An endowment is a type of investment mechanism that many nonprofit organizations utilize to manage their assets for the future. Professional financial advisory firms typically handle endowments with the goal of maximizing their assets for growth and the future stability of the nonprofit organization.
Creating Endowments
Nonprofit organizations often create endowments when they receive a sizable charitable donation or gift that restricts the use of the funds in a way by which the nonprofit organization can use the funds on a current basis. In some cases, the donor may specify that the gift is used to create an endowment. Donors also may continue to add to the endowment fund’s principal over time. There is no minimum amount required to create an endowment.
The California Corporations Code and the Uniform Prudent Management of Institutional Funds Act (UPMIFA), which California and most other states have adopted, establish some guidelines for endowments. For example, UPMIFA requires a “gift instrument” in writing or a written document that memorializes the donation.
An endowment remains somewhat separate from the nonprofit organization and is typically subject to various restrictions. In addition to any contractual restrictions, state law also restricts endowments.
Investment Restrictions
One common type of restriction for an endowment is an investment restriction. For instance, the terms of the endowment may instruct the financial advisor to pursue a particular investment strategy.
State law also places some investment restrictions on endowments. Generally, endowment fund managers must manage their investments in good faith and with the care that an ordinarily prudent person would exercise under the circumstances. The endowment fund manager must take the following factors into account in making investment decisions:
- Current economic market conditions
- Tax consequences
- Expected total returns
- Long-term goals of the charity
- The role of the investment in the charity’s overall assets
- The other resources available to the charity
Spending Restrictions
Spending rates among endowment funds may vary somewhat based on the needs of the nonprofit organization and the available resources. However, UPMIFA provides that a spending rate of more than seven percent of the fund’s value is considered imprudent. Generally, organizations cannot use permanent endowment funds to pay for operational expenses or as collateral for a debt.
In many cases, organizations may spend only the income from the investment of the endowment funds, but not the principal. In other cases, organizations may spend a certain amount of the principal annually or periodically as needed.
Use Restrictions
Some endowments may include restrictions on how the organization may use endowment funds. For instance, nonprofits may reserve those funds for capital expenditures, such as structural repairs to existing buildings or to fund expansions. However, when specific use restrictions exist, the nonprofit organization may only use the funds for those stated purposes.
As unexpected situations may arise, having a detailed document explaining the use restrictions is advisable. This document can also address under what circumstances the organization can alter, lift, or temporarily abate the use restrictions on the endowment funds. For example, the document could spell out a process by which the donor could consent in writing to a permanent or temporary alteration of the use restrictions on the gift.
Without a procedure for donor consent to the modification of use restrictions on an endowment, the nonprofit organization typically would have to seek a court order approving modification. According to UPMIFA, the organization may be able to get such an order if it can prove that circumstances have arisen that the donor did not anticipate or the restrictions have become “unlawful, impracticable, impossible to achieve, or wasteful.” However, UPMIFA also creates an exception to the need to get a court order to modify endowment fund restrictions for endowment funds that are more than 20 years old and that have a current value of less than $100,000.
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