Confero Spring 2015: The Endowment and Foundation Issue

CONFERO A quarterly publication of Westminster Consulting

www.ConferoMag.com

ISSUE NO. 10

The Endowment and Foundation Issue

ALSO INSIDE ENDOWMENT& FOUNDATION SPENDING GUIDELINES /// DEMONSTRATING GOOD STEWARDSHIP FOR ELEEMOSYNARIES

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Features Spring Issue 2015 • Issue no. 10

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REDEFINING CHARITY

DEMONSTRATING GOOD STEWARDSHIP FOR ELEEMOSYNARIES

TURNING ORDINARY CITIZENS INTO PHILANTHROPISTS

charity: water is no ordinary non-profit.

Read how the organization is not only solving the water crisis, but redefining charity in the process.

In this article, Gabriel Potter and Thomas Zamiara provide an overview on stewardship principles and actionable tasks for eleemosynaries.

Not everyone sees themselves as a philanthropist. The Rochester Area Community Foundation discusses how they turn everyday people into charity superstars.

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22 ENDOWMENT AND FOUNDATION SPENDING GUIDELINES John Ameriks, Ph.D. goes over spending policy guidelines that balance two competing goals: maintaining the level of current spending, or preserving the endowment to support future spending.

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Contents Spring Issue 2015 • Issue no. 10

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810

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ONE PAGE MAGAZINE A brief overview of recent events and notable discussions within the industry.

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RES IPSA LOQUITOR The Law of Endowments — An overview of the Uniform Prudent Management of Institutional Funds Act.

ON TOPIC How Endowments and Foundations have been Affected by the Financial Dip— Markets will ultimately crash. Plan accordingly.

IN EVERY ISSUE: 3 CALENDAR 4 PUBLISHERS’ LETTER 5 CONTRIBUTORS

2 | SPRING 2015

2015 CALENDAR 1

2

April Fool’s Day

5

6

12

13

Easter Sunday

7

ERISA 8 Litigation & Enforcement Webcast 14 The CIO 15 TRADETech Summit TRADETech

19

20

21

22

9 16

The CIO Summit

23

3

4

10

11

17

18

Good Friday

The CIO Summit

24

April April 8.

Webcast: ERISA Litigation and Enforcement: The Role of the Independent Fiduciary and Best Practices for Financial Advisors. —BenefitsLink.com

April 14-15.

25

TRADETech • CNIT La Defense, Paris —TheTradeNews.com

April 15-17.

APRIL

26

27

AIF Designation Training

28

29

The Chief Investment Office Summit New York • The Harvard Club of NYC —PlanSponsor.com

30

April 27.

AIF Designation Training • Washington, DC —fi360.com

1

2

May May 19.

3

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5

6

7

8

9

10

11

12

13

14

15

16

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18

19

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22

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AIF Designation Training • Los Angeles, CA —fi360.com

May 26.

AIF Designation Training • Washington, DC —fi360.com

MAY

24

25

Memorial Day

AIF Designation Training

26

AIF Designation Training

June 27

28

29

30

June 2-4.

PLANSPONSOR National Conference • Fairmont Hotel, Chicago —Plansponsor.com

31

June 4-5.

ASPPA Chicago Regional Conference • Wyndham Grand Chicago Riverfront, Chicago, IL —ASPPA.org

1

JUNE

7

NTSA 403(b) Summit

2

Plansponsor National Conference

3

4

Plansponsor National Conference

Plansponsor National Conference

5

6

June 8-11.

Women Business Leaders Forum • Francis Marion Hotel, Charleston, SC —ASPPA.org

8

9

10

11

12

13

14

15

16

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18

19

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AIF Designation Training • Minneapolis, MN —fi360.com

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22

23

24

25

26

27

June 30.

28

Women Women Women Women Business Business Business Business Leaders Forum Leaders Forum Leaders Forum Leaders Forum

29

NTSA 403(b) Summit

30

NTSA 403(b) Summit

June 9.

AIF Designation Training • Pittsburgh, PA —fi360.com

June 28-30.

NTSA 403(b) Summit • Gaylord Opryland, Nashville, TN —ASPPA.org

www.conferomag.com | 3

PUBLISHER’S LETTER

confero A quarterly publication by Westminster Consulting

A quarterly publication of fiduciary ideas by various contributors within the industry.

Welcome to the Spring Issue of Confero.

We’ve committed this entire issue to Endowments and Foundations: to discussions around charitable spending, charitable initiatives, and asset planning. In our Fall issue, A Focus on Non-Profits, we highlighted the challenges that non-profits face and the skill sets that are required and how they differ from the corporate or for-profit space.

This issue provides a deeper dive into the regulatory environment, best practices, and first-hand accounts of charitable organizations and their stories. We hope you enjoy the varied discussions.

Our first feature article on page 12 is about a terrific agency, charity: water. The organization’s goal is to bring clean and safe drinking water to people in developing countries. We were all extremely impressed with the organization’s commitment to transparency and their 100% model—100 cents of every dollar they take in goes directly to the field to fund water projects. Please take a few minutes and visit www. charitywater.org for their complete story.

Publisher Westminster Consulting, LLC Editor-In-Chief Gabriella A. Hunt Contributing Editors Sean D. Patton Thomas F. Zamiara, AIFA®

On page 16, the article Demonstrating Good Stewardship for Eleemosynaries, is a collaboration between Gabriel Potter and Thomas Zamiara. In this article, we discuss the importance of good stewardship and the best practices that both organizations and donors alike should consider. We paid special attention to two very important concepts and practices: governance and transparency.

Creative Director

We were very fortunate to sit down and talk with Dana Miller, VP of Advancement at the Rochester Area Community Foundation in Rochester, NY. RACF’s mission is clearly contained in this article’s title, Turning Ordinary Citizens Into Philanthropists.

The work at RACF is just an example of the commitment and great work being done by community foundations all over the United States - matching donors with community needs and causes. I encourage you to look into a community foundation near you.

You can read the article on page 18.

John Ameriks, Ph.D. Erik Dryburgh Gabriella A. Hunt Gabriel Potter, MBA, AIFA® Roland Salmi, MBA Thomas F. Zamiara, AIFA®

Gabriella A. Hunt Contributors

John Ameriks from Vanguard provides an overview of spending policies and guidelines on page 22. He provides us with an interesting case study and a discussion on the challenges that Endowments and Foundations face when deciding how to most effective allocate the assets.

We purposely preceded all of these terrific articles with a refresher on the Law of Endowments, known commonly by some as The Uniform Prudent Management of Institutional Funds Act on page 8. I want to thank Erik Dryburgh of the San Franciscobased law firm Adler & Colvin. Erik’s review of the various laws and statutes governing charities was a great jumping off point for this issue of Confero.

Enjoy the issue and please keep the comments coming—they are a great help and provide us with inspiration for future issues and topics.

Enjoy Spring!

Tom & Sean Thomas F. Zamiara

4 | SPRING 2015

Sean D. Patton

Questions or Comments? email us at info@conferomag.com

The information contained in this on-line magazine is for general information purposes only. The information is provided by Westminster Consulting and while every effort is made to provide information which is both current and correct, Westminster Consulting makes no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability or availability with respect to the on-line magazine or the information, products, services, or related graphics contained within the on-line magazine for any purpose. Any reliance you place on such information is therefore strictly at your own risk.

In no event will Westminster Consulting be liable for any loss or damage including without limitation, indirect or consequential loss or damage, or any loss or damage whatsoever arising from loss of data or profits arising out of, or in connection with, the use of this on-line magazine.

CONTRIBUTORS Gabriella A. Hunt Editor Gabriella is a marketing professional with over seven years of experience. She currently holds a Bachelor of Science in Multidisciplinary Studies with concentrations in Marketing, Printing & Publishing, Photographic Arts & Sciences and Psychology from Rochester Institute of Technology. She has been a featured writer and editor in several publications including Rochester Woman Magazine and Pup Culture.

Gabriel Potter,MBA, AIFA ® Contributing Writer Gabriel is a Senior Investment Research Associate of Westminster Consulting where he designs strategic asset allocations and conducts proprietary market research.

He earned a B.A. in Economics and a Certificate of Business Management from the University of Rochester and an M.B.A. with concentrations in Corporate Finance and Computers & Information Systems from the University of Rochester’s William E. Simon School of Business. He also holds an Accredited Investment Fiduciary Analyst (AIFA®) designation and has been quoted in Human Resources Executive Magazine and his articles have been published through fi360 and AdvisorOne.

Thomas F. Zamiara, AIFA ® Contributing Editor Tom is one of the founding partners of Westminster Consulting and today serves as the managing partner where he currently works with corporate, non-profit and foundation clients.

Tom began his career in the financial services industry managing the fixed income desk of the Regional Institutional Sales Group for the Lehman Brothers division of Shearson in Rochester NY. In 1994, he joined Prudential Securities, Inc. and helped develop the Private Client Group and Qualified Plan Consulting Group practices.

A graduate of Boston College, Tom also attended The Wharton School at the University of Pennsylvania where he earned the University of Pittsburgh’s Katz School of Business Accredited Investment Fiduciary Analyst (AIFA®) designation. Today, he also serves as a member of the Brothers of Holy Cross Investment Advisory Committee.

Erik Dryburgh Contributing Writer Erik is a principal in the law firm of Adler & Colvin, a law firm specializing in representing nonprofit organizations and their donors. He has an undergraduate business degree from the University of Wisconsin at Madison, and earned his J.D. at the University of California at Berkeley, Boalt Hall. He is also a Certified Public Accountant (inactive). Erik’s areas of expertise include charitable gift planning, endowments, and not-for-profit organizations

John Ameriks, Ph.D. Contributing Writer John is a principal and head of the Active Equity Group within Vanguard Equity Investment Group. He oversees the portfolio management team that serves as investment advisor to Vanguard Strategic Equity Fund and Vanguard Strategic Small-Cap Equity Fund.

The team also manages portions of 10 other Vanguard stock funds.

Mr. Ameriks previously served as head of Vanguard Investment Counseling & Research group, which, in conjunction with Vanguard Investment Strategy Group, develops the firm’s advice methodology and conducts investment research.

Mr. Ameriks’ research has been published in The Journal of Finance, The American Economic Review, The Quarterly Journal of Economics, The Review of Economics and Statistics, and the Journal of Financial Planning. He is coeditor, with Olivia Mitchell of the Wharton School of the University of Pennsylvania, of Recalibrating Retirement Spending and Saving (Oxford University Press). His current research interests include quantitative equity investment strategies, behavioral economics, issues in retirement finance, and solutions-oriented single-fund investments.

Before joining Vanguard in 2003, Mr. Ameriks was a senior research fellow at the TIAA-CREF Institute.

Mr. Ameriks received an A.B. from Stanford University and his M.A., M.Phil., and Ph.D. in economics from Columbia University.

Roland Salmi Contributing Writer Roland is a Associate Analyst of Westminster Consulting where he is involved in performance analysis, client projects, and Senior Consultant support.

Roland earned a B.S. in Psychology, an A.S. in Business Administration from Elmira College and an M.B.A. with concentrations in Corporate Finance and Accounting.

www.conferomag.com | 5

SPRING 2015

THE ONE PAGE MAGAZINE ESOPs Outperformed The S&P 500 Private employee stock ownership retirement plans (ESOPs) outperformed the S&P 500 total return index in terms of total return per participant by 62% from 2002 to 20112, according to a study

by Ernst & Young (EY). Research by EY’s quantitative economics and statistics (QUEST) practice reveals the total return for an average S corporation ESOP participant over the past decade was $99,000 implying an 11.5% compound annual growth. “S ESOPs are a model for how to make retirement security a reality for the broad American middle class” said Steve Smith, EmployeeOwned S Corporation of America (ESCA) chairman, he is also VP of the General Counsel of Amsted Industries. — PlanSponsor.com

The Younger Generation Forty-nine percent of Americans younger than 30 do not feel in control of determining their retirement date. Among the same group thirty-one percent said their retirement date is “not at all” in their control. Fifty-five percent of Americans under 30 feel not saving enough could be the greatest setback on their path to retirement. Sixty-nine percent anticipate living 15 years in retirement; however twenty-six percent of those younger than 30 anticipate living 30 years or longer in retirement. This data is from COUNTRY Financial Security Index and was compiled by GfK, an independent research firm that compiled the data from a survey of approximately 1,000 U.S. adults. —www. countryfinancialsecurityblog.com

HSA Recap Health Savings Accounts (HSAs) held $24.2 billion in assets as of December 31, 2014. This is an increase of 25% in HSA assets from December 31, 2013. During 2014 new health plans were the leading driver of new HSA account growth, accounting for 35% of new accounts. The average balance of an HSA account holder is $12,995. These accounts achieved an average annualized return of 12.5% over the last three years. In 2014, $19.4 billion was contributed to HSA accounts, while $13.2 billion was withdrawn, leaving $6.2 billion carried forward into 2015. Employee Benefits Research Institue (EBRI) found that about 15% of the U.S. working population is enrolled in some form of Consumer-driven health plans (CDHPs) in 2014, representing about 26 million individuals with private insurance. The percentage of workers with an HRA or HSA-eligible health plan whose employers contributed to the account had steadily increased since 2009 and reached its highest level of 71% in 2013 and fell slightly to 67% in 2014.

— PlanSponsor.com 6 | SPRING 2015

Health Care Costs in Retirement

Affluent May Need More Savings Than Retirement Plan According to this study affluent Americans on average will need to save at least $2.5 million before they retire. When asked if they were making progress on this challenging goal, almost four in 10 (38%) said they were “not doing well” or only doing “somewhat well.” Legg Mason found that its sample had an average retirement plan savings of $385,000 and is close to age 58. Seventy percent of respondents said they had a defined contribution (DC) plan holding substantial portions of their net savings. — PlanSponsor.com

Average expected retirement health care costs for Medicare B, D and Supplemental insurance for a healthy couple retiring this year at age 65 will be $266,589 in today’s dollars. For a couple retiring in 10 years at 65, expect costs will rise to $320,996.

However, when you add in dental, vision, hearing, co-pays, and all other out-of-pocket costs, total health care costs are approximately $394,954 for a couple retiring this year at age 65. For a 55year old couple retiring in 10 years, total lifetime health care costs are expected to be $463,849.

Health care costs are expected to increase yearover-year by approximately 6.5% (not including the cost of long-term care services). The report was constructed by HealthView Services that looked at year-end 2014 health care cost data from 50 million cases. HealthView Services is a provider of retirement health care cost data and Medicare, Social Security, and long-term care retirement planning tools for financial advisers and individuals.— PlanSponsor.com

Ameriprise Suit on 401(k) Fees Is Settled Ameriprise Financial agreed to pay $27.5 million to settle a lawsuit which claimed the company breached its fiduciary duty to 24,000 current and former employees who participate in its 401(k) retirement-savings plan. As part of the settlement, Ameriprise agreed to put its plan’s recordkeeping functions out for bidding and to pay a flat or per-participant fee for such services. It also agreed to certain fee disclosures and to seek the lowest-cost investment options. —blogs.wsj.com/ totalreturn/2015/03/26/another-suit-on-401k-fees-is-settled/

Adler & Colvin is deeply committed to serving the legal needs of the nonprofit sector —————

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We bring a depth of experience and passion to our representation of tax-exempt organizations and individual philanthropists.

Our expertise includes: Charitable Gift Planning Grantmaking and Social Investing Nonprofit Governance and Ethics Revenue-Generating Activities Social Enterprise Tax Treatment of Lobbying and Political Activities ———————————————————————————————————— 235 Montgomery Street, Suite 1220 · San Francisco, California 94104 · (415) 421-7555 www.adlercolvin.com www.nonprofitlawmatters.com {00655894.DOCX; 2}

Res Ipsa Loquitor

The Law of Endowments (The Uniform Prudent Management of Institutional Funds Act)

By Erik Dryburgh | Adler & Colvin

I. WHAT IS AN ENDOWMENT? A. To a donor, an endowment is a sum of money given to a charity for charitable purposes, with only the “income” being spent and “principal” being preserved.

B. To an accountant, it is a fund which is “permanently restricted.”

C. To a lawyer, it is an institutional fund not wholly expendable on a current basis under the terms of the gift instrument.

D. Thus, a “true” endowment is one established or created by the donor. A board-restricted endowment (or “quasiendowment”) is created when the Board takes unrestricted funds and imposes a spending restriction.

II. WHAT WAS UMIFA AND WHY WAS IT ADOPTED? The Uniform Management of Institutional Funds Act (UMIFA) is a uniform law which provides rules regarding how much of an endowment a charity can spend, for what 8 | SPRING 2015

purpose, and how the charity should invest the endowment funds. UMIFA was the governing law in California through December 31, 2008. It was adopted because charities and their lawyers were unsure how to define “income” in the context of an endowment.

Many looked to trust law, which generally defines “income” as including interest, dividends and the like, but defines gains as “principal.” Thus, charities invested endowments in bonds and high-dividend stocks, but passed by investments with favorable growth prospects if they had a low current yield. Consequently, long-term yield suffered. The drafters of UMIFA thought charities should be able to spend a prudent portion of the gains earned by an endowment.

III. SO WHAT IS UPMIFA? A. UMIFA is thought to be out of date, particularly as to management, investment, and spending issues. In particular, the post-dot.com “down” market resulted in many “underwater” endowments, exposing the flaws in the UMIFA spending rules.

B. UPMIFA (“Uniform Prudent Management of Institutional Funds Act”) was approved by the National Conference of Commissioners on Uniform State Laws in July 2006, and has been adopted in virtually every state.

C. California adopted UPMIFA (Senate Bill 1329) effective January 1, 2009. It applies to funds created after that date, and to decisions made after that date for existing endowments (i.e., it will be “retroactive”).

IV. HOW DOES AN ENDOWMENT GET CREATED? A. An endowment fund is a fund not wholly expendable by the institution on a current basis under the terms of the applicable gift instrument. UPMIFA makes it clear that the term “endowment fund” does not include funds that the charity designates as endowment (these are “quasi-endowment” funds).

The Law of Endowments B. UPMIFA defines a gift instrument as being a “record” – information inscribed on a tangible medium or stored electronically – including an institutional solicitation, under which property is given. UPMIFA thus makes it clear that a gift instrument must be in writing, but expands the definition to include email. Governance documents, such as Bylaws, may be part of the gift instrument. A record is part of the gift instrument, however, only if the donor and the charity were, or should have been, aware of its terms.

V. HOW SHOULD A CHARITY INVEST ITS ENDOWMENT? A. Investment is a matter of state law.

In California, the Board is subject to the rules on prudent investments as set forth in both the Corporations Code and UPMIFA (which unfortunately are not entirely consistent).

B. The Corporations Code provides that in making investments, a Board must “avoid speculation, looking instead to the permanent disposition of the funds, considering the probable income, as well as the probable safety of funds.” This is an “old fashioned” and fairly conservative statement of the prudent investor rule.

C. UPMIFA articulates a standard of care for both managing and investing an endowment. It requires the charity to consider the charitable purposes of the charity, and the purposes of the endowment fund. It requires the Board (and others responsible for managing and investing) to act in good faith and with the care of an ordinary prudent person, and notes that the charity may incur only appropriate and reasonable costs.

The charity must consider: 1. General economic conditions, 2. Effects of inflation and deflation, 3. Tax consequences, 4. The role of each investment in the overall portfolio,

UPMIFA makes it clear that the term “endowment fund” does not include funds that the charity designates as endowment (these are “quasi-endowment” funds).”

5. Expected total return from income and appreciation, 6. The charity’s other resources, and 7. The needs of the charity and the fund to make distributions and preserve capital.

D. UPMIFA provides that an individual investment must be analyzed in the context of the total portfolio and the overall riskreward objectives, and that a charity can invest in any kind of property that is not inconsistent with the standard of care.

E. UPMIFA imposes a duty to diversify.

VI. HOW MUCH OF AN ENDOWMENT CAN A CHARITY SPEND? A. UMIFA provided that “The governing board may appropriate for expenditure for the uses and purposes for which an endowment fund is established so much of the net appreciation, both realized and unrealized, in the fair value of the assets of an endowment fund over the historic dollar value of the fund as is prudent ….”

Net appreciation includes realized gains and unrealized gains.

Historic dollar value is “the aggregate fair value in dollars of (1) an endowment fund at the time it became an endowment fund, (2) each subsequent donation to the endowment fund at the time it is made, and (3) each accumulation made pursuant to a direction in the applicable gift instrument at the time the accumulation is added to the endowment fund.”

Although UMIFA did not explicitly so state, most attorneys concluded that “income” (e.g., interest and dividends) could be spent as well (even with an “underwater” endowment).

B. UPMIFA makes a radical change and does away with the concept of “historic dollar value.” UPMIFA allows a charity to appropriate for expenditure, or accumulate, so much of an endowment fund as the charity determines is prudent for the purposes for which the fund was established.

The charity must consider: 1. The duration and preservation of the endowment fund, 2. The purposes of the charity and the fund, 3. General economic conditions, 4. Effects of inflation and deflation, 5. Expected total return from income and appreciation, 6. The charity’s other resources, and 7. The charity’s investment policy.

C. California’s UPMIFA includes the optional provision stating that an appropriation of greater than 7% of the average FMV of an endowment (averaged over the last three years) is presumptively imprudent.

VII. WHAT ABOUT DELEGATION? UPMIFA allows a charity to delegate management and/or investment decisions to agents. The charity must act prudently in www.conferomag.com | 9

Res Ipsa Loquitor selecting the agent, establishing the scope of the delegation, and reviewing the agent’s actions. A charity that does so is not liable for the actions of the agent. However, the agent is held to a “reasonable care” standard and is expressly made subject to appropriate court jurisdiction.

VIII. WHAT ABOUT CHANGING A RESTRICTION? A. UPMIFA allows a charity to release or modify a restriction regarding management, investment, or purpose of a fund if the donor consents in writing.

B. If a purpose or use restriction becomes unlawful, impracticable, impossible to achieve, or wasteful, the court may modify the restriction in a manner consistent with the donor’s intent. The Attorney General must be notified.

C. The court can modify a management or investment restriction if it has become impracticable or wasteful, impairs the management or investment of the fund, or (if due to unforeseen circumstances) the release would further the purposes of the fund. The Attorney General must be notified.

D. If a fund is less than $100,000 in value and over 20 years old, and the charity determines that a restriction on the management, investment, or use of the fund is unlawful, impracticable, impossible to achieve, or wasteful, the charity can (after notice to the Attorney General) release or modify the restriction. It must thereafter use the funds in a manner consistent with the donor’s charitable purposes.

IX. WHAT ABOUT ENFORCING SPENDING OR PURPOSE RESTRICTIONS? A. The Attorney General can bring an action to enforce the terms of a restricted gift. Depending on the law governing the internal affairs of the charity, an officer, director, or even a voting member may be able to challenge a breach of trust. See, e.g., Cal. Corp. Code §5142 (for California nonprofit public benefit corporations).

10 | SPRING 2015

UPMIFA allows a charity to appropriate for expenditure, or accumulate, so much of an endowment fund as the charity determines is prudent for the purposes for which the fund was established.”

B. What if the donor believes the institution is violating the use restriction?

Some states have held that unless the donor reserves a right to enforce in the gift instrument, only the state Attorney General has legal standing (Carl Herzog Foundation v. University of Bridgeport, 699 A.2d 995 (1997)). Other states have concluded that a donor may have standing (LB Research and Education Foundation v. UCLA Foundation, 130 CalApp 4th 171 (2005); Smithers v. St. Luke’s Roosevelt Hospital Center, 723 N.Y.S.2d 426 (2001)).

C. A donor may consider building donor standing into the gift instrument.

A power of reversion is likely to render the gift incomplete and non-deductible for income tax purposes; consider including a power to redirect the gift to another charity willing to abide by the restrictions in the event of default.

X. WHAT ABOUT THOSE ACCOUNTANTS? A. In general, for accounting purposes, funds received as “true” endowments are classified as permanently restricted. Funds subject to a restriction that the Board can satisfy – such as a timing restriction or purpose restriction – are classified as temporarily restricted. Funds received with no donor-imposed restrictions are classified as unrestricted.

B. FASB Staff Position 117-1 sets forth guidelines for reporting endowments governed by UPMIFA. It states that a

charity should classify “all or a portion” of an endowment as permanently restricted net assets, based upon explicit donor restrictions (if any) or what the Board determines must be retained permanently.

For example, a Board could determine that UPMIFA requires it to maintain the “historic dollar value” of its endowments.

The value of an endowment in excess of the amount reported as permanently restricted is to be reported as temporarily restricted, until such time as some amount is “appropriated for expenditure,” at which time that amount becomes unrestricted.

FASB Staff is not encouraging charities to report as permanently restricted the purchasing power of an endowment (e.g., initial value increased by the rate of inflation, not reduced for losses or expenditures). FSP 117-1 also requires more disclosure, including information regarding a charity’s spending policy and investment policy.

C. FASB 124 requires that distributions from the endowment, and losses suffered by the endowment, be taken from the endowment portion of the temporarily restricted asset class first (until it goes to zero), then from the unrestricted asset class. Put another way, the amount reported as permanently restricted funds would not change if there is a significant investment loss; the loss would reduce the temporarily restricted and the unrestricted asset classes.

Erik Dryburgh is a principal at the law firm of Adler & Colvin. He can be reached at dryburgh@adlercolvin.com

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Feature

R e d e f i n i n g C h a r i t y.

By Gabriella Hunt | Westminster Consulting | Photos provided by charity: water

12 | SPRING 2015

Redefining Charity.

No Ordinary Non-Profit charity: water is no ordinary non-profit. With their 100% model and unique marketing tactics, it is no wonder the organization has received praise from outlets such as TIME, Forbes, and The Wallstreet Journal. The company has raised more than 100 million dollars in donations to bring safe, clean drinking water to developing nations since its start in 2006 by CEO Scott Harrison. Not only are they slowly bringing an end to the water crisis, charity: water is also setting a new standard for charities which range from how they inspire their donor base to the handling of donations.

“What differentiates us from a lot of non-profits, not just water non-profits, are two things: our 100% model and we approve every dollar,” said Christine Choe, Senior Manager of Strategy & Business Operations. “So the 100% model means 100% of every dollar donated, that the public gives, goes directly to the field to fund water projects. Even if you donate $10 dollars, all of that goes to a water project. We even reimburse credit card fees if you give by credit card.”

To clarify, the organization manages two pools of money: public donations which fund water projects and “The Well”—a membership program where donors give a set amount towards their operating expenses each year. The Well usually consists of private donors, foundations, and sponsors.

With 100% of public funds going towards water projects and an incredible knack for story-telling, charity: water is inspiring donors (or campaigners, as the organization likes to call them) to fundraise with contagious enthusiasm. To date, more than 20,000 donors have held birthday campaigns, created videos, etc. all to raise funds for the company’s main mission: bringing people in developing countries clean water. “People have been really creative: [campaigners] give up birthdays and weddings for us.

[They do things] like polar plunges. So we have an amazing group of supporters that way… They campaign for us and we use their network to help fund for water,” Choe explains.

The Water Crisis charity: water is working tirelessly to educate the world on the water crisis our world is currently suffering from. Their website emphasizes while the water crisis begins with water, it affects far more than that—education, health, poverty, and women and children.

Currently, 1 in 9 people lack access to safe drinking water. While that may seem far-fetched to most people, given that 70 percent of our world is covered in water, only 2.5 percent of the water on earth is fresh. Of that 2.5 percent, only 1 percent is easily accessed by the world’s approximately 6.8 billion people. Therefore, the water crisis affects everyone, but those in developing areas of Africa and Southeast Asia are particularly affected.

www.conferomag.com | 13

Feature

According to the World Health Organization over 3.6% of the global disease burden can be prevented by simply improving water supply, sanitation, and hygiene. Feeding our world takes up to 90% of our freshwater withdrawals, and in most rural communities, women and young girls are responsible for walking to collect water for their families, filling up time that would otherwise be used to pursue an education or earn extra income.

Due Diligence and Good Stewardship charity: water continuously strives to be good stewards of fundraising efforts and donor funds. They take several steps to ensure money is utilized in the way it was intended. “We have two separate bank accounts, one is for operational and the other is for water—you cannot touch one or the other for different reasons,” Choe said. “So every single dollar we get from the public goes to our accounts for water and ever single dollar from “The Well” goes towards our operations.”

Since its inception, charity: water has provided a way for donors to track every completed water project on Google Maps, along with photos of the project. Now, charity: water’s program Dollars to Projects, takes that one step further by showing the water project impact, dollar by dollar.

18 | SPRING 14 SUMMER2015 2013

How the program works is this: when you donate, charity: water sends your money to local partners in the field (who build and implement the water projects). Once the water project is completed, local partners gather final photos and log GPS coordinates of each community and a final report is delivered to charity: water. Once the information is verified as correct by charity: water, they use a custom built assignment tool to match the money raised by donors with the projects they helped fund. Then a Project Detail Report is created, which shows donor dollars tied to that specific project, GPS coordinates, photos, and other details about the community helped. “You can see the actual project and where it is on [Google Maps], photos of that water solution, whether it’s a well or sand filter. So, you can track where your dollar went,” Choe said.

Pipeline According to charity: water, the average well is pumped an average of 13,698 times every day—approximately 5 million times a year.

With such extensive use, major repairs are an inevitable reality.

While the organization has always trained local communities to make simple repairs to their own water projects, their newest project, Pipeline, aims to “keep water flowing” and help when complex repairs beyond their capabilities arise. This newest project helps implement the use of remote sensors—helping charity: water

Redefining Charity.

... The 100% model means 100% of every dollar donated, that the public gives, goes directly to the field to fund water projects. Even if you donate $10 dollars, all of that goes to a water project. We even reimburse credit card fees if you give by credit card.” monitor the status of their current water projects. How it works is this: the sensor in the well detects when something is wrong and alerts a team of local mechanics trained by charity: water, which then goes out and fixes the issue, usually having water flowing within a few days.

This is how they see the future: a system of local leaders, innovative technology and trained mechanics working together with communities to keep water flowing for thousands of people around the world.

The future charity: water operates in a way most other non-profits don’t— their investment in content and focus on opportunity (how water changes everything)—is how they have been able to cut through the clutter and impassion donors. “We are great story-tellers,” explains Choe. “That helps mobilize a diverse group of supporters.”

However, they don’t just stop there. The organization’s Dollars to Projects program, gives donors a complete experience—they can see the impact their fundraising efforts and dollars are making— inspiring them to continually give.

To date, charity: water has served 5.2 million people through over 16,000 projects—totaling about 100 million dollars. In 2014 alone, they served over one million people. The organization’s main goal is to continue this upward trend. “There are still 748 million people without access to clean drinking water, so that is a huge number, but it is tangible. We hope to bring that number down. In a longer term approach, our approach is to reinvent charity, so we’re trying new things…We are trying to figure out how to best inspire and motivate our donors in a way that hasn’t been done before,” Choe said. “So not only do we hope to bring water to the 748 million people that currently don’t have access to clean water, but also redefine and reimagine what charity actually means and how it looks.”

A Call to ACT Fostering a passion for water is what charity: water does best, and it shows through their campaigners. charity:water differentiates itself from other non-profits in that it’s not about having donors just give money; it’s about giving them a meaningful platform to act.

The goal is to have donors commit to fundraising by creating and maintaining their own campaign and use their own social network to inspire others to donate.

To date, more than 190,000 members have raised over $35 million dollars through their mycharity: water platform—the site where the organization provides donors everything they need run a successful campaign. charity: water’s campaigners come from all walks for life and all ages. Cosette is just one example of the organization’s long line of campaigners working tirelessly to help end the water crisis—and she’s only 4 years old. Like many of charity: water’s other donors, Cosette focuses on changing the world based on what she can do right now (she’s not your typical toddler).

When she found out there were people without food, water, and other basic necessities we all take for granted, Cosette determined to make a change. She began to save money in a jar to raise money to buy a cow from one of charity: water’s implementing partners, World Vision. Eventually, a plan was made to sell her paintings in an effort to increase donations. Within four months, Cosette was able to raise $1900 and bought not only a cow, but an alpaca and sheep as well. Her current campaign running the mycharity: water platform has raised approximately $2900 of her $4000 goal.

View her campaign site and donate here: https://my.charitywater.org/cosettes-paintings-with-a-purpose For more information on charity:water visit: www.charitywater.org

Gabriella Hunt is the Social Media and Marketing Coordinator at Westminster Consulting.

She can be reached at gmartinez@westminster-consulting.com

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Feature

Demonstrating Good Stewardship for Eleemosynaries

By Thomas F. Zamiara, AIFA® and Gabriel Potter, MBA, AIFA® | Westminster Consulting

Why Should Donors Support Your Charity?

Demonstrating Exceptional Stewardship

Besides the people behind the organization, admittedly a charity’s most important asset, are the hard and soft assets that allow a notfor-profit to exist. The asset category that is the focus of this article is those monetary or investment assets that exist because of the passion and generosity of the donors. Without these donors and their commitment and affinity to the mission, a charity’s longevity would be no more than a short-lived social experiment. It is these investment assets that assures the longevity of the mission and the quality of experience the charity espouses.

Endowments and foundations have legal, ethical, and practical reasons to promote good stewardship, but there are a number of ways to define it. The Centre for Fiduciary Excellence (www. cefex.org) has a limited definition of stewardship which applies primarily to investment stewardship. Don Trone, CEO of 3ethos (www.3ethos.com), describes it more broadly as “the passion and discipline to protect the long term interests of others.” No matter how you define it, the principles which promote good decisions are the bedrock of good results.

Consider for a moment you have been introduced to a certain not-for-profit and are being wooed to be a supporter, and hopefully, a loyal and significant donor. What kind of qualities would be of interest to you and instill a level of comfort with the organization which would allow you to make a substantial or long-term financial commitment?

At the heart, there are two key principles to good stewardship: loyalty and care.

•

Loyalty: Is your loyalty for the organization and its mission, or elsewhere? Do you have to balance your goals with a different party? Is your loyalty divided or focused on the mission?

With so many charities losing public funds as a source of funding, many are “competing” for the same dollars in the private sector.

Additionally, the private sector has become more discriminating in their giving practices due to many factors. These include scandal, mismanagement of donor funds, lavish expenditures, and a whole host of other obstacles that have given donors pause when considering supporting an organization.

•

Care: Are you doing enough due diligence in your decision making process, either in terms of vetting vendors, selecting investments, or setting & monitoring goal?

Charities that are inspiring new donor contributions and have successfully maintained their long-tenured contributors are able to articulate, quite compellingly, its pledge to exceptional stewardship with “loyalty and care” imbedded in its DNA. 16 | SPRING 2015

Qualities to Look For The key principles of loyalty and care are simple but vague.

When these basic principles get applied, what sort of effect can it have on a non-profit organization? In short, how do you know if you’re demonstrating adherence to these principles with your actions or merely providing lip-service to the concepts without your words matching your deeds?

Demonstrating Good Stewardship There are a few qualities which are highly correlated with good stewardship. If you want to take a self-assessment, look for these features:

•

•

Digging Deeper: Governance & Transparency

•

Governance: Having in place policies and procedures which set the expectations for actions, like rebalancing, the criteria for selecting investment managers, delegation of authority.

Furthermore, a set of pre-ordained contingency plans within accepted policies can allow a charity to be nimble when reacting to time-sensitive needs, but not forced into poor decisions by ad hoc crises.

Transparency: Every organization has some items they need to keep confidential (employee records, donor information), but total secrecy is a rare requirement for charities. Promoting transparency by disclosing operational details can demonstrate high accountability and a commitment to fixing mistakes or making improvements.

•

Legal Compliance: Obviously, a charity which has trouble meeting the legal requirements of the various laws (the NYS Non-Profit Revitalization Act, UPMIFA, etc.) should be held under higher suspicion.

•

Independence: Charitable institutions typically have multiple professional engagements, simultaneously watching each other to catch mistakes and avoid conflicts of interest. For instance, it may be problematic if your audit firm is also acting as your investment advisor. Having independent operators servicing your plan, with a clear delineation of duties, promotes independent and comprehensive decision making. Demonstrated independence via utilization of multiple vendors (including auditors, investment managers, and investment consultants) can ensure a higher standard of both loyalty and care.

•

•

•

Low costs: Every fee paid to a vendor diminishes the potential advancement of the charity’s mission. Excessive salaries to employees represent an abuse of charitable donations. There are many charities which abuse the goodwill and donations of everyday people, but there are an equal number of charities which keep external costs and internal spending in check.

Longevity: Sadly, some untrustworthy charities exist to collect donations from generous individuals rather than serve the advancement of the charity’s supposed mission. On the other hand, some charities exist for decades because of a demonstrated ability to meet their goals and value to donors.

The longevity of a charity should give donors the ability to benchmark their history of supporting their given mission.

Budgeting: A good steward acknowledges its resources and budgets them accordingly. A long term, stable budget can set expectations for the community partners.

Solid returns – It is no coincidence that good practices are highly correlated with good results. After all, fortune favors the prepared.

Let’s revisit the above qualities or visible components of stewardship and focus on the first two: Governance & Transparency.

Quoting Wikipedia, governance refers to “all processes of governing, whether undertaken by a government, market or network, whether over a family, tribe, formal or informal organization or territory and whether through laws, norms, power or language.” It relates to “the processes of interaction and decision-making among the actors involved in a collective problem that lead to the creation, reinforcement, or reproduction of social norms and institutions.”

Does your organization have its processes expressed in such a way that an outsider looking in can understand how things get done, who is responsible for what duty, who owns a particular responsibility, and where the buck stops? Thoughtful governance documentation will demonstrate these processes. Board charter, committee charters, board resolutions, investment policy statements, minutes (to name a few) are all necessities to demonstrating commitment to good governance and high standards of “loyalty and care”.

Transparency represents the amino acids or building blocks of good governance. An organization that welcomes the bright light of transparency will endure any examination required of it. The Ford Foundation in its effort to “promote transparent, effective and accountable government” states on its website that, the goal of this work is to improve the transparency, accountability and inclusiveness of government institutions and processes.

An attentive donor to an organization is going to ask questions of an organization far beyond mission-based. The ability of an organization to share openly its challenges that promote long-term growth is of keen interest to supporters.

Take Action A well-managed charity can have an enormous, positive impact on the world. Demonstrating a commitment to supporting the factors of good stewardship will create donor comfort, thus improving your charity’s ability to enact positive change. Take action. If you need clarification on what specifically your organization should do, find a qualified fiduciary consultant to lead you through a process to improve your practices. n Thomas F. Zamiara is a Partner and Senior Consultant at Westminster Consulting. Thomas can be reached at tfzamiara@westminster-consulting.com Gabriel Potter, MBA, AIF® is a Senior Investment Research Associate at Westminster Consulting.

Gabriel can be reached at gpotter@westminster-consulting.com

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Turning Ordinary Citizens Into Philanthropists

By Roland Salmi, MBA | Westminster Consulting | Photos Provided By The RACF

R

oy Vaneliver was a simple man. He began as a high school teacher and eventually became a high school administrator; he lived with his mother his entire life and never owned a car. Roy didn’t dress in top quality clothes, and often had holes in the soles of his shoes, but he really wanted to make a difference in education.

Sadly, Roy passed away in 2010.

Education was Roy’s whole life. Upon his passing, he established scholarship funds for students studying history and organ studies, as well as students attending the theological school his sister attended. His intent was to make a major difference in a student’s life so, on a revolving basis, one student concentrating in one of these fields of study receives an $80,000 scholarship.

This scholarship and other philanthropic gifts are made possible by the Rochester Area Community Foundation (RACF). The RACF is nestled in the Historic East End, placing it central within the city it works hard to improve. Throughout the building, there are several plaques and pictures honoring past donors, founders, and activists at the Foundation. Focused on being an anchor for the Rochester area, the RACF provides

18 | SPRING 2015

a history of Rochester to donors, gives an in-depth look at current issues, and creates solutions to help the city thrive.

“The purpose of the Community Foundation is [to be] a place for people to carry out their charitable interests in a way that allows the money to be available now and into the future,” explains Dana K. Miller, Vice President of Advancement for the RACF. The Emergence of Community Foundations For the past century, community foundations have cultivated community livelihoods by allowing them to carry out the charitable interests of donors. The first Community Foundation was established in Cleveland in 1914. The Rochester Community Foundation is a newer foundation—established in 1972.

It was Joe Posner, an insurance salesman, who stressed the importance of having a community foundation. Posner’s strong beliefs drove his ambition to meet Rochestarians, explain what a community foundation is, and ultimately what it can do for the community.

It was because of his dedication the Rochester Area Community Foundation was born.

While some may think the United Way is similar in function to Community Foundations, they play two different roles.

“The United Way is like the community’s checkbook and the Community Foundation is like the community’s savings account,” explains Miller. The money that comes into the foundation doesn’t get spent, but rather invested for the long-term. The principal stays intact, while the income from those investments is donated to charities.

The RACF’s focus has been on individuals who would like to create a long-term fund with them. Essentially, donors create an endowment fund which lasts in perpetuity, giving to charity on an ongoing basis rather than a single donation. Miller explains most of the RACF’s gifts come from a will, a charitable remainder trust, or some other planned gift.

Donor Intent and Education The RACF is very active in the community, and is frequently in the public eye as a supporter of events and programs. Donors are obtained two main ways: directly and through their professional advisor network.

Those who donate directly typically have a previous knowledge of the Foundation’s

The Rochester Area Community Foundation

... “If we were to look back 50 or 60 years ago and say, ‘What are the two biggest issues?’ it would have been polio and civil rights. If we went back to the 80s, the issue would be AIDS, and if we went back 6 months ago, it would have been Ebola,” Miller said. “So issues continue to change over time.”

Top: The Rochester Area Community Foundation offices.

Right: Dana K. Miller, VP of Advancement for the Rochester Area Community Foundation www.conferomag.com | 19

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work within the community. These donors often have an idea of their goals, often needing minimal direction and guidance.

For these types of donors, the RACF has an online system that donors can log into and make grants how they see fit. This online system also hosts a compilation of reports of charitable programs and their effectiveness. “That is a great resource for donors to decide where to designate funds” says Miller.

In addition to the direct donors, the RACF has a professional advisor liaison committee.

The committee members consisting of attorneys, tax planners, CPAs, and financial planners reach out to their colleagues. They host seminars and open houses a couple times a year and they send out quarterly e-blasts out to their network. This is essential for the RACF as their typical donor is already working with a business professional.

Other times, donors come into the RACF with an idea of what charity they would like to give to, but had not narrowed down the intent of their giving. For example, an animal lover might want to donate all their money to Lollypop Farm (The Humane Society of Greater Rochester), but it is up to the RACF to dig a little deeper to find out exactly what their intentions are. “We talk to donors about really understanding what their charitable interests are.” Miller explains.

The RACF tries to help donors understand needs are constantly changing over time.

“If we were to look back 50 or 60 years ago and say, ‘What are the two biggest issues?’

it would have been polio and civil rights, if we went back to the 80s the issue would be AIDS, and if we went back 6 months ago, it would have been Ebola,” Miller said. “So issues continue to change over time …”

Therefore, for donors that want to give, but do not have a specific charity or idea they would like to contribute to, the RACF offers “Forever Funds”. These funds are unrestricted in use and are part of their competitive grant-making process. This is different from donor-advised funds (the donor directs where their money goes each year) and designated funds (funds that give to specific charities).

Since unrestricted, the money in these funds goes towards the current needs of the community and towards the two main goals of the RACF: to create an equitable community and strengthen the region’s vitality.

Equitable community goals focus on raising awareness of poverty and how it affects our community economic development efforts, the academic achievement gap, and fostering racial and ethnic equality. This is what drove the RACF’s work in addressing the issue of poverty that is heavily concentrated in the city of Rochester, helped establish a universal Pre-K, and drives other programs like Dialogues Without Borders and the RACE: Are We Really So Different? exhibit.

Strengthening our region’s vitality focuses on diverse cultural offerings, improving the capacity of local arts organizations, preserving the region’s rich historical assets,

and creating more successful age-friendly communities. The RACF hopes to ultimately promote systemic change and sustainable impact within the Rochester community.

With donor intent being the most important aspect of the foundation, donor education is a close second. Therefore, donor education events are integral to their initiatives. Such events include “Joe U” breakfasts—inspired by their founder Joe Posner, who was famous for holding breakfast meetings as an opportunity to inform others of his current charitable endeavors. According to Miller, the goal is for these events to be peer-led, “You have a donor who is talking about [a particular charity] to other donors, so at that point it’s more credible than a charity talking about themselves to other donors.”

Maintaining the Funds The RACF‘s purpose is to maintain donor funds prudently for growth and donate the income through their investment structure.

According to Miller, their investment structure started at 70% equity and 30% fixed income since 1972. However, just last year they changed their strategy to 70% equity, 20% fixed income, and 10% alternatives. The performance of their longterm strategy has been 9.6% return over a 22-year-period.

As a foundation, they are required to distribute at least 5% of their corpus a year.

In addition, the RACF charges a 1% fee on all of their funds for operational costs.

Any return past the mandatory 5% and 1% operations fee, gets reinvested. “The

... We tend to talk to people here about philanthropy and the first thing everyone says is, ‘Well no, I’m not a philanthropist. Tom Golisano is a philanthropist, Bill Gates is a philanthropist, I’m not a philanthropist,’ but you actually are...”

20 | SPRING 2015

The Rochester Area Community Foundation

organization ends up being three things: on one end, we’re a fund raiser in terms of getting donations, but we’re also a grant maker in terms of giving money away, but in the middle is where we are managing a pretty significant pool of investments,” Miller said.

“If we were to describe ourselves as a three legged stool, the investment management is really the third leg of that stool. It is very important as the money comes in, it’s invested prudently for growth and we’re able to use the income for grants.”

out pretty well’ or ‘it didn’t work out’,” Miller explained.

Measuring the Benefit of Funding

Community foundations are instrumental in contributing to a community’s success.

They bring communities together in times of despair and foster change during times of struggle. The Rochester Area Community Foundation is no different. Led by a team of devoted and passionate staff, they continuously strive to make the area a better place to live by pairing those who have charitable interests with the needs of the community.

The RACF diligently collects data from their data arm, ACT Rochester, as well as the United Way, the Department of Governmental Research, and the Census Bureau. They use a qualitative and quantitative approach when assessing the effectiveness of donations. By collecting this data, the RACF can track the effectiveness of its funding. “In the case of early childhood education there are very specific standards in place. We can look at the results of the program we funded and compare results to national standards and say, ‘well it worked

The Foundation also requires grantees to provide a report when their project is completed. The RACF looks at the results to ensure projects have actually been accomplished. Program officers also make site visits to keep tabs on the grants that have been received.

Legacy Benefit

Tom Golisano is a philanthropist. Bill Gates is a philanthropist, I’m not a philanthropist,’ but you are,” Miller explains. “By making a gift that becomes a permanent commitment, you are really engaging in philanthropy in exactly the same way they are you are just doing it at a different level…”

The RACF continuously works towards their goals of creating a vital region and an equitable community within Rochester and its eight counties. “Hopefully it will not take 50 years, but in 50 years we should see a revitalized city” says Miller.

The Rochester Area Community Foundation is located at 500 East Avenue, Rochester, NY 14607-1912.

Roland Salmi, MBA is an Associate Analyst at Westminster Consulting. Roland can be reached at rsalmi@westminsterconsulting.com

“We tend to talk to people here about philanthropy and the first thing everyone says is, ‘Well no, I’m not a philanthropist,

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Feature

Endowment and Foundation Spending Guidelines

By John Ameriks, Ph.D. | Vanguard

Endowments and foundations face many challenges when deciding how to allocate their resources. One of the most difficult is choosing a spending policy that will best balance their two competing goals: maintaining the level of current spending, and growing or preserving the endowment in order to support future spending. This report discusses several common spending policies along with the factors to be considered in making this important decision.

Common spending policies

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Dollar amount grown by inflation.

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Percentage of portfolio with a smoothing term.

This policy aims to provide a stable amount of inflation-adjusted spending each year. If all goes well, this spending pattern can greatly assist with budgeting over time. However, while such policies typically produce stable year-to-year spending levels in the short term, difficulties can arise over the long term. The policy makes no provision for adjusting spending downward when market returns have been poor. This means that all potentially necessary reductions in spending must occur in the future, rather than the present.

•

Percentage of portfolio with a ceiling and a floor.

Percentage of portfolio with smoothing term

•

Hybrid—a combination of dollar amount grown by inflation and one of the percentage of portfolio policies.

Dollar amount grown by inflation

As the name implies, a percentage of portfolio policy bases annual spending on a stated portion of the portfolio value at the end of the prior year. A smoothing term modifies this to a percentage of the average ending balances over a number of years. For example, if the smoothing term is three years, each year’s spending is equal to a percentage of the average ending balance for the prior three years.

Under the dollar amount grown by inflation policy, a dollar amount of spending is calculated in the initial year on the basis of need or other criteria. (The amount is usually expressed as a percentage of the initial portfolio value.) The spending amount for each subsequent year is then determined by multiplying the prior year’s spending by an inflation factor— typically the change in the Consumer Price Index (CPI) or another cost inflation index.

As a result, spending levels vary based on investment returns.

This can make budgeting more difficult in the short run (although the existence of a smoothing term can dampen the volatility somewhat). On the other hand, spending is automatically cut back when the markets have been doing poorly, and automatically increased after periods when the markets have done well. Thus, poor investment returns are at least partially offset by reductions

Some institutions are required by law to spend a certain amount annually, such as 5% of the portfolio balance; others have more discretion in selecting a spending policy. Many such policies have been devised, but this report focuses on four of the most common:

The following article provides brief descriptions of these policies, followed by a case study that illustrates their application.

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Endowment and Foundation Spending Guidelines

in current spending. This helps to preserve the endowment value and thereby sustain future spending. As a result, over the longer term, the percentage of portfolio with smoothing term policy provides the most consistent spending levels.

Percentage of portfolio with ceiling and floor This policy is similar to the method described above, with one variation—rather than using a smoothing term, the amount of spending is held within a fixed range. For example, if a 15% ceiling and a 15% floor were selected, the annual spending amount would always be between 85% and 115% of the initial dollar amount, adjusted for inflation. If the initial spending (based on a percentage of the portfolio) was $100, then the annual spending going forward would not fall below $85 or rise above $115 adjusted for inflation (unless the corpus is exhausted).

As a result, although spending will vary from year to year based on the markets, it is not allowed to go beyond a set range as long as assets remain—a fact that can assist with budgeting. In addition, in good market years, this policy can result in a surplus of return to be reinvested in the portfolio, creating some flexibility that may allow higher spending in bad years. Keep in mind, however, that while the policy provides for some downward adjustment to spending in poor markets, the adjustments may not significantly reduce the potential for a significant decline in corpus (principal).

Such declines could require reductions in spending in the future beyond the spending “floor.”

Hybrid: Combination of dollar amount grown by inflation and percentage of portfolio Under this hybrid policy, the level of annual spending is determined by combining a fixed percentage of the dollar amount

grown by inflation spending figure with a fixed percentage of the percentage of portfolio spending figure. For example, the policy may combine 40% of the prior year’s spending amount grown by inflation with 60% of the amount determined by calculating percentage of portfolio with three-year smoothing. As a result, a portion of the spending varies based on the markets, and a portion is predictable, which makes budgeting easier. Under this policy, there is some downward adjustment to spending when markets have been poor (percentage of portfolio portion). (Note, however, that the existence of a hard “floor” on spending again results in a risk that the corpus could be exhausted in extreme circumstances.)

Each endowment and foundation needs to evaluate its objectives and select the spending policy that will best help meet its goals.

Table 1 shows our (subjective) ranking of the four methods as they relate to shortterm spending stability and long-term spending stability/asset growth. The table highlights the tradeoff between short-term and long-term benefits.

Endowments and foundations that place a strong emphasis on short-term spending stability, leaving little room for fluctuations in spending from year to year, face a greater chance that future spending will have to be significantly reduced.1

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grown by inflation policy, then for 5%/ceiling and floor, and then for the hybrid policy. But the 5%/smoothing term policy was able to maintain some level of spending throughout the entire 45 years.

Figure 3 shows the range of downside spending volatility displayed by each policy over all 45 return paths.2 As you can see, the dollar amount grown by inflation policy shows the highest range of downside volatility: Average deviation below the target over the 45 paths ranged from a high of $1.52 million to a low of $0 (along a fortunate path in which spending levels never had to change). The average deviation below target across all time paths was $530,000 (0.53 in Figure 3).

In contrast to this, the 5%/smoothing term spending policy provided the tightest range of deviations below target and the second-lowest level of average shortfalls (0.38). As Figure 3 shows, none of the strategies eliminated the potential for downside volatility in the set of scenarios examined.

Each endowment and foundation must determine the extent to which it can accept volatility in its nearterm spending. This decision should take into account many factors, such as the level of annual contributions, the accessibility of additional funds, the degree of flexibility in annual commitments, and overall risk tolerance.

Case study The following case study illustrates the four spending policies.

Table 2 on page 19 lists the assumptions for the study.

We analyzed each policy along 45 historical return paths using data from 1960 through 2004 (“looping” returns when reaching the end of available data). Because limiting spending volatility is important to endowments and foundations, we identified a “best case” and a “worst case” return path for each policy. The “best case” was the path with the lowest average deviation in spending below the initial spending target (which was $2.5 million, or 5% of the endowment). The “worst case” was the path with the greatest average spending deviation below the initial target. Figures 1 and 2 chart the results (in real dollars).

Among the “best case” scenarios, the greatest spending stability was provided by the dollar amount grown by inflation policy, which produced a constant level of $2.5 million (in real terms) a year. The next most stable spending was provided by 5%/ceiling and floor. The most volatile “best case” was produced by the 5%/smoothing term policy. On the other hand, the results for the “worst case” scenario were almost exactly the opposite. Spending dropped to zero first (in less than 20 years) for the dollar amount

Assuming a level of spending that generates the possibility of exhaustion. Almost all spending rates currently in use produce some chance that, given certain circumstances, withdrawals will not be sustainable. Based on the historical data we used, initial spending rates as low as 3.25% of the starting balance could not be maintained in all 45 historical paths.

1

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Endowment and Foundation Spending Guidelines

Two other factors that can make the decision particularly challenging are the changing levels of both revenue and liability streams.

Managing changing liabilities and revenue Liabilities Another important consideration in selecting a spending policy is the growth rate to use for liabilities. The liability stream depends on the mission of the institution and may or may not be linked to a traditional growth rate, such as the change in the CPI. Assessing liability growth is important, because increases in liabilities work like asset returns in reverse (or to put it another way, adverse investment returns are similar to adverse cost increases). Like a negative spell in the markets, a surge in liabilities can jeopardize the corpus of the portfolio. As a result, any correlation between liabilities and investment performance should be factored into the asset allocation decision.3 Revenues A final consideration when selecting a spending policy is the expected level and volatility of future revenues or contributions.

This expected income is an asset similar to any other, and “returns” (i.e., future revenues) can deviate from expectations. In years when contributions fall short of expectations, spending commitments may require that additional funds be taken from the portfolio. If such shortfalls happen frequently enough, the long-term viability of the portfolio may be jeopardized.

Therefore, the correlation between contributions and investment performance should be factored into the asset-allocation decision.

When stocks are performing well, institutions may receive higher contributions than expected; when stocks perform poorly, the reverse may occur. If such a correlation exists, holding stocks in the portfolio may be riskier to the institution’s spending plans than if there were no relation between revenues and the market.

Endowments and foundations typically can address this risk by making minor changes in their asset allocation to reflect the strength of the correlation.4 Best practices Flexibility is the one word that best describes a solid spending policy. Rigid spending rules cannot eliminate investment volatility; they simply push it into the future. Spending policies insensitive to returns are risky, inasmuch as they rely on the assumption that the portfolio will recover before the endowment level reaches a crisis point (at which time much more dramatic reductions in

spending would be necessary). Hedging that assumption, at least in part, by accepting some reduction in current spending is an appropriate response to market volatility.

If prudent, returns-based reductions in current spending are a reasonable, acceptable part of a spending policy, then prudent, returns-based increases in spending are also reasonable when investment returns are more favorable.

If the portfolio is to include volatile investments that are expected to produce high average returns, then administrators must either accept continuous, relatively smaller changes in spending or else run the risk of having to make abrupt and significantly larger adjustments later. The more an institution can tolerate some shortterm fluctuations in spending, the more likely it is to achieve its longer-term goals.

Conclusion In conclusion, our analysis illustrates that there is no optimal, “one size fits all” spending policy for endowments and foundations.

Which policy should be implemented depends on what is most important to the institution. There is an inherent tradeoff between maintaining constant spending levels and achieving long-term asset growth to support future spending. The right spending policy should meet the needs of both current beneficiaries and future ones.

Volatility is measured as the average absolute deviation of spending below the initial level of $2.5 million over the 45 time paths for each method.

For more on this topic, see Donald G. Bennyhoff, 2005: Preserving a Portfolio’s Real Value: Is There an Optimal Strategy? Valley Forge, Pa.: Investment Counseling & Research, The Vanguard Group, 20 p.

4 For a technical treatment of this issue, see Robert C. Merton, 1993: Optimal Investment Strategies for University Endowment Funds. In Studies of Supply and Demand in Higher Education, Charles Clotfelter and Michael Rothschild (ed.). Chicago, Ill.: University of Chicago Press.

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On Topic

How Endowments & Foundations Have Been Affected by the Financial Dip

By Gabriel Potter, MBA , AIFA® | Westminster Consulting

Long Term Goals vs. Short Term Market Pressure A charity’s balance sheet inflows are subject to two basic factors: external contributions (i.e. donations) and market actions, either through capital appreciation, or dividends & income. As an investment and fiduciary consultant, we often spend more of our time focusing on the inputs, rather than the spending side – the outflows. However, the 2008 financial crisis and associated market downturn put sufficient pressure on charitable organizations’ health such that their spending policies were similarly affected.

In broad terms, there is nothing wrong with lowering your spending when your income goes down. Everyone has to make compensations during times of stress.

However, since the need for charity often gets stronger during market downturns, it is in everyone’s interest, at a bare minimum, to set expectations for charitable spending during market downturns.

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Market downturns are inevitable. As the pessimistic adage goes, the only sure things in life are death and taxes. To expand upon this cheery thought, let us add market downturns to this list. In the financial industry, most advisors have been well trained to avoid making promises or guarantees for the future. We will make an exception here: we guarantee that markets will, at least occasionally, be terrible. Given this certainty, it behooves an investment committee to have a plan of action.

Spending: the 5% Problem We often consider tactical reallocations, donor outreach, investment changes as part of managing market stress. For this article, let us focus instead on the spending behavior of a charitable organization.

There are several laws which impact investment and spending guidelines - UMIFA (Uniform Management of Institutional Funds), UPIA (Uniform Prudent Investor

Act), NYPMIFA, etc. Perhaps the most important standard, however, is federal tax law which mandates a 5% annual payout for family foundations and similar private foundations.

This 5% payout level is the eleemosynary standard widely adopted by endowments and more flexible foundations.

A 5% payout seems like a manageable rate of return to target, but 5% is only the start of the hurdle. First, consider the 5% payout is net of fees – investment management fees, consultant fees, and trading fees. We have known widely-known wirehouse brokers add a full percentage point of fees, or more, to the cost of investing, thus pushing the 5% initial hurdle to over 6%.

Next, there is inflation. Most endowments and foundations are intended to exist forever, so they try to maintain the principal’s buying power. In the long term, inflation averages in the US between 2% and 3%. Therefore,

How Endowments & Foundations Have Been Affected by the Financial Dip

the +6% net of fees hurdle now looks closer to 9% nominal return, to maintain real purchasing power.

We aren’t done; there are extra costs. The foundation may be a lean, cost-effective non-profit, but there may be a few people on staff. Are there miscellaneous taxes?

Do you hire an accountancy firm full time or hire a Chief Financial Officer to take care of it? Does the foundation need the services of an attorney? Are there marketing personnel or community outreach staffers?

Do you maintain an office? These costs may add another percentage point to the bottom line requirement.

After fees, inflation, and other expenses, the charity may actually need a target rate of return closer to 10%, rather than the presumed 5% target. A 10% target is pretty high under the best of market circumstances.

Making matters worse, the current market environment has unprecedented low interest rates. As a result, most fixed income portfolios have yields which are several percentage points below their historical averages. Therefore, to generate a high average rate of return upward of 10%, some foundations may need to allocate their portfolios heavily into equities and similarly aggressive, volatile asset classes. This, in

turn, increases the probability of having significant depreciation during inevitable market downturns.

favored status for certain foundations.

•

Some donors specifically require their donation to maintain its nominal value. Naturally, these restrictions will significantly influence the types of investment permitted and spending policy against those assets.

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If spending targets are immune to market downturns (i.e. – you have committed spending), consider separating these earmarked funds into separately managed accounts. For example, if you’ve committed to spending $100K per year for 3 years, then establishing a separate corresponding bond ladder to match that commitment may be the best option.

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Similarly, isolating restricted and unrestricted investments into separate portfolios is prudent.

Going Forward Here are some action items you, or your committee, can take to ensure transparency in your operations and for your community network of donors, staff, and volunteers: •

Set the criteria for spending behavior within your investment policy statement.

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Set the expectations for spending projects when they are adopted. If spending targets are contingent upon market behavior, set expectation with those project managers.

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Smooth out your spending targets based on 3-year or 5-year rolling performance. You can still be sensitive to market pressures without wild swings in spending levels.

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Clearly establish your priority - which is either maintaining the current spending levels or protecting the perpetuity of the portfolio. You sometimes can’t have both. Of course, this assumes you have a choice in the matter. The 5% payout is a requirement for tax

Gabriel Potter, MBA, AIF® is a Senior Investment Research Associate at Westminster Consulting. Gabriel can be reached at gpotter@westminster-consulting.com

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