of Governing Boards of Universities and Colleges, recommends that nonprofit groups set up a formal procedure to get board members and others involved in deciding when to spend money from devalued funds.

He suggests, too, that organizations document how they weighed the criteria laid out in the statute. Such steps, he says, would protect charities from upsetting donors and would shield officials from personal liability should the outcome be challenged by a donor or charity regulator.

Some auditors and state charity regulators have raised questions about whether plans to dip into restricted funds are even legal in the first place.

“There’s a lack of clarity,” says John M. Horak, a Connecticut lawyer, “a tension between state attorneys general saying that only the courts have jurisdiction to allow groups to invade corpus [spend the money originally contributed] and the state legislatures passing laws that give organizations the right to do it without the courts.”

Restraining Spending

Not all charities are eager for the legal authority to spend money in an “underwater” endowment.

Steven W. Martineau, president of the board of the Mount Pleasant Area Community Foundation, in Michigan, says he is in no rush to see his state legislature ease the spending rules, a move it is now considering.

His organization practically halted its 2009 grant making after its endowment, created in 1990, dropped sharply in value during the stock market’s collapse.

Mr. Martineau says the decision to defer spending this year will help the organization’s fund recover faster as the economy improves.

And, he says, the move accommodates donors who have an expectation that their gifts will grow over time, providing more and more income for grants to charities.

“We have a simple statement that we share with donors: for good, forever,” Mr. Martineau says.

Barry C. Hawkins, a Connecticut lawyer who helped draft the endowment-spending statute adopted by all but seven states, says he understands the hesitancy to consider spending from ailing funds.

But, he argues, the new laws give charities a better chance than previous rules did to spend money wisely and according to what donors would want.

“Donors don’t want money maintained for the sake of maintaining it,” he says. “They would rather see the scholarship paid or the organization to keep operating than to see the charity that they cared enough about to support not have the means to do its work.”

He says that the new state laws encourage nonprofit officials to put substantial time and thought into their choices. The top consideration, he says: Preserve the endowment.

Mr. Sullivan at the Connecticut children’s museum agrees that care in decision making is key to striking the right balance between spending and accumulating gift money.

The museum’s staff and board members, in consultation with lawyers, financial advisers, and auditors, resolved a few months ago to withdraw $20,000 from the organization’s endowment to pay for unforeseen, needed renovations to the museum’s preschool center.

But, says Mr. Sullivan, the staff and board determined that it made sense financially to tap the endowment rather than borrow money for the project.

“Before Upmifa, we would have been stuck and would have had to go to the credit market,” Mr. Sullivan says. “Upmifa gave us the flexibility we needed to make the right decision, best for the organization, our donors, and our future.”