Washington State Enacts New Rules for Charities on Investment Management and Endowment Fund Spending

A new law in Washington state changes the rules on how charities must manage and invest their charitable assets, and provides greater flexibility for spending from endowment funds. These changes have significant implications for charities in today’s challenging economic environment.

On May 11, 2009, Gov. Chris Gregoire signed Substitute HB 1119, the Uniform Prudent Management of Institutional Funds Act (UPMIFA). The Washington legislation is based on a new model act that has now been adopted in 32 states.

UPMIFA provides: (1) a set of “prudent” management and investment standards that apply to all investment decisions by a charity, and (2) spending rules that apply to a charity’s endowment funds. UPMIFA applies to charities, i.e., organizations that hold assets that are dedicated exclusively to charitable purposes, including colleges, universities, schools, hospitals, arts organizations and social service agencies. It does not apply to charities formed as trusts that are managed by corporate or individual trustees or to split-interest trusts (e.g., charitable remainder trusts).

Management and investment of charitable funds

A charity’s board of directors is responsible for the prudent management and proper utilization of the charity’s assets. While the board typically fulfills these responsibilities by delegation to a committee or an investment advisor, it remains responsible for compliance with applicable rules. UPMIFA sets out the standards that any person responsible for managing and investing a charity’s assets must follow. First and foremost, when dealing with assets contributed by a donor, a charity must comply with the donor’s wishes, as expressed in a gift instrument. At the same time, when dealing with any assets, a charity must consider its charitable purposes in making management and investment decisions.

Persons responsible for managing and investing charitable assets must act “in good faith and with the care an ordinarily prudent person in a like position would exercise under similar circumstances.” This means that responsible persons must act as a prudent investor would, using a portfolio approach in making investments and considering the risk and return objectives of the fund. Specifically, directors and others responsible for managing and investing a charity’s funds must consider the following factors:

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 that each investment or course of action plays within the overall investment portfolio of the fund;
5. The expected total return from income and the appreciation of investments;
6. Other resources of the charity;
7. The needs of the charity, or a particular fund within the charity, to make distributions and to preserve capital; and
8. An asset’s special relationship or special value, if any, to the charity’s purposes.
   

In addition to considering these factors, UPMIFA requires a charity and those responsible for managing and investing its funds to:

1. Incur only reasonable investment and management costs;
2. Make a reasonable effort to verify relevant facts;
3. Make decisions about each asset in the context of the portfolio of investments as a whole, and as part of an overall investment strategy that is appropriate for the specific fund and the charity;
4. Diversify investments unless, due to special circumstances, the purposes of the fund are better served without diversification; and
5. Dispose of unsuitable property within a reasonable time after receiving the property.

Endowment spending

UPMIFA’s spending provisions apply to “endowment funds,” defined as assets held by a charity for charitable purposes which, under the terms of the donor’s gift instrument, cannot be spent in their entirety on a current basis. UPMIFA effectively provides a default rule for spending from endowment funds. If a donor has provided specific spending limitations in a gift instrument that may be either more or less restrictive than what UPMIFA would permit, e.g., a provision that the charity may not spend more than 3 percent of asset value annually, then the charity must respect the donor’s wishes. Where the donor has instead provided only that the gift is for “endowment,” or that the charity may spend only “income,” then UPMIFA’s spending rules will apply.

UPMIFA’s spending provisions apply to funds that are subject to donor-imposed restrictions on spending. They do not apply to funds that are subject only to board restrictions on spending, so-called “quasi endowment” funds. A donor may impose either spending or use restrictions, or both, on a gift. A gift that is subject only to a use restriction is not an endowment fund. For example, if a donor requires the charity to use the gift only for a scholarship program, but does not restrict spending in any way, the fund is not an endowment for purposes of UPMIFA.

UPMIFA replaces and updates the Uniform Management of Institutional Funds Act (UMIFA), which had governed endowment fund management in Washington state since 1973. Under the old UMIFA rules, if the value of an endowment fund dropped below its “historic dollar value” (i.e., the value of assets contributed to the fund at the time of contribution), the only spending permitted from the fund was its current income (e.g., interest and dividends), if any.

UPMIFA abolishes the concept of historic dollar value and replaces it with a more flexible spending rule. Under UPMIFA, a charity may spend so much of an endowment fund as the charity determines is prudent, regardless of whether the fund value is below its historic dollar value. The new standard gives charities the ability to meet current spending needs more easily in the face of fluctuations in the value of their endowment funds.

UPMIFA requires a charity to consider the following seven factors (to the extent that each is relevant) in determining a prudent spending rate:

1. The duration and preservation of the endowment fund;
2. The purposes of the institution and the endowment fund;
3. General economic conditions;
4. The possible effect of inflation or deflation;
5. The expected total return from income and the appreciation of investments;
6. Other resources of the institution; and
7. The investment policy of the institution.

This multifactor analysis is likely to leave many boards concerned as to the spending rate they should apply in order to satisfy the prudence standard. Some of the versions of UPMIFA enacted in other states include a rule under which an annual spending rate above 7 percent of the endowment fund’s value (computed over a rolling three-year period) is presumed to be imprudent. While Washington’s version of UPMIFA does not include this rule, it can serve as a guidepost. Any charity considering an annual spending rate above 7 percent for an endowment fund should have a very compelling justification under the factors listed above.

Changing donor restrictions and special treatment for old, small funds

UPMIFA allows a charity to release or modify a donor restriction if it obtains the donor’s written consent. It also allows charities to seek court approval to modify a donor restriction in certain circumstances, with participation by the attorney general.

Under these new rules, a charity may release or modify a donor restriction without donor or court approval if the fund is both old and small and the charity determines that the restriction is unlawful, impracticable, impossible to achieve or wasteful. This option is available to charities if the fund is more than 20 years old and has a value of less than $75,000. The $75,000 limit will increase by $2,500 each year, beginning on July 1, 2011.

The purpose of this provision is to make it easier and less expensive for charities to remove impractical or wasteful donor restrictions on old and small funds. Charities are not required to give notice to donors under this provision. They are required to provide 60-days’ notice to the attorney general, however, before releasing or modifying the restriction.

When will the new UPMIFA rules apply?

UPMIFA will apply to both existing and future endowment funds held by Washington charities as of July 1, 2009. A charity’s governing body may elect to have UPMIFA apply earlier, however, to investment and spending decisions made between the date of the election and July 1, 2009. A charity with a fiscal year-end of June 30 could therefore elect to have the rules apply before the end of the current fiscal year.

Conclusion and recommended actions

Under the new rules, charities in Washington state may make expenditures from an endowment fund so long as the expenditures are prudent, subject to specific donor restrictions that may mandate a different spending regime. It is essential that charities and donors communicate to each other their expectations regarding spending from donated funds. Given the flexible rules that apply to endowment spending under UPMIFA, some donors may wish to include more specific spending restrictions in their gift instruments.

Charities should consider revising their investment and spending policies to reference the investment and spending considerations under the new rules. Boards, committees and others with board-delegated authority over investment and spending decisions must be able to demonstrate that they have considered all relevant listed factors in reaching their decisions as to investment management and a prudent spending policy.

Finally, charities should ensure that all investment and spending decisions are well-documented to demonstrate that proper procedures were followed and that the decisions were prudent under the circumstances.