Endowment funds are a form of investment vehicle used by many types of nonprofit organization to provide for structure and long-term management of the organization’s financial assets. Managed by financial advisory firms, endowment funds are first and foremost about making the most of an organization’s money. But they also have important legal characteristics, driven by their contractual and governance limitations.
Endowments are subject to governance restrictions.
An endowment fund can be thought of as quasi-independent from the nonprofit that owns it. That is because an endowment is set up with a variety of restrictions, including:
Investment restrictions. The manager—usually a professional financial advisor—can be instructed to follow a particular investment strategy, such as only investing in certain asset classes. Many nonprofits also want to restrict investments in things that are antithetical to their organization’s mission. In California, endowments are subject to the “prudent investment” rules set forth in the Corporations Code and the Uniform Prudent Management of Institutional Funds Act (UPMIFA). Under UPMIFA, endowment fund managers must act in good faith and with the care of an ordinary prudent person. In making investment decisions, managers must consider:
- General economic conditions
- Effects of inflation and deflation
- Tax consequences
- The role of each investment in the overall portfolio
- Expected total return from income and appreciation
- The charity’s other resources
- The needs of the charity and the fund to make distributions and preserve capital
Spending restrictions. Typically, the annual spending rate for endowments is between 3-6% of the fund’s value. Under UPMIFA, a spending rate in excess of 7% of the fund’s value is considered imprudent. In general, the principal of a permanent endowment can’t be used to fund operational expenses or as collateral for debt. Boards have to tread very carefully when looking for ways to utilize endowment funds outside the current spending policy.
Use restrictions. Some endowment funds also restrict how profits can be used. For example, a large donor may provide capital for an endowment to finance a specific recurring expense or a major project.
Modification of endowment fund restrictions
Due to the COVID-19 pandemic, the California Office of the Attorney General has made it possible for nonprofits to modify the use of endowment funds with the following restrictions:
Nonprofits with endowment funds that are over 20 years old with a value of less than $100,000 may modify or release restrictions on those funds after 60 days’ written notice to the California AG and the donor’s last known address. In the AG’s notice, the nonprofit must show how the endowment has become unlawful, impossible, impracticable or wasteful to operate with the restrictions. The notice should also propose an alternate use that is consistent with the charitable purposes expressed in the gift instrument.
Nonprofits with endowment funds of more than $100,000 must seek court approval to modify any restrictions on those funds, with notice of the petition provided to the AG’s office. A nonprofit must demonstrate that either the purpose of the restriction has become unlawful, impracticable, impossible to achieve or wasteful, or that restrictions in the gift instrument regarding management or investment have become impracticable or wasteful, or that due to circumstances not anticipated by the donor, a modification on the restriction will further the purposes of the fund.
Endowments are largely financial in character, but the decision of whether to form one, and how a new fund should be organized, can require careful analysis of legal questions. The Church Law Center of California provides counsel to religious and secular nonprofits. We’re happy to answer your questions about endowments and how one might be of benefit to your organization. Call us at (949) 689-0437 or reach out to us through our contact page.