Unique Characteristics of Endowment Management.

At first thought, it may seem that managing an endowment is largely the same as managing any investment portfolio. While there certainly are core principles that relate to the management of any investment portfolio (see our Portfolio Management page), endowment management involves numerous additional complexities including:

1. •an indefinite investment time horizon
   

2. •opposing interests of current beneficiaries and future beneficiaries
   

3. •laws that govern nonprofit/institutional investing
   

4. •the involvement of numerous stakeholders
   

Indefinite Time Horizon.

The difference in time horizon between individuals and endowments (i.e., longevity vs. perpetuity) creates significant differences in management perspective. For anyone sharing responsibility for an endowment, the term “capital preservation” takes on unequaled consequence — it means preservation forever. For some of the implications of this difference, see the Payout Policy section below.

Current vs. Future Needs.

In endowment management, there is always a tug-of-war between the opposing interests of current needs and the needs of future beneficiaries (i.e., future generations). Money that is spent today can’t be used next year. In most asset management practices, the beneficiaries, or clients, can speak for themselves. However, in the case of endowment management, future beneficiaries may be unidentified or not even exist yet. Nonetheless, future beneficiaries have as much entitlement to the benefits of the endowment as do current beneficiaries, and their rights must be protected.

Laws Governing Nonprofit Investing.

Prior to the 1970s, when the investment activities of nonprofit organizations were legally challenged, the courts would typically hold the fiduciaries accountable on an asset-by-asset basis. As a result, investments were selected individually with an emphasis on protection of principal. Unfortunately, this resulted in extremely conservative portfolios at the expense of growth and future beneficiaries. Fortunately, the standards of accountability have changed considerably with the adoption of the following acts:

1. •Uniform Management of Institutional Funds Act (UMIFA), 1972
   

2. •Uniform Prudent Investor Act (UPIA), 1995
   

3. •Uniform Prudent Management of Institutional Funds Act (UPMIFA), 2006
   

Collectively, these acts have eliminated outdated concepts of investment management in favor of Modern Portfolio Theory (MPT). Therefore, it is important that all of the fiduciaries have a working knowledge of MPT and how to apply it to the organization’s investments (see the Education section below). It is also important to note that not all states have adopted all of these laws and standards, and even those that have may not have adopted them in their entirety and/or may apply the rules in different ways. Consequently, it is important to consult your organization’s legal counsel to determine exactly what laws and concepts apply to you.

Numerous Stakeholders.

In addition to some endowment beneficiaries (i.e., future beneficiaries) not being able to speak for themselves, no endowment beneficiary is represented by a single voice. Rather, they are represented by the various voices of the Board of Directors/Trustees, members of the Investment Committee, officers and staff of the organization, etc. While the Board members sit at the top of the food chain, successful endowment management requires coordinating the potentially disparate interests and opinions of numerous stakeholders.

Implications for Fiduciaries and Advisors.

The unique characteristics of endowment management outlined above have a number of implications for the various stakeholders and advisors.

Endowment Policy Statement.

The Board, in consultation with the executive staff, should determine the objectives of the endowment and the policies that will guide its management, document them in a written statement, and periodically review and update the statement. The policy statement sets the course for endowment management, and it maintains continuity as times change and the Board, committees and staff change. The clarity of the statement can make a vital difference in the months and years ahead. Key issues that it should resolve include:

1. •  The role of the endowment in supporting the organization’s charter and mission
   

2. •  The role of the endowment in maintaining a healthy balance sheet
   

3. •  How much of the return should be spent vs. reinvested (see Payout Policy below)
   

4. •  How much of gifts received should be added to the endowment vs. used for current needs
   

5. •  Overall investment strategy, including asset allocation, restrictions and rationale
   

6. •  Responsibilities of all participants (Board, committees, staff, outside advisors, etc.)
   

Costs, Stewardship and Transparency.

Since the Board must ensure that future beneficiaries will be able to obtain the same level of benefits from the endowment as current beneficiaries, the endowment must earn a total return at least equal to the spending rate, plus inflation, plus the cost of managing the endowment’s funds. Furthermore, donors rightfully expect recipients to be prudent stewards of their financial resources. Therefore, responsible endowment management requires a disciplined and comprehensive commitment to minimizing the total costs of investing. Effective cost management, in turn, requires complete transparency of fees (and indeed there are other reasons that fee transparency is a necessity). The only way to ensure complete fee transparency is by working with a fee-only advisory firm. For a detailed discussion of the total costs of investing, visit our Fees and Costs page.

Payout Policy.

Annual withdrawals from endowments have tended to average about 5.5% of the net value of the endowment. Not surprisingly, organizations with smaller endowments tend to take a somewhat higher percentage and those with the largest endowments take a much smaller percentage. While high payout rates provide increased funding for current needs, they do so at the expense of future needs. In fact, the UPMIFA specifies that payout rates in excess of 7% are inherently imprudent because the real return, after accounting for inflation and endowment management expenses, may not prove adequate to match the growth of the organization’s budget. Comparing payout rates of 4%-7% for 20 years, it’s been shown that the lower payout rate, which allows for greater capital accumulation in the endowment, will ultimately result in a higher absolute dollar level of payout. Less becomes more.

The state of the markets will, of course, impact investment results and hence payout rates. To smooth out the effects of year-by-year variations, many organizations base their payout calculations on a moving average (e.g., over the past three or five years), rather than just the last year. While this can be very effective in insulating the organization from the impact of short-term declines in the investment markets (e.g., declines of one to three years) longer-term declines can still represent a significant challenge. In the long run, it is the balance of the assets in the portfolio (i.e., asset allocation) that will have the greatest impact on investment risk and return.

Asset Allocation.

In seeking the investment return necessary to support a payout policy, there are both short-term and long-term risks that must be addressed. The principal short-term risk is not being able to adequately support the operating budget, and the principal long-term risk is failing to earn a return sufficient to preserve the value of the endowment after accounting for annual spending, management expenses and inflation. A temporary decline in market value and hence spending can be prevented by investing in stable securities such as cash equivalents, but that strategy would offer little chance of preserving the real value of the endowment over time. Equities offer the best chance of outpacing inflation, but they are certain to experience periodic declines in value. The challenge is to construct an asset allocation that offers a high probability of preserving real value while keeping the frequency and magnitude of short-term declines at acceptable levels.

Education.

As mentioned above, it is essential for all of the investment decision makers to have an understanding of core concepts such as Modern Portfolio Theory. While some of the Directors/Trustees, committee members, and staff will have some of this knowledge, many will not and turnover, even if merely occasional, will ensure that ongoing training and education is a necessity. The investment advisor needs to be willing and able to educate stakeholders on a variety of related topics on an ongoing basis. It’s also extremely valuable for the investment advisor to educate donors and prospects in order to help facilitate gifts, helping the donors to understand how the endowment is managed and why. At Sierra Wealth Advisors, we make a commitment to provide ongoing educational support to all of our nonprofit clients.

Process not Performance.

When it comes to determining whether fiduciaries (including Directors/Trustees and members of the Investment Committee) have lived up to their responsibilities, the laws cited above clearly indicate that the investment process is more important than investment performance. While it may be tempting to evaluate investment advisors based primarily on investment performance, it’s not particularly defensible. It is, however, critical to work with an advisor who understands your fiduciary responsibility, so look for an advisor with the Accredited Investment Fiduciary® (AIF) designation.