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Dec 19, 2011

December Business First, Part 1: Nonprofit boards must reconsider endowment distribution decisions

Yearly distribution of endowments is the focus of the December edition of my Business First column. It was inspired by an article in Commonfund’s periodical, Mission Matters, by CEO Verne Sedlacek (an old friend from my Harvard days). Verne is a very thoughtful, data-oriented commentator on the nonprofit world and manager of endowments for educational institutions across the country. He sees firsthand what these endowment-dependent institutions face each year.

Many of us have become lazy in our endowment distribution. We put a formula into our policy, generally a spending rate of 4 to 6 percent calculated against a three to seven year moving average of the market value of the endowment at the end of the year. It’s pretty automatic, so we devote most of our investment time to choosing the asset allocation of our portfolio. Verne challenges this approach.

Up until the year 2000, investment income was generally positive each year and endowment spending was commonly about five percent of a three to five year moving average of the value of the endowment. This produced stable increases in endowment spending to support the programs of the nonprofit. All the while the endowment increased faster than inflation, sustaining the endowment’s value to future generations. This fortunate alignment allowed nonprofit boards to spend most of their time on the asset allocation of their endowment portfolio.

This practice fell apart in the last decade. Weak returns and two calamitous market collapses created a variety of dilemmas. For example, the goal to have the endowment keep up with inflation conflicted with the goal to maintain stable support of the nonprofit’s operating budget. Over the last decade the average university endowment earned 3.4 percent while inflation in their expenses grew 4.3 percent. Trustees had to choose which goal to follow.

Additionally, the rule to never invade principal conflicted with the donor’s intent to support nonprofit programs. Some trustees chose to continue support of programs and saw their endowments plunge. Others opted to maintain endowment principal and reduced or completely suspended all distributions, leaving operating budgets in tatters.

A new endowment law called The Uniform Prudent Management of Institutional Funds Act (UPMIFA) was adopted in virtually all states to eliminate this particular problem. UPMIFA now allows distributions to continue even when an endowment is sunken. But the dilemma of spending stability versus endowment sustainability remains. After a disastrous 2008 and 2009, the S&P 500 rose 14 percent for the June 2010 fiscal year and 30 percent for the June 2011 fiscal year. It seemed at the time that endowments had resurfaced and returns were sufficient both to cover inflation and to allow distribution to operations. And yet the September 2011 quarter saw a decline of more than 13 percent, bringing the dilemma back to the fore.

It is pretty clear to me that nonprofit boards can no longer put their endowment distribution rules on automatic pilot and focus entirely on asset allocation. Now it is necessary to spend more time on distribution decisions and whether the conventional rule of thumb retains any relevance to their situation.

In the second part of this post, I’ll address the insights gleaned from the current endowment situation and follow up with some suggestions on best practices. Stay tuned until then!