UPMIFA Ins & Outs
Let's say you're a volunteer board member for a charity named Buckeye Good Works. For years, BGW has funded its good works in part by receiving annual distributions of $250,000 from its permanent endowment fund.
But suddenly it's 2008, and the investment markets are crashing. The Good Works endowment, which had grown to well above $5 million, is now worth only $3.5 million-below its "historic gift value" of $4 million. Sorry, says your legal counsel, but you're not allowed to "invade the principal" of the endowment by taking that annual $250,000. In fact, you can't take anything at all until the endowment grows back to at least $4 million.
That's the painful situation quite a few Ohio charities and foundations found themselves facing a couple of years ago, hamstrung by the Uniform Management of Institutional Funds Act (UMIFA). Without a change in the rules, the good works of Good Works might have ended abruptly.
Fortunately, the Ohio General Assembly came to the rescue. On June 1, 2009, UMIFA was replaced by the Uniform Prudent Management of Institutional Funds Act (UPMIFA). And adding that one new word, "prudent," has made a world of difference.
Decisions about endowment fund spending, previously restricted by UMIFA's somewhat rigid rules, can now be made within the larger spectrum of an organization's total investment strategy. UPMIFA "affects all charitable organizations," says attorney John Furniss, a partner in Bricker & Eckler's tax, trusts and estates group. "However, the organizations most impacted will be those that have a significant amount of endowed funds as well as those that issue bonds."
Although UPMIFA's origins preceded the stock market meltdown of 2008, the crash pushed along the reforms. For example, the Catholic Foundation, which administers more than 500 endowments for parishes in the 23-county Roman Catholic Diocese of Columbus, would have had difficulty making annual distributions without the change in law.
"We were concerned ... that UPMIFA wouldn't be accepted in time for our cycle, and it worked out wonderfully for our organization and the organizations we serve," says Jennifer Damiano, the foundation's president and CEO. Without UPMIFA, "We would have had to restrain our distribution." Under the new rules, the foundation made $5 million in distributions for both 2008 and 2009.
While UPMIFA makes it easier for charities to spend endowment dollars, the new law also requires nonprofits to jump through some compliance hoops. "Larger not-for-profit organizations had to spend time updating policies to match the enacted version of UPMIFA in Ohio," says Michael Borowitz, a CPA and shareholder in the Columbus office of accounting firm Clark Schaefer Hackett. "They must go back and reevaluate their agreements, how they treat them, and get together with major donors to see how they line up."
UPMIFA and new requirements from the Financial Accounting Standards Board (FASB) affect any nonprofit with an endowment. These organizations must detail their endowment spending strategy, investment policies, institutional purpose and goals, potential impact of inflation or deflation, estimated investment returns and long-term appreciation, and other financial resources.
Not all local endowments are feeling the effects of UPMIFA. The Columbus Foundation, which holds nearly $1 billion in assets, drafts all fund agreements to refer to the variance powers of the foundation's Revised Declaration of Trust, effectively superseding UPMIFA. Other large charitable institutions, such as the Nationwide Insurance Foundation, report little impact from the updated law.
A 5 Percent Solution
UMIFA required distributions from endowed funds to be calculated based on "net appreciation over historic dollar value." If gifts to an endowment totaled $1 million, but investment losses had reduced the fund balance to $900,000, no distribution was permitted.
Ohio's version of UPMIFA (there are many variations in other states) establishes a "safe harbor" annual spending limit of 5 percent of the fund's average value over the preceding 12 quarters, without regard to historic gift value. So the endowment whose value had dropped to $900,000 could still make a distribution.
The 5 percent rule is one of numerous provisions which cross over from the Institutional Trust Funds Act, which regulates institutional trusts, to UPMIFA, which regulates charitable endowments. "It has been a long process of modifying the trust code and the institutional management of funds," says attorney Martha Sweterlitsch, of counsel for Benesch, Friedlander, Coplan & Aronoff.
Even before UPMIFA, some foundations were using "trailing fund balance" calculations to determine their distribution limits. "We've been using that formula for many years," Damiano says. "It put into law what we were already practicing. Five percent over 12 quarters is prudent. That gave us the ability to serve need when it was greatest, during the last two years."
"Now we know what a prudent standard is," says Sweterlitsch. "A higher distribution could also be prudent. The questions arose because we had such huge capital gains when the stock market was flying high."
Of course, huge capital gains can evaporate in a matter of months, as they did in 2008 and early 2009, leaving many diversified investment portfolios with essentially zero return for an entire decade. That gave new emphasis to the word "prudence" as endowments struggled to preserve capital without abandoning their charitable purposes.
"Liquidity has been key for the past year or so," says financial planner Peggy Ruhlin, a principal at Budros, Ruhlin & Roe and chairwoman of the investment committee of Otterbein University's board of trustees. Ruhlin says the market meltdown "didn't impact Otterbein's financial planning. But it was a concern. Not invading the principal is a big concern for all endowment funds."
In other words, just because an endowment is permitted to distribute 5 percent from an "underwater" fund doesn't mean the endowment will spend the money. Many endowment trustees may opt for more conservative spending policies, waiting for investment returns to get back to something approaching historical norms.
The AG's New Role
For many smaller charitable funds, UPMIFA makes it simpler-and less costly-to remove or alter restrictive rules. Consider a $200,000 fund, established in 1925 to fund health-care benefits for veterans of World War I. There aren't many WWI vets around these days-none, at last count-so the charity managing the fund would like to allow it to fund health-care benefits for all veterans.
Under UMIFA, the charity likely would have had to ask the Franklin County Probate Court to approve the change. But UPMIFA allows the charity to seek approval from the Ohio attorney general, whose staffers can sign off on a change without a lot of judicial pomp and circumstance.
Borowitz says some charities "have been holding permanently restricted funds for a number of years," unwilling to go through the hassle and expense of a probate court proceeding involving relatively little money. "The option to go through the attorney general's office will help some clean up their holdings," he says.
To qualify for a change, the charity must document to the attorney general's office that the restriction on the fund is unlawful, impracticable, impossible to achieve-giving benefits to WWI vets, for example-or wasteful. Alterations can include combining funds or modifying the amount of the principal that can be awarded.
Fund managers must prove the need for alteration and notify the attorney general's office two months prior to changing the rules. If the AG's office rejects the move, the fund holder still may apply for the change in probate court, Sweterlitsch says. Funds larger than $250,000 must go through the judicial process in any case.
Although it manages funds of numerous sizes, the Catholic Foundation has not yet undertaken any modifications under the new law. "We do have some that are small and sometimes issues arise with them," Damiano says. "The new legislation will help us when those issues arrive. But we haven't done anything to them because of UPMIFA. We have left those funds alone. Some of those funds could [receive] another gift in the long run."
Universities Under Stress
In Ohio as well as nationally, colleges and universities are among the most prominent endowment fund holders. And institutions of higher learning, just like most other charitable funds, took a big hit in the last few years. Endowment fund balances declined an average of 18.7 percent in fiscal 2009, according to the National Association of College and University Business Officers. Ohio State University's endowment, valued at $1.6 billion in 2009, lost 20 percent during the market collapse. Capital University lost 18 percent, its endowment falling to $49 million.
"What happened in late 2008 and early 2009 impacted all asset classes," says Ruhlin. Even a conservatively managed portfolio, she says, "could have found itself hit from all sides."
Most local colleges and universities have highly diversified portfolios containing few high-risk, high-volatility investments. So a school like Otterbein did not see its endowment slip as badly as more heavily-endowed (and more risk-oriented) universities such as Harvard and Yale, which saw endowments fall 29.8 percent and 28.6 percent, respectively. "Otterbein has never had an issue with [losses of that magnitude]. We've never come close," Ruhlin says. "With what happened in the economy, this was a big concern for many institutions."
Costs & Benefits
Being able to spend 5 percent of an endowment's 12-quarter "rolling average" fund balance might sound like an invitation for trustees to dig deeper into the original fund principal. But Borowitz says smaller funds aren't likely to spend themselves out of business. "They're comfortable with spending some of the money [the endowment] earns from year to year," he says. "The fluctuation in what they spend doesn't change that much."
The pivotal change for smaller endowments is opening their funds up to make at least some grants when previous law would have kept them shut in a bad economy. It won't mean a glut of new awards, in any event. "The smaller funds have been holding their money and not spending a lot," Borowitz says.
Offsetting the benefit of additional spending flexibility, UPMIFA does pose a few challenges for endowment funds. "The primary disadvantage arises from the difficulty of converting accounting systems to comport with the new act," Furniss says. "To make matters more challenging, the accounting standards that apply to endowment funds are inconsistent with the provisions of the new act." He notes that UPMIFA eliminates the use of historic dollar values in favor of the three-year fair market value, but accounting standards continue to rely on historic values.
New reporting requirements potentially complicate matters. Trustees and staff may need to devote more time to improving processes. There is also potential expense for spending more time with legal and financial advisors. "Most of the costs of complying appear to come from staff and volunteer time, formalizing processes and policies," Borowitz says. "For some of the more large and complex arrangements, CPAs and attorneys are retained to assist with compliance."
The trustees of an endowment fund are not always sophisticated professionals, Sweter-litsch notes. In many cases, a single family member oversees a charitable fund. "They have a fiduciary duty, and it was difficult to know what that meant," she says. "Not all trustees are lawyers."
An endowment's ability to dip into the fund principal to make distributions could make some donors skittish. Fund managers and trustees will need to communicate the changes effectively to their donor bases. "The more conservative donors are probably a little nervous about the added flexibility to spend below the historical cost," Borowitz says. "The donors more focused on providing an uninterrupted cash flow for programs are probably excited about the new rules."
"The act does help donors insofar as it ensures that their donations are being invested in accordance with modern investment standards," Furniss says. "Further, it ensures that donations to an endowment fund can be utilized even when that fund is operating at a loss historically. That said, I don't think a lot of donors have focused on the act."
Perhaps donors haven't paid much attention to UPMIFA, but it's a safe bet that many charities that rely on distributions from endowed funds are well aware of the new law-and happy to be getting those annual checks, even though the endowments are still struggling to get back to where they were in 2007.
Bill Melville is a freelance writer.
Reprinted from the December 2010 issue of Columbus C.E.O. Copyright © Columbus C.E.O.