An endowment is established with the goal of providing perpetual financial support for a specific purpose or program. However, when the market declines, the value of the endowment can dip below the original amount of the donation and cause the endowment to be “underwater.” In that instance, schools are forced to make tough decisions about funding, donor relations and long-term financial strategies. Schools should prepare for managing underwater endowments before they happen — and with increased market volatility, an endowment could go underwater at any time.
The Tradeoff
An underwater endowment creates tension between the school’s current and future needs. On the one hand, the school is obligated to satisfy the donor’s intent to provide funding for a particular purpose (e.g., a program, scholarship) On the other hand, school leaders may feel obligated to preserve the endowment and not spend below the gift value. Adhering to these conflicting principles simultaneously is what makes dealing with underwater endowments challenging, and a school may find itself in a no-win situation. If the school cuts spending, it risks upsetting the donor, but if it keeps spending at the same rate, it risks alienating future donors and the long-term sustainability of the endowment (and therefore possibly the purpose for which it was intended.)
Legal Obligations
This is not just an ethical issue; it is a legal one. The Uniform Prudent Management of Institutional Funds Act (UPMIFA) permits “prudent” spending from underwater endowments, but only provided that fiduciaries work to ensure purchasing power in perpetuity. If a school spends principal from an underwater endowment, the board must do the following under UPMIFA:
- Explain and document why the current programmatic needs are so important that the risk of depletion is acceptable.
- Develop a plan for restoring the principal amount by fundraising, adopting an investment policy that is more aggressive, reducing the spending rate or implementing other new revenue streams.
- Have a long-term plan that addresses how the organization will remain viable into the future.
Proactive Steps
With ample preparation, a school can mitigate the impact of an underwater endowment. The first thing it should do is monitor the endowment throughout the year, keeping track of how close the endowment’s market value is to the gift value. Having a watchlist of endowments nearing their original value enables you to reduce endowment spending as part of the budgeting process. Not all schools will be able to take a reduced endowment draw, but the earlier you identify a potential problem, the more likely you can avoid driving gifts below book value.
Next, schools should establish policies that make it less likely for an endowment to go underwater. It is important that all policies are clearly laid out in the gift agreement, so donors understand the terms of their endowment gift. Having clear gift agreements can help avoid awkward conversations with donors if the endowment goes underwater.
One potential policy is to require a “seasoning period.” This is period of time, often six months to one year, that the endowment gift is invested and no distributions are made. The goal is to build up gains in the endowment fund and provide a buffer in a drawdown to prevent it from being underwater. Although the donor may be disappointed not to see their money put to work immediately, if the rationale for the policy is clearly communicated upfront, donors will generally appreciate knowing that their gift is being protected for the future.
The endowment’s investment policy should balance the need for growth with strategies that protect it in down markets. UPMIFA requires endowment returns to exceed spending plus inflation. Using a specialist advisor to manage the funds provides additional risk management over an in-house approach and gives comfort to donors that their endowment gift will be stewarded properly.
It is also helpful to have a policy that addresses how much to spend from an underwater endowment. For instance, a school may decide with the donor to allow spending from an underwater endowment up to a certain threshold (e.g., 90% of original gift value to reflect a normal range of investment volatility). Alternatively, a policy may stipulate that spending be reduced for all underwater endowments to 50% of the spending policy.
Bouncing Back
Once an endowment is underwater, a school must develop a plan to address it in accordance with UPMIFA. Effective management of an underwater endowment requires seamless coordination between the board, investment professionals, finance staff and development staff.
To start, the school should review their investment policy and consider whether revising it would improve the endowment’s recovery prospects. It may be tempting to reduce the risk of the investment portfolio during a downturn, but doing so can impair the endowment’s ability to recover to its original value. Equities have historically been the highest-returning asset class and often a downturn is the right time to increase exposure to equities and other risk assets.
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Likewise, a school with an underwater endowment should reevaluate its spending policies. This requires modeling out different levels of endowment spending, their impact on the budget or program and a likely trajectory for recovery. For instance, an endowment that is 10% underwater and earning 7% annually will take 6 years to recover if it spends 5%. But if spending is cut to 4.5%, the recovery time is reduced to 5 years, and if spending is cut further to 4%, the recovery time is reduced to just over 4 years.
One of the impetuses to reduce spending the right way is that the farther underwater you go, the longer it takes to recover. As shown in the chart, an endowment that is at 85% of gift value could take 9 years to recover.
The bottom line is that spending from an underwater endowment can create significant complications. It is generally better not to spend from an underwater endowment if you don’t have to. Rather than continue spending from the endowment, a school might explore alternative funding sources, such as new grants or fundraising initiatives. Alternatively, the school might consider going back to the donor to ask for additional funding while the endowment recovers.
This last option underscores the importance of strong donor relations. Giving endowment donors regular updates about their fund’s value, performance and impact show thoughtful stewardship that fosters trust and support in difficult times. A school with multiple donor-designated endowments might consider having pre-prepared communication templates that address the status and management of underwater endowments.
Independent school leaders must keep a delicate balance between donor intent and the long-term health of their endowment funds. By implementing robust policies for endowment monitoring, spending and investment strategy, paired with transparent communication with donors, schools will be less at risk of having underwater endowments. A proactive approach is essential to maintaining endowment funds and the valuable programs they support.
