Endowments in an Underwater Environment

In today’s ever-changing marketplace, not-for-profit organizations face many difficulties, such as generational turnover, sourcing new major donors, reduction in past donors’ willingness to give, operational budget shortfalls caused by decreased funding, increased costs and lower enrollment. And the list goes on.

As organizations continue to see declines in their operational net income, many rely on the endowment spending policy to cover those shortages. Some organizations are able to cover their shortages from the original spending policy, while others rely on additional Board-approved spending. Whether organizations draw additional spending or not, many notice individual endowment funds in an underwater environment, meaning the value of the fund has fallen below the corpus of the original gift. An endowment can be underwater as a result of down markets, overspending, or both.

The biggest question that organizations and Boards ask is: How can we navigate poor investment returns while continuing to spend from the endowment to support the donor’s intent of the use of the funds? There is no one-size-fits-all approach. Instead, we recommend that management and the Board incorporate these key discussion points into their meetings:

What is your asset allocation policy?

Your asset allocation should be determined by your Investment Policy Statement. Review your rate of return based on your asset allocation over the last year and the last 3-5 years. Determine if that asset allocation is providing your organization the most benefit for the risk it is taking compared to similar organizations. Work with your investment advisor to rebalance your portfolio and review your performance at least annually. Management, with Board approval, has the ability to adjust the asset allocation and risk tolerance by updating the Investment Policy Statement, in order to gain the most benefit for your endowment holdings.

What is your spending model for the rate of spending?

Is your current spending policy causing overdraws? When using a moving average spending model, an organization creates overspending in years that the market is down, as the average is based on past years that may have had a positive return. In thinking through the last few years, we saw moderate returns in the years leading up to 2020. For years ending in June 2021, we saw an over 20% rate of return which almost fully reversed during the years ending June 2022. If the June 2022 spending rate is based on a 3 to 5-year moving average with the last year being June 2021, the organization likely created overspending for many funds during 2022. There are organizations that have considered expending the moving average model to encapsulate a larger pool of activity.

One consideration would be to adjust your spending rule. Rather than looking at a 3 to 5-year moving average, management could think through using an annual spend based on a percentage of the market value of the fund at that point in time. This would take into account any current year market activity and would limit the spend each year on the individual funds.

What is your policy for drawing funds past the corpus (donor principal balance)?

Consider limiting the draws up to the corpus amount. This helps eliminate the potential for underwater funds. However, keep in mind that in taking this approach, budgeting for future years can be more difficult as your spend may be limited to individual funds. This may be a favorable approach to ensure you’re preserving the fund, as well as being able to respond to donor inquiries on the status of their fund and the value it holds.

In addition, if you adjust a fund for the annual spending rate and later determine that the funds were not expended but the value of the fund has been reduced, management and the Board should consider replenishing the fund for those unspent monies which would assist in retaining the corpus.

While there isn’t a quick fix to re-establishing underwater endowments, the discussion points we outline above are areas above key for management and the Board. When it comes to creating, monitoring and maintaining their endowment funds, it is essential to keep UPMIFA and donor intent top of mind. The challenge that all organizations balance is current operating needs and preserving resources for the future. Management, the Board and investment advisors are key to maintaining that balance with open, thorough discussions and monitoring.