Investing reserves and endowment gifts: the prudent way

This guide is for treasurers and boards of charities that have money they don't need to spend right away: a reserve the board has built up, or an endowment gift that a donor wants kept and invested. Leaving it in a checking account may be safe, but a board also has a duty to look after it sensibly. After reading, you'll know the difference between a board reserve and a donor endowment, the prudence rules most states use, how to decide how much to spend each year, what a simple investment policy covers, and how to choose and watch an outside adviser.

The rules come from state law. This guide uses New York's version as its worked example, because the New York Attorney General publishes a clear guide to it. Check your own state's law, and get professional advice before you invest. This guide explains the rules a board must follow; it isn't investment advice and doesn't recommend any investment.

Board reserves and donor endowments

Two kinds of long-term money look alike but follow different rules.

• A board-designated reserve (sometimes called a "quasi-endowment") is money the board has chosen to set aside. The board can change its mind and spend it. Our guide to reading financial statements explains operating reserves.
• A donor endowment is a gift the donor said must be kept, with only part spent each year. The New York guide describes endowment funds as "funds that are not wholly expendable on a current basis due to donor-imposed restrictions on spending." The board can't simply decide to spend it all.

Keep them separate in your records. Our restricted funds guide explains how to track donor restrictions.

The law most states use: UPMIFA

Most states have adopted a version of the Uniform Prudent Management of Institutional Funds Act (UPMIFA), a model law from the Uniform Law Commission. The New York guide, published in 2011, says New York's version added protections "unique among the 47 states that had thus far adopted UPMIFA." UPMIFA covers:

• how to manage and invest charitable funds prudently;
• how much may be spent from endowments;
• how to hand investment work to outside advisers; and
• how to change or lift a donor's restrictions.

The prudence standard

Under New York's law, each person responsible for managing and investing a fund "shall manage and invest the fund in good faith and with the care an ordinarily prudent person in a like position would exercise under similar circumstances." The New York guide lists factors to weigh, if relevant, including:

• general economic conditions;
• the possible effect of inflation or deflation;
• expected tax consequences;
• the role each investment plays in the overall portfolio;
• the expected total return from income and growth;
• the charity's other resources; and
• the need to make distributions and to preserve capital.

New York's law also requires investments to be diversified unless the charity prudently decides that special circumstances make that unwise, and it requires every institution to adopt a written investment policy.

How much to spend from an endowment

Spending from an endowment is a board decision, called "appropriating" funds for spending. Under New York's law, the board must act "in good faith, with the care that an ordinarily prudent person in a like position would exercise under similar circumstances," and consider, if relevant, factors including:

• the duration and preservation of the endowment fund;
• the purposes of the charity and the fund;
• economic conditions and inflation;
• expected total return;
• the charity's other resources;
• alternatives to spending the endowment (a factor unique to New York); and
• the charity's investment policy.

The board must make a contemporaneous record, written at the time of the decision, of how it considered each factor. The New York guide says it's not enough to state "in a conclusory fashion" that a factor was considered.

The 7% line in New York. For endowment gifts made after September 17, 2010, New York's law creates a "rebuttable presumption of imprudence" if a charity spends more than 7% of the fund's fair market value, averaged over at least the preceding five years, in any one year. The guide adds that spending 7% or less "is not presumptively prudent": it still has to be justified by the factors above.

Many charities set a yearly spending rate, a percentage of the fund's average value, and review it each year. Ask your accountant how to apply it, and check your state's rules.

A simple investment policy

The New York guide says there's no "one size fits all" policy, but lists topics a policy may cover, including:

1. general investment objectives;
2. permitted and prohibited investments;
3. acceptable levels of risk;
4. asset allocation and diversification;
5. how investment performance is monitored;
6. what is delegated to an outside manager, and on what terms;
7. how outside advisers are selected and reviewed; and
8. how and when the policy itself is reviewed.

For a small charity, two pages are often enough. Adopt it by a board vote, record it in the minutes, and review it at least once a year. Keep short-term money, like next year's budget and an operating reserve you may need soon, in insured bank accounts. Our guide to banking for a new nonprofit explains deposit insurance.

Using an outside adviser

You can hand day-to-day investing to a professional, but the board still oversees it. Under New York's law, the board must act prudently in:

• selecting, keeping or ending an adviser, including assessing their independence and any conflicts of interest;
• setting the scope and terms, including fees; and
• monitoring the adviser's performance.

New York's law also requires that contracts delegating investment management can be ended at any time, without penalty, on no more than 60 days' notice.

The New York guide warns about advisers connected to board members. Its example is a board chair asking the board to move the charity's funds to his own firm. At a minimum, the guide says, a charity should have a conflict of interest policy and follow it when choosing or keeping an adviser.

Changing a donor's restriction

If an endowment's purpose or rules no longer make sense, start by asking the donor. The New York guide explains that a charity may get the donor's written consent to release or change a restriction. If the donor is unavailable or says no, the charity may ask a court. New York also has a simpler procedure for funds worth less than $100,000 that have existed for more than 20 years, with notice to the Attorney General. Your state may have similar rules.

Your investment checklist

• Board reserves and donor endowments are tracked separately
• We know which version of UPMIFA our state has adopted
• The board adopted a written investment policy and reviews it yearly
• Investments are diversified, or the board recorded why not
• Each decision to spend from an endowment is recorded at the time, with the factors considered
• We know whether our state has a spending limit like New York's 7% presumption
• Any outside adviser was chosen under our conflict of interest policy and is reviewed regularly
• Short-term money is kept in insured bank accounts