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Dec 21, 2011

December Business First, Part 2: Nonprofit boards must reconsider endowment distribution decisions

In my first post from this blog entry, I presented my readers with the current endowment dilemma facing nonprofits. My conclusion was that nonprofit boards can no longer put their endowment distribution rules on automatic pilot and focus entirely on asset allocation. It is clear that more time must be spent on distribution decisions.

This is where Sedlacek’s insights are most helpful. First, he notes a three or five year rolling average is a short time span when evaluating a perpetual endowment. A three year period would suggest strong distributions in 2007 and 2011 yet we know the past decade suggests the opposite.

Second, this approach produces volatility in the amount of funds distributed to the operating budget. The primary duty of a board member is to make the nonprofit a reliable provider of a community need. Having the dollar value of endowment distribution rise and fall with fluctuations in the investment market compromises the board’s duty to maintain reliability. Indeed, operating budget cuts in reaction to plunging endowment values were widespread in 2009 and 2010.

Third, Verne makes the important observation that this formulaic approach to endowment distribution places all risk on the mission of the institution and none on the endowment. He notes, “If you only pay out the return of the endowment, then all risk is placed on the current operations.” He then adds, “If you increase spending every year by the rate of inflation irrespective of endowment return, then all risk is placed on the sustainability of the endowment.”

The trick lies in finding the right balance. The Uniform Prudent Management of Institutional Funds Act (UPMIFA) provides some help in moving beyond a formula. Before making any decisions regarding endowment spending, it requires boards to weigh eight factors in balancing the needs of the nonprofit with the needs of the endowment:

  1. General economic conditions
  2. The possible effect of inflation or deflation
  3. The expected tax consequences, if any, of investment decisions or strategies
  4. The role each investment or course of action plays in the overall investment portfolio of the fund
  5. The expected total return from income and the appreciation of investments
  6. Other resources of the institution
  7. The need of the institution and of the fund to make distributions and preserve capital
  8. An asset’s special relationship or value, if any, to the charitable purposes of the institution

For example, compare a community foundation which supports all of its work from endowment spending to a nonprofit where endowment provides minor support to operations. Clearly the former has a stronger case for stable spending over endowment sustainability than the latter. Or compare a museum’s endowment for education programming to that same museum’s endowment for acquisition of art. Surely, acquisitions can be postponed a year to support the sustainability of the endowment, but suspending educational programming for a year to sustain the endowment may have great short-term consequences.

There is no single answer. Boards must carefully link their endowment distribution decisions to the needs and purpose of their nonprofit mission.

The days of an easy distribution formula may be over. Because government and donor support will continue to fluctuate, nonprofit boards preparing their budgets will need to devote more time to determining the appropriate amount to spend from their endowments in order to stabilize their mission activities.

If your organization needs endowment counsel in preparation for the coming year, consider hiring a consultant for a board retreat. I’ve had great success with my board retreats for nonprofits and would love to offer some expertise. Together we can help your organization devise a specific, tailored strategy to help you succeed. If you’re looking to educate more than just your board, a workshop is also a great option. “Uses and Abuses in Nonprofit Finance” and “A Layperson’s Guide to Reviewing Financial Statements” are two selections that would greatly benefit any nonprofit employee looking to improve their own education and the sustainability of their organization.