A recent study published by the National Association of College and University Business Officers (NACUBO) indicated that participating institutions saw their endowment returns decrease by 13 percent for the fiscal year that ended June 30, 2015, compared to the fiscal year that ended June 30, 2014. Considering the market performances from July 1, 2015 through January 31, 2016, the fiscal year that will end June 30, 2016, is shaping up to be a disappointment for endowment portfolios everywhere. As the market declines continue, the issue of underwater endowments will again become center stage in the not-for-profit sector.
Underwater endowments affect nearly all not-for-profits, but they are particularly vital for colleges and universities. According to the NACUBO study, endowments make up nearly 10 percent of institutions’ operating budget. When endowments decline or go underwater, many educational institutions are forced to draw from their unrestricted assets to make up for the loss of spending from these funds. They must also look for ways to cut expenses and put capital projects on hold. Though sometimes necessary in times of financial crisis, this practice reduces or even eliminates the unrestricted funds in their endowments. As a result, many continuing programs, such as scholarships or faculty support, are negatively impacted because they are typically funded by income generated by these restricted gifts.
Most states and the District of Columbia have adopted the Uniform Prudent Management of Institutional Funds Act (UPMIFA), which allows for organizations to spend income generated by underwater endowments provided that the organization has adopted a prudent endowment spending policy. It also eliminates the historic dollar limitation.
Not-for-Profits Face Limited Options
Not-for-profits face restrictions both from donors and applicable laws about how much their organization can spend from an underwater endowment. Donors often require that the income from their endowments be spent to fund specific programs and that a certain portion of the original income will always remain in the fund.
For example, say that a college received a $1 million restricted gift intended to pay for a scholarship program. Since the gift was made, market forces drove down the fund’s value by $50,000 so it is now only worth $950,000 and is considered underwater. Under the new UPMIFA rules, the college could still continue to pay for scholarships as planned, however, the college must have a prudent plan in place to evidence why spending this underwater endowment is in the best interest of the college. As a result, the school may not be allowed to tap this gift to pay for any scholarships as planned and won’t be able to do so until the fund’s value exceeds the $1 million of the original gift. Additionally, the $50,000 shortfall may have to be made up by temporarily restricted or unrestricted assets.
Even if the income was not restricted by the donor, the organization still might not be able to access the funds because of legal restrictions, which vary by state. UPMIFA requires an organization to base endowment spending on the fund’s income and what the charity deems a “prudent portion of appreciation” of its assets. Rules differ by state—some states allow all appreciation to be classified as unrestricted while other states require appreciation to be classified as temporarily restricted and subsequently “prudently” appropriated. In many instances, underwater endowments must be “made whole” by transferring temporarily restricted or unrestricted net assets to the permanently restricted endowment. This leads to an erosion of unrestricted net assets and could lead to liquidity issues and covenant violations. Organizations should work with their boards and lenders if such issues start to surface.
The varying treatments of underwater endowment accounting led the Financial Accounting Standards Board (FASB) to consider how to make it uniform. The FASB included changes to underwater endowment accounting as part of its recently proposed improvements to not-for-profit financial statement reporting. Recently, the FASB announced its timeline for the new not-for-profit financial reporting standards. Changes will occur in two phases: phase 1 on or before June 30, 2016, and phase 2 after June 30, 2016. The details, such as whether the new reporting model rules will address the uniformity of the accounting treatment for underwater endowments, remains uncertain.
How to Approach Underwater Endowments
For not-for-profits in both UPMIFA and non-UPMIFA-compliant states, addressing underwater endowments requires significant analysis and, in some cases, hand-wringing. Here are some steps to take if your organization’s endowments are underwater:
- Accurately track the fair value of your donors’ original endowment gifts. Consider evaluating permanently restricted gifts within the past 10 years to identify declines below historic cost.
- Review applicable governing documents, applicable state laws, endowment investment and spending policies, articles of incorporation and bylaws to determine any limitations on your ability to disburse investment income, accumulated appreciation or corpus.
- Explore options with your organization’s finance committee, other executive committees and Board of Trustees. If appropriate, consider modifying your spending policies or fund agreements.
- Communicate with your donors to educate them about how the financial market affected their funds and the organization’s ability to spend or make grants from these funds. Be sure to also outline options they might consider to meet your organization’s mission and critical spending needs.
For More Information
If you have questions regarding your organization’s endowments or would like assistance evaluating your organization’s restricted gifts, please contact us here.
Adam Nelson is an Audit Director in our Not-for-Profit & Education Practice and is located in our Boston, MA office. Adam can be reached at email@example.com or 617.761.0516.
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