September 17, 2009 | Read Time: 5 minutes
As a result of the market gyrations of the past year, nearly 15 percent of endowments have lost some of the principal that donors invested, according to the Urban Institute. Also affected by the downturn are quasi-endowments — unrestricted funds designated by a board of directors to function like an endowment. They are resources that organizations may be tempted to liquidate in a crisis.
Until recently this would have been illegal in most states. In the past three years, 43 states have revised their charitable-investment laws in accordance with a new Uniform Prudent Management of Institutional Funds Act — promulgated by the Uniform Laws Commissioners, a group that seeks to keep state laws consistent — which gives institutions more flexibility in dealing with fluctuations in the value of their endowments. Most states have adopted one or both of two key provisions.
The first one allows nonprofit groups to take 7 percent from the fund’s value during a year in which the organization faces emergency conditions. That is a high percentage for groups to spend over any period of time and cannot be sustained indefinitely. Assuming a normal spending rate of 5 percent — a level that researchers say will preserve the value of endowments over time — the new 7-percent standard allows a 40-percent increase in spending withdrawals to cope with an economic crisis.
The second provision applies to any charity with an endowment of less than $2-million. In such cases, a charity must notify the state attorney general 60 days in advance of a spending withdrawal that is expected to reduce the value of investments below the dollar value donors originally contributed. The rule does not require approval by the attorney general. Rather, its purpose is to give the attorney general an opportunity to comment and to counsel the charity.
Since states often modify legislation proposed by the Uniform Laws Commissioners, charities would do well to educate themselves on the language of the new law in the state where they are chartered. They should also think carefully before rushing to take advantage of it.
The relief that the new laws give charities is not a free lunch. The uniform law emphasizes prudence and fidelity to donor restrictions. If a charity is forced to dig deeply into an endowment during an economic emergency, it is obligated to rebuild it as soon as possible. In effect, the law’s goal is to allow a charity to borrow from itself and still uphold a donor’s desire to set up a fund to support specific causes forever, such as offering annual scholarships or supporting the preservation of a museum collection.
Charities should not ignore the difficulty they will face in rebuilding an endowment that has been used to finance a vast array of emergency needs. After a series of lean years, charities can expect enormous pressure to spend when their economic situation improves. But rebuilding requires surpluses, which requires resisting this pressure.
Organizations whose boards have set aside unrestricted funds as a quasi-endowment don’t have to worry about the legal concern of protecting a donor’s intentions. However such institutions would do well to look to the institutional-funds act for guidance in the present economic emergency because it is the product of years of study and debate by experts who were mindful of the special needs of organizations in times of crisis.
Organizations that rely on investment income to support their operating budget should think hard about the long-term consequences before revising their spending formulas upward or abandoning them altogether. They should explore three issues: How long can it afford to wait to have pre-crisis spending levels restored? Are they delaying the inevitable? Are they shooting themselves in the foot?
An endowment that loses half its value will take 15 years to rebuild, but one that loses an additional 25 percent due to overspending will take 30 years to rebuild. In other words, for every 5 percent of its investments that an organization draws upon in a crisis, it extends the return-to-normal date by three years. (These numbers assume an average investment return of 5 percent. Results also depend on the amount of overspending. Every organization should do its own simulations.)
The endowment may vanish before life is back to normal. In the end, an organization that liquidates investments to pay current bills may find that it only postponed the pain of deep cuts. Delayed budget cuts are deeper budget cuts and, once an endowment runs out, current revenue must support everything. Building an endowment from scratch is extremely difficult.
Donors may feel uneasy about entrusting their money to an organization that eats its seed corn. According to Edward Schumacher, a fund raiser who has written about endowments, “The existence of an endowment fund is an incentive for donors to give to an organization, because an organization with an endowment is likely to be perceived as stable and financially mature.”
Or, to quote the nonprofit scholar Francie Ostrower, “Donors like the idea of perpetuity — that is, giving beyond their own life.”
When an organization’s survival is on the line, an endowment can be a lifesaver. It should not be a crutch that props up an organization in the hope that things will get better. Boards hold the destiny of their organizations in their hands and need to make hard decisions about their future. If they don’t do this now, they will eventually wish they had.
H. Woods Bowman is an associate professor of public service at DePaul University.
