By L. Nicholas Deane

Lessons Learned

North Carolina State University in Raleigh, N.C., recently cut back on its scholarship distributions. The reason? Approximately 300 out of its 1,500 endowment funds were underwater, according to Jill Tasaico, the university's director of foundations accounting and investment.

When an endowment fund goes underwater, North Carolina State does not spend from that fund until the situation corrects itself, she explained.

North Carolina State is far from alone. The University of Washington, which reported possession of 1,724 endowments as of the year ended December 31, 2002, had 484 of them underwater on that date. Emory University and Yale University also had a good number of underwater endowment funds.

Nancy Shelmon, a partner with the accounting firm PricewaterhouseCoopers, LLP, in Los Angeles, said that most endowments made in the past couple of years were underwater at some time or other. Commonfund, a Wilton, Conn.-based investment fund manager for nonprofits recently released a survey of 657 educational institutions. According to John Griswold, its executive director, “This was a pervasive problem. We found that 54 percent of our survey respondents had underwater endowments in 2003.”

At a recent AICPA Not-for-Profit Financial Executive Forum, Shelmon defined an underwater endowment as an “individual permanently restricted endowment fund whose market value has decreased below its historic dollar value.” She defined “historic dollar value” as “the value of the original gift adjusted for amounts required to be added to it either by the donor or law.” When investment markets are down, endowments tend to go underwater.

To illustrate an underwater endowment, Shelmon gave the example of a million dollar gift that was donated to endow a fund for a particular purpose. Because of investment losses, that gift is now worth $950,000. The endowment fund is now underwater to the tune of $50,000.

While the problem is widespread, it was particularly acute in certain areas of the country. For example, Geralyne Mahoney, a partner with the San Francisco accounting firm Burr, Pilger and Mayer, cited Silicon Valley as a place where underwater endowments are common. With the large influx of cash to technology firms, a lot of newly wealthy individuals wanted to make a difference and set up endowments. Setting up endowments in the boom years led to a number of these endowments ending up underwater in later years.

Cash flow

A problem with an underwater endowment is that a nonprofit will budget programs based on a certain rate of return, and when the endowment goes underwater, it is restricted as to how much it can spend from that endowment. Restrictions come from two sources: The donor and by the law.

Donors often make endowed gifts with such restrictions as the income shall be spent to fund a program, say a scholarship, and a certain portion of the income will stay in the fund to grow it and let it keep pace with inflation. In this case, if an endowment has gone underwater, the institution can't tap the equity below the original amount contributed plus the annual adjustment required by the donor.

Legal restrictions are more complicated. According to Erik Dryburgh, a partner with the law firm Silk, Adler and Colvin, in San Francisco, all but Alaska, Arizona, Florida, Pennsylvania, Puerto Rico, and the U.S. Virgin Islands have adopted some form of the Uniform Management of Institutional Funds Act (UMIFA), which creates these restrictions. A major focus of UMIFA when it was written during the early 1970s was to get fund managers to invest for total return, rather than simply high yields. While high yields maximize the amounts that can be spent each year, they can minimize the value of the endowment funds. This is because they do not account for the effects of inflation each year.

UMIFA requires an endowment to base its spending on its income and what it deems a prudent portion of appreciation of its assets. Different states have different rules regarding the appreciation of assets and how it can be spent. Some states allow all appreciation to be spent, i.e., these funds are unrestricted. Others require that you use the appreciation to make sure that the donor's restrictions are met (i.e., temporarily restricted).

For example, say a donor makes a $1 million endowment with the understanding that the fund can't call below that amount. If stock losses have dropped the value of the fund to $900,000, then the next $100,000 in appreciation is temporarily restricted, that is, it must be used to get the fund back to its original $1 million. Other states say that the fund must grow a certain percentage each year, therefore making the dollar value of the original gift plus this legally proscribed growth permanently restricted.

You still have money

Just because a fund is underwater doesn't mean that you can't spend the money you have budgeted for your programs. You can't spend money from the fund, but you can spend money from other, unrestricted sources, like your general bank account. Many nonprofits resorted to this, rather than cut their program spending. Also, many increased their debt levels, according to Griswold. His survey reported that 30 percent of respondents increased their debt last year, and the average debt service was 6 percent of the overall budget.

Many nonprofits just cut their budgets. “About half of our respondents cut their operating budgets,” said Griswold. “About a third made them to academic programs -- such as with hiring or salary freezes.” Fewer made them to athletic programs. This is because, as Griswold pointed out, athletic programs are deemed to be their own source of revenue, both directly and because of the donations they generate.

Many schools made cuts to building and maintenance, and many just made straight across the board cuts. “MIT, Stanford and Yale have all just announced layoffs,” said Griswold. North Carolina State only uses its endowment funds for scholarship programs, not operating expenses, so its cuts were simply made to the scholarship programs.

Griswold pointed out yet another solution. He said that many nonprofit business and development officers went back to the donors and either asked for more money or for a release from the restrictions. For the most part, he said, they were successful. “These donors are sophisticated, and they know what the nonprofit is going through.”

Another problem is caused by accounting rules. When any endowment fund goes underwater, you have to segregate out that fund and identify its sources and investment history to determine just how far it is underwater. You don't have to segregate funds if you have no underwater endowments. While not an insurmountable problem, it is an additional accounting requirement that will be more work for the accountants and more expense for the organization.

Mahoney said that often she finds that accountants had not segregated these funds in the past, which makes the job of the current auditor more difficult.

But the bigger accounting problem is caused by how you have to report underwater funds (see sidebar).

One nonprofit that rode out the storm without a problem was the Jewish Community Foundation in Los Angeles, with more than $460 million in total assets under management. According to Simone Savlov, its chief operating officer, there were a few reasons for getting through the issue. “An endowment going underwater is related to both investing and spending,” she said. In 1993, foundation managers undertook an initiative to adopt spending policies and to determine a prudent and appropriate spending rate. They hired a consultant and looked at long-term market performance, which included not just, as she described it, the “go-go years,” but five decades of returns.

The board determined that, based on the organization's risk tolerance, the expected total rate of return would probably be 8 percent over the long run. When you adjust for inflation, which the board estimated at 3 percent, that leaves a real return of 5 percent, which they spend annually.

In the years when they were doing great, they never adjusted spending upward. Also of note is the fact that the 5 percent they spend is calculated on a five-year rolling average of the market value of the endowment. So it is not 5 percent of the most recent year. It is 5 percent of the average of the previous five years, which, in a generally up market, is lower.

Therefore, when you include earlier years in the calculation, the effective rate is less than a straight 5 percent. Also, inflation has been less than 3 percent recently, so that builds in a surplus.

“This enables us to build in a layer -- a cushion -- that helped us out in the more difficult years, “ said Savlov.

One of these difficult years was 2000. Many endowments suffered a loss that year, but the Jewish Community Foundation had a gain of 4 percent. Another difficult time was 2002 when the foundation was flat, but in 2002, Savlov said “flat was good.” In 2003, its endowments grew by 15 percent, not including new gifts.

With regard to investing decisions, Savlov pointed to the experience and leadership of her investment committee. They are “highly skilled professionals who manage portfolios totaling more than $25 billion in their own firms. Remaining active in the investment business, these individuals have current business relationships they can turn to. They are smart, and they are effective.” 

Griswold used Harvard as an example of another institution that rode out the bear market very well. He said that as the market started to boom, Harvard actually cut its spending rate. While this approach was met with a lot of raised eyebrows, with tirades against it in The New York Times and The Wall Street Journal, it is receiving kudos now.

The recent upturn in the stock markets is good news for nonprofits with underwater endowments, because these funds will usually correct themselves in an up-market. According to the study by Commonfund, educational endowments showed moderate improvement in returns in Fiscal Year June 30, 2003. Educational endowments and foundations reported average annual total returns, net of fees, of 3.1 percent for that year. Compare this with the average annual total returns of -6 percent for their Fiscal Year 2002 study and -3 percent in 2001. Compare this with 1.55 percent for the S&P 500 and -2.79 percent for the Dow Jones Industrial Average for that fiscal year ending June 30, 2003.

With the market up-turn, these underwater endowments are now correcting themselves in most situations. Jill Tasaico of North Carolina State said that she believes the problem for her university will be corrected by next year, and in some instances the problems are already resolved.

What lessons were learned from the down market? Mahoney said you should establish an investment policy and stick to it, regardless of what the markets are doing. “You can't change your strategy to react to a short-term blip,” she said.

Those endowments whose managers kept their discipline in 1998 and 1999 rather than fall to the then-common tendency to be over-invested in tech stocks, fared relatively well. And while respondents to a recent survey by the National Association of College and University Business Officers said that they averaged slightly more than 21 percent of their portfolios in fixed income instruments, some fund managers suggested this figure should go much higher than that.

Also, nonprofits should watch spending and consider doing like Harvard did and reduce the spending rate in good times. This is not as difficult as it seems, because you can still increase your overall spending dollars in a bull market at the same time you cut your spending rate.

According to Griswold, “It's clear that many institutions took advantage of an improved climate to reduce spending and that they are actively managing their spending -- half changed their spending rate over the past year.” In his organization's study average spending rates declined to from 5.1 percent to 4.9 percent.

Savlov of the Jewish Community Foundation advised nonprofits to build an endowment without making distributions for a while, letting it build so that you have a surplus for tough times.

Dryburgh suggested that nonprofits should be careful as to how they solicit funds. They should be more proactive in setting up endowments, with their needs in mind as well as that of the donor. He said this should not affect donations, because endowment donors tend to be sophisticated investors who have the best interests of the nonprofit at hear.

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