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The endowment goose and its golden eggs.

Remember Aesop's fable about the magic goose that laid golden eggs? The more eggs the goose laid, the richer the owners became. Unfortunately, they didn't think they were getting rich fast enough--they wanted all of the gold immediately. So they cut the goose open, only to find there were no eggs inside. Impatience for immediate wealth destroyed any chance of future riches.

Whether a not-for-profit organization (NPO) has a small or a large endowment goose, it relies on its golden eggs today and anticipates more eggs will be available tomorrow. NPOs are the stewards of nearly $325 billion of endowment investments. What must these institutions do to ensure the endowment goose remains healthy so it can continue to supply golden eggs? Is legal guidance available?

The answers to these questions have changed over the years. The Uniform Management of Institutional Funds Act (UMIFA) outlines how NPO endowments should be managed. This article describes what led to UMIFA's passage and discusses the law and its practical application. CPAs either employed by NPOs or retained by them can play an important advisory role by understanding the law's intent and how an organization sets and complies with its investment policies.


The basic endowment challenge is found in the Oxford English Dictionary definition of endow: "To enrich with property; to provide, by bequest or gift, a permanent income." Because many institutions still pursue investment policies that include elements of the past, the history of endowments can help explain current spending patterns.

The first endowments were land. Land produces rents, which are spendable income that satisfies current needs. Land tends to increase in value over time, and rents increase accordingly. In the past, rent increases enabled endowed institutions to keep pace with operating needs. Land-based endowments and simple spending policies enabled institutions to balance immediate needs with future ones.

By the beginning of the twentieth century, bonds had replaced land as the primary endowment investment. As land does, bonds produce spendable income. Unlike land, however, bonds do not maintain their purchasing power during periods of inflation. (Since a typical bond pays only interest and its nominal value remains fixed, the real value declines in inflationary periods.) Because inflation was not a constant factor in the United States until after World War II, few institutions knew that by shifting from land to bonds they were sacrificing their ability to maintain endowment purchasing power.



As endowment investments changed, what prevented endowed institutions from investing in stocks that would have allowed them to keep pace with inflation? The legal standard of fiduciary responsibility applicable to trustees of endowed institutions comes from a 1830 case, Harvard College v. Amory. Known as the prudent man rule, it requires a trustee to "observe how men of prudence...manage their own affairs...considering the probable income as well as the probable safety of the capital to be invested."

Interpretation of the prudent man rule gradually narrowed. By 1900, endowment scales had tipped in favor of maintaining the safety of the corpus--the value of the original gift. Bonds were considered safe because their values generally did not fluctuate.

Before securities regulation and the advent of the Securities and Exchange Commission, many considered investing in stocks to be imprudent. Socalled legal lists of permissible institutional investments were compiled; stocks were not included. In fact, New York State did not outlaw legal lists until 1970.

After World War II, inflation ravaged the value of bond portfolios. Endowed institutions desperately needed to reallocate assets in a way that would provide future growth by maintaining purchasing power. They needed to invest in stocks, but fiduciary responsibility had evolved in favor of maintaining the original gift's value with no inflation provision. Endowments invested only in bonds complied with the popular interpretation of fiduciary responsibility but conflicted with modern investment theory.


By the 1960s, a few institutions began to challenge the status quo by investing in common stocks. Policies based exclusively on expending yield did not capture equity growth for current spending. If an institution provided for future growth with stocks, it did so at the expense of supplying current funds.

The 1965-1966 Yale University treasurer's report made one of the first public challenges to the limited permissibility of spending only dividend and interest income. Other institutions, including New York City's Museum of Modern Art, Cornell University and the University of Chicago began to consider spending policies not based solely on yield.

An early requirement that gains be realized before being taken into account was dropped. A handful of institutions adopted total return spending policies emphasizing a portfolio's total change in value over time from both yield and appreciation--realized or unrealized--enabling them to make the best investments for future growth while also providing for current operations. Only a few sophisticated institutions invested in stocks and adopted total return policies. Many were advised by legal counsel not to do so based on the argument--found in trust law--that gains belong to corpus and thus were not expendable.


Funding sources, however, urged institutions to update their strategies. A chief critic was the Ford Foundation. In reaction to McGeorge Bundy's first report as its president, the foundation commissioned two attorneys, William L. Cary and Craig B. Bright, to determine the legal basis for investment and spending policy restrictions. In April 1969, they published their landmark findings, The Law and the Lore of Endowment Funds, concluding "legal impediments which have been thought to deprive managers of their freedom of action appear on analysis to be more legendary than real." There was no legal basis for the view that endowment gains were principal and thus not available to be spent.

In 1972, the National Conference of Commissioners on Uniform State Laws approved UMIFA--a model act states can adopt in whole or in part. To date, 38 states and the District of Columbia have adopted it. (See exhibit 1, at left, for a complete list.) Organizations in the remaining states may find themselves in the ambiguous position of having no justification for using a total return spending policy.

Exhibit 1: Jurisdictions in Which UMIFA Has Been Adopted
State Year adopted
Arkansas 1992
California 1973
Colorado 1973
Connecticut 1973
Delaware 1974
District of Columbia 1977
Florida 1990
Georgia 1984
Illinois 1973
Indiana 1989
Iowa 1990
Kansas 1973
Kentucky 1976
Louisiana 1976
Maine 1993
Maryland 1973
Massachusetts 1976
Michigan 1976
Minnesota 1973
Missouri 1976
Montana 1973
New Hampshire 1973
New Jersey 1975
New York 1978
North Carolina 1985
North Dakota 1975
Ohio 1975
Oklahoma 1992
Oregon 1975
Rhode Island 1972
South Carolina 1990
Tennessee 1973
Texas 1989
Vermont 1973
Virginia 1973
Washington 1973
West Virginia 1979
Wisconsin 1976
Wyoming 1991

UMIFA provides legal solutions to five endowment issues:

1. The prudent use of appreciation.

2. The board of directors' specific investment authority, including permission to invest in stock.

3. A board's right to delegate investment decisions to investment managers, investment committees and staff.

4. A board member's standard of care: its similarity to that of a director of a business corporation as opposed to that of a trustee.

5. How to release donor-imposed restrictions.

UMIFA does not apply to board-designated or quasi endowments. If a donor specifies how a gift, income or net appreciation from a gift should be spent, the donor's wishes govern. If a donor does not say how earnings on his or her true endowment gift are to be spent and net appreciation is expended, UMIFA's rules on appropriation of appreciation apply.

UMIFA allows a prudent portion of appreciation over a fund's historic dollar value--defined as the value of the original gift--to be spent. In other words, UMIFA gives explicit legal permission to use a total return spending policy. In determining what is prudent, UMIFA says boards should consider short- and long-term needs, present and anticipated financial requirements, expected total investment returns, price level trends and general economic conditions.

UMIFA is not a restrictive statute. Broadly written and intended to provide legal guidance where there was none, it grants legal permission to expend net appreciation. If a governing board spends net appreciation and UMIFA has been adopted in that state, all of the law's provisions apply.


How does an institution put state law into practice? Endowed institutions should adopt policies that allow a balance between today's operating needs and maintaining the ability to provide for tomorrow's. By establishing appropriate investment and endowment spending policies, institutions can judiciously place the spending fulcrum on the time continuum. An investment policy normally would define the appropriate asset mix and risk tolerance given an NPO's spending needs. An endowment spending policy should include both a means of determining permissible current spending and a calculation of endowment principal.

CPAs retained by NPOs can ensure these policies, which usually are set by boards or their investment committees, have been reviewed in conjunction with state laws. CPAs employed by NPOs can make certain appropriate policies exist and are being followed.

Establishing a spending rate is a common way of determining current endowment draw while using a total return investment concept. The rate usually is expressed as a percentage of market value of investments over a period of time. UMIFA says governing boards should consider price level trends. An appropriate rate would therefore be one that makes available for spending no more than earnings less inflation--over a reasonable period of time. Averaging over several quarters or a few years will smooth the effects of volatile investment returns. All endowment reductions should be considered part of the draw. Thus, investment management fees, fund-raising expenses or any other expenses paid from the endowment should be added to the operating draw when computing what was spent in a given year.

There is an optimal spending rate. Too high a rate reduces the real base of the endowment over time, resulting in less cumulative endowment draw than if a smaller rate is drawn. Defining endowment expenditures addresses today's operating needs. Tomorrow's requirements will be provided by ensuring that endowment principal remains intact. UMIFA implies the endowment's purchasing power should be maintained. Two principal computations, which incorporate the maintenance of purchasing power, are discussed below.

A simple way to calculate principal is to compare the market value of investments to the inflation-adjusted value of gifts. If market value is higher, an excess exists and principal is intact. If market value is less, a gap exists and principal has been violated. The inflation-adjusted value of gifts can be computed by inflating endowment layers. Each year's cash gifts are increased by inflation and added to the cumulative beginning inflated value of gifts. The sum of these two numbers becomes the ending inflated value of gifts, which can be compared to the market value of investments. Exhibit 2, below, provides an example.


Another approach to computing endowment principal tracks operating activity. Annual operating activity includes investment return less all spending and inflation. The net operating result either increases or decreases on endowment reserve. If the reserve is positive, principal is intact. If it is negative, principal has not been maintained. New endowment gifts, which are additions to capital, cannot affect the operating reserve and should not be used in the activity-based computation.


Endowments are crucial to many NPOs. To ensure the magic goose continues to lay its golden eggs, endowed institutions must balance current and future needs. Many states have adopted UMIFA. If an institution spends net appreciation, all UMIFA provisions apply. UMIFA suggests an endowment policy be defined that would include a total return spending policy and a computation of endowment principal that considers inflation. Maintaining the real value of investments will help accomplish an endowment's dual goals: to provide income, permanently.

RELATED ARTICLE: Trust versus Corporate Law

In their search of the body of law, Cary and Bright, authors of The Law and the Lore of Endowment Funds, performed an exhaustive search of contract, trust and corporate law to determine the legal definition of endowment income.

If endowment income were defined under contract law, an NPO would comply with its contractual agreement with a donor. However, most donors do not specifically identify how an endowment gift is to be spent. Therefore, contract law cannot be used in most cases.

Historically, endowed institutions were advised to use trust law to determine what was legally spendable. Under trust law, gains belong to corpus. Unlike in NPOs, there exists in trusts a dichotomy of interests between the income beneficiary and the remainderman. Any income that is distributed to an income beneficiary is not available to the remainderman.

NPOs do not have parties with conflicting interests. The income beneficiary, the remainderman and at times the trustee are the same. An endowed institution is one entity. Therefore, Cary and Bright concluded the use of trust law was not appropriate for determining endowment income.

NPOs essentially are corporations. Under corporate law all items of income, gain, expense and loss are used to compute net profit. Cary and Bright found no jurisdiction applied contract, trust or corporate law exclusively to all cases involving NPOs. However, in cases involving matters of administration, the courts typically drew on corporate law. Because NPOs are corporations and endowment spending is an administrative matter, Cary and Bright concluded corporate law should determine the definition of endowment income.


* ENDOWMENTS ARE INTENDED TO provide permanent support to not-for-profit organizations. The requirement that an endowment's return be available for future as well as current expenditures forces institutions to balance two conflicting goals.

* THE HISTORICAL EVOLUTION OF endowment investment policies, from land to bonds to stocks and other investments, helps to explain the investment and spending policies some institutions follow today.

* THE UNIFORM MANAGEMENT OF Institutional Funds Act (UMIFA) is the law that allows governing boards of NPOs to expend net capital appreciation on their endowments. Thirty-nine jurisdictions have adopted UMIFA.

* UMIFA CALLS FOR GOVERNING BOARDS to consider total investment return, present and future financial requirements and price level trends in making their spending decisions. It also allows for the use of a total return investment concept.

* PRACTICAL APPLICATION OF UMIFA might include adoption of an endowment policy that defines spending as some portion of total investment return and makes a computation of endowment principal that provides for the maintenance of the endowment's purchasing power.


Financial Accounting Standards Board Statement no. 116, Accounting for Contributions Received and Contributions Made, and Statement no. 117, Financial Statements of Not-for-Profit Organizations, (see "Implementing FASB 116 and 117" on page 41) require that the three components of an endowment be evaluated separately: the original gift, interest and dividend income and realized and unrealized gains and losses (net appreciation).

If a gift, its income or net appreciation is subject to donor-imposed restrictions, those restrictions determine the classification of net assets. If an endowment's donor does not stipulate how the gift's income or net appreciation is to be spent, the gift is classified as permanently restricted; income is classified as unrestricted. Classification of net appreciation follows income. In this case, net appreciation would be reported as unrestricted.

However, if a state has adopted UMIFA and the NPO's governing board determines the law requires the entity to retain its endowment's purchasing power, part of net appreciation should be retained in permanently restricted net assets. Remaining appreciation, after an inflation component has been permanently retained, is reported in the same manner as interest and dividend income on that gift.


Assuming these facts, the Leo Fund, a not-for-profit organization, could report its investment return on its true endowment as shown below.

* $100 million of permanently restricted endowment.

* Investment return of 10% ($6 million in interest and dividend income and $4 million in net appreciation).

* Inflation of 3%.
 Unrestricted restricted Total
 (Dollars in thousands)
Interest and
dividend income $6,000 $6,000
Net appreciation 1,000 $3,000 4,000
Total investment
return $7,000 $3,000 $10,000

According to the FASB exposure draft, Accounting for Certain Investments Held by Not-For-Profit Organizations, if there is a loss on investments instead of net appreciation, the loss should reduce unrestricted net assets. Given the same situation described above except with an investment return of --4% ($6 million in interest and dividend income and $10 million in realized and unrealized investment losses), such a loss would be accounted for as follows:
 Unrestricted restricted Total
 (Dollars in thousands)
Interest and
dividend income $6,000 $6,000
Net appreciation (13,000) $3,000 (10,000)
Total investment
return ($7,000) $3,000 ($4,000)

RELATED ARTICLE: The History of Endowments

The first endowment gift is shrouded in antiquity. England's King Henry VIII certainly was one of the first donors of very large endowment gifts. In his sixteenth-century dispute over the annulment of his marriage to Catherine of Aragon, Henry broke all ties with Rome. He declared himself "supreme head" of the Church of England. A 1536 act of Parliament dissolved all monasteries. From these monastic lands, which became the king's property, Henry made two large gifts to Oxford and Cambridge Universities. Over 500 years later, Oxford and Cambridge still hold these endowed lands.


Endowments: Managing for Growth

Tom Hallett, CPA and chief financial officer of the Chicago Symphony Orchestra, is responsible for all internal and external financial reporting. Hallett also considers himself the liaison for all financial matters between the symphony's chief executive officer and its 100-member board of trustees. All of the spending and investment policies for the symphony's endowment fund are coordinated through Hallett's office, but there is no question of who is running the show. "All the fiduciary responsibilities are held by our board of trustees," said Hallett. "They approve the budget, the direction of the organization and the policies of our endowment. Of course," he continued, "the interplay between investment management and the amount of money we draw from the endowment is an accounting issue for which I am ultimately responsible."

Founded in 1891, the Chicago Symphony Orchestra has a budget of $36 million and an endowment of over $80 million. Hallett said the board's investment posture is both active and aggressive. To ensure a variety of investment options, the board divides the endowment among a dozen investment managers. "Some of our investment managers are mutual funds and limited partnerships in which we share a piece of a large pool of investments," said Hallett. "The remainder of the managers are given a set amount of the symphony's money to invest using their own investment policies. We hire these managers because they do one thing very well. The moment they stray from their original investment philosophy they are gone. It doesn't matter if they have been with us for three months or eight years." Hallett said no manager was given a disproportionate sum to invest. "The largest amount one investment manager holds is $8 million, the smallest is $1 million."

The board also determines how the symphony's investments should be allocated. Its goal is to maintain an approximate 75% equity, 25% fixed-income balance, give or take the 1% invested in real estate. Hallett said the board takes a very conservative approach to its fixed-income investments. "A significant part of our fixed-income investments is in long-term Treasury securities to hedge against the impact of inflation on the equity portfolio," said Hallett. "We invest in short-term Treasury bills to hedge against fluctuating interest rates."

Spending the golden egg

Hallett said the Chicago Symphony Orchestra has received plenty of gifts in recent years, but surges in the stock market have provided the real boost to the endowment--it has grown by over $30 million in the last four years. Despite this windfall, the board maintains a very conservative spending policy. "Only 5% of the average of the fair market value of the endowment fund over the past four years is added to the budget," said Hallett. "We have experienced a large increase in our endowment fund, but our four-year average is $60 million. This gives us $3 million for operations." Hallett said the orchestra will not feel the full benefit of the recent surges in the Dow Jones Average for four years. "We may be the most conservative spenders of our endowment of all the orchestras in the country," said Hallett.

One reason for this conservative spending policy--the symphony has a number of other income sources. In fact, ticket sales contribute approximately $14 million to the annual budget, while donations contribute $10 million annually. The symphony rents its hall to others for performances, and it earns income for special concerts and tours. There's also a Chicago Symphony store.

A healthy endowment

The Chicago Symphony Orchestra has embarked on a $104 million capital expansion program. It will renovate the auditorium and construct a music center to house a symphony store, a multifunctional rehearsal space, an education center and a restaurant. Most of the expansion project will be financed by issuing tax-exempt bonds, but without a healthy endowment the symphony would not be able to borrow the money it needs for this expansion. Hallett believes the expansion program will add more than $100 million in new donations to the endowment fund, and it will use the income from this increase to service the $100 million debt it will accumulate to build and operate the expanded facilities.

--John von Brachel
COPYRIGHT 1995 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1995, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:includes related article on endowment growth management
Author:von Brachel, John
Publication:Journal of Accountancy
Date:Sep 1, 1995
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