The New York Times recently reported that from July 2008 to November 2008, universities and colleges experienced an average drop of their investment value of 23 percent, the largest drop in value since the mid-1970s. Across the nation, plummeting endowments have caused charities of all kinds to make painful budget cuts and to review their spending policies to determine just what amount of endowment expenditures are legally permissible and fiscally prudent in light of current economic conditions.
As Pennsylvania educational institutions and other charities address these difficult issues, it is important to note that the commentary and advice from national nonprofit resources and national advisors on these issues may not take into account some unique aspects of the Pennsylvania laws governing endowment funds. Most importantly, charities should be assured that endowment losses do not preclude them from taking draws from their endowment, although such losses will reduce the amount of allowable draws, particularly in future years. This bulletin is intended to provide a brief primer on Pennsylvania's laws on charitable endowments in comparison with the two prevailing standards for endowment expenditures in other states, as well as some practical advice for Pennsylvania charities concerned about legal compliance.
What are the Pennsylvania Rules Governing Endowment Spending?
Under Pennsylvania Law (15 Pa. C.S.A. §5548 and 20 Pa. C.S.A. Ch. 81), a charitable trust or a nonprofit corporation that holds donor-designated endowment funds may make an election to calculate the annual permissible expenditure from its endowment fund based on a percentage of the endowment fund's total value. (In general, non-electing charities are limited to expenditures of income, excluding capital gains, from their donor-designated endowment funds.) An electing charity must establish its allowable expenditure percentage annually in a writing maintained as part of its permanent records. The annual expenditure percentage of an electing charity may not be less than 2 percent or exceed 7 percent of the charity's endowment fund value. In addition, the charity must determine that the expenditure percentage is consistent with the long-term preservation of the real value of the endowment fund's principal. Once the charity has made the election, its endowment fund's "income" will be defined as the expenditure percentage of the fund determined by the charity on an annual basis. "Principal" will then be defined as all other assets held in the endowment.
A charity makes an election under the Act by adopting and following an investment policy seeking a total return for its endowment fund investments. The policy constituting the election under the Act must be in a writing that acknowledges that it is intended to constitute an election under the Act. The charity must maintain such documentation as part of its permanent records.
A charity may revoke its election to be governed by the Act if the revocation is made as part of an alternative investment policy seeking the long-term preservation of the real value of the principal of the endowment fund. The charity must maintain as part of its permanent records written documentation of its decision to revoke the election, as well as the alternative investment policy it approved.
For purposes of determining the expenditure percentage for an electing charity, the value of the endowment fund is the fair-market value of the cash and other assets held as donor-restricted endowment, whether such assets would be considered income or principal. The charity must determine the value at least annually, and base the expenditure percentage on the average value of the endowment fund over a period of three or more preceding years.
Notwithstanding the spending permitted under the Act, the governing board of the charity is still subject to the standards of prudence otherwise applicable to investments by fiduciaries with respect to the management and expenditure of endowment funds.
What is an "Underwater Fund"?
The term "underwater fund" is not applicable to endowment funds governed by Pennsylvania law. The term generally applies only to charitable endowment funds governed by the Uniform Management of Institutional Funds Act ("UMIFA"), a uniform law introduced in 1972 that was enacted in all states other than Pennsylvania, Alaska, and South Dakota. While the version of UMIFA adopted varies from state to state, charities with endowment funds subject to UMIFA are entitled to spend so much of the net appreciation of the endowment, both realized and unrealized, as is prudent. However, such expenditures are subject to the limitation that they may not cause the fund to drop below its historic dollar value. Historic dollar value is defined as the aggregate of: (1) the fair value of the fund at the time it became an endowment fund, (2) the value of subsequent additional contributions of the fund at the time contributed, plus (3) the value of donor-directed accumulations to the fund at the time such accumulations were made. Charities whose endowment funds have a current fair value that is less than the funds' historic dollar value are said to have "underwater funds," and some expenditures from these funds may be prohibited by applicable state law. Again, this is not the law in Pennsylvania.
What about the "new law" called "UPMIFA"?
"UPMIFA" refers to the Uniform Prudent Management of Institutional Funds Act. UPMIFA was introduced in 2006 and has already been adopted by 26 states and the District of Columbia. The version of UPMIFA adopted varies from state to state. In general, UPMIFA allows a charity to expend or accumulate so much of an endowment fund as the charity determines is prudent, taking into consideration: (1) the duration and preservation of the endowment fund, (2) the purposes of the charity and the fund, (3) general economic conditions, (4) effects of inflation and deflation, (5) expected total return from income and appreciation, (6) the charity's other resources, and (7) the charity's investment policy. The model version of UPMIFA also includes a provision that presumes that any expenditure of greater than 7 percent of the fair value of the endowment (averaged over at least three years) is imprudent. While Pennsylvania has not yet adopted UPMIFA, it is quite possible that sometime in the future, Pennsylvania could replace or modify the current standards under the Act with UPMIFA standards. UPMIFA, like current Pennsylvania law, permits draws on an endowment fund that is below the historic dollar value of the fund. UPMIFA does, however, provide specific factors that must be taken into account when determining the appropriate level of expenditures.
What does all of this mean for our endowment funds?
While Pennsylvania charities need not be concerned with "underwater fund" limitations on their endowment fund expenditures—meaning that they may use funds that have decreased below their original value—endowment expenditures by Pennsylvania organizations may be subject to unique considerations and procedural requirements that are not applicable in states governed by UMIFA or UPMIFA standards. First, charities wishing to calculate endowment expenditures as a percentage of total endowment fund value should ensure that they have satisfied all of the technical requirements for making an election under the Act. Second, charities that have made such an election should recognize the long-term impact of the three-year average on their expenditure percentage budgets in future years. The expenditure amount for future years (based on the three-year average including years when assets are in deep decline) may significantly reduce allowable expenditure amounts for future years. Finally, some charities that have already made an election under the Act may be concerned that they are obligated under the Act to significantly decrease their expenditure percentages, or suspend endowment expenditures altogether in order to satisfy their fiduciary obligations to preserve endowment fund principal. Charities should be assured that the three-year averaging period for determining distributable amounts under the Act is intended to equalize the expenditures over time. Accordingly, it is generally consistent with prudent administration of an endowment fund for organizations to select standard prudent distribution percentage and continue to use it. Radical decreases in prudently set expenditure percentages or complete suspension of endowment expenditures for an electing charity should not be required to satisfy the charity's fiduciary obligations to manage endowment funds prudently.