Abstract
The financial management of endowment funds is a significant activity for many not-for-profit organizations (NPOs). The central idea is to set aside a certain sum of money which can be invested to earn a sustainable form of income for the NPO, thus making it less dependent on fluctuations and uncertainties involved in donations and other operational income.
For many NPOs around the world, the endowment funds management and performance are monitored very closely and carefully, and form a major component of their balance sheets. In the United States for example, most top ranking universities manage endowment funds which, in the case of some institutions, are worth billions of dollars. Accordingly, in the US there are various legislations which exist relating to how to establish the funds, their financial management, and their financial reporting and disclosure requirements. As well as a strong legislative base, best practices have been established by some of the larger and reputable NPOs. Many of them publish detailed endowment reports, going beyond the minimum legal requirements. These endowment reports provide in depth insights to stakeholders on the fund’s performance during the year for each class of investment as well as other details like payout policy and highlights for that year.
Detailed legislative guidance or best practice examples are not present in Pakistan. The Institute of Chartered Accountants of Pakistan (ICAP) has issued accounting and reporting guidelines for NPOs, however, these guidelines address the general accounting issues relating to NPOs and do not provide detailed guidance on accounting for endowments. In addition, the absence of an established non-profit industry or professional association means that that there is no reference point for nonprofits to assess the ‘quality’ of their financial management and reporting.
This note attempts to provide initial guidance to non-profit managers in Pakistan with regards to the financial management of endowment funds. In order to provide this guidance, two US based endowment funds have been selected, that is, Harvard and Yale endowment funds. These funds are generally recognized in the international non-profit industry as examples of the most well managed endowment funds (Brazenor 2008). This is due to their broad selection of investment products, exposure to alternative asset classes and consistently achieving higher returns with low risk (Brazenor 2008). In view of this, it is considered that the financial management practices of these funds provide a good reference point for all non-profits including those operating in Pakistan.
The following key areas will be discussed:
the purpose and types of endowment funds; their establishment and financial management and their accounting and disclosure requirements.
Purpose and Types of Endowment Funds
Nonprofits commonly disclose in their financial statements a balance known as restricted funds. Restricted funds are called such because their use is restricted or defined for a specific purpose. This restriction may be imposed by the donor although sometimes, organizations may themselves set aside funds for a predefined objective. A certain type of restricted fund, in which the principal amount donated, is not to be used but rather invested to earn a regular income is what is commonly known as an endowment fund. The ICAP regulations give the following definition:
A different form of a restricted fund is an ‘endowment’, which is held on trust to be retained for the benefit of the organization as a capital fund. Such funds cannot normally be spent as if it were income to the organization. The income earned from such capital may, however, be utilised for restricted or other purposes of the organization.
A more elaborate definition of the different types of endowment funds is given by the Federal Accounting Standard Board (FASB), the US accounting standard setting body. FAS 117 (Financial Statements of NPOs) states the following:
An established fund of cash, securities, or other assets to provide income for the maintenance of a not-for-profit organization. The use of the assets of the fund may be permanently restricted, temporarily restricted, or unrestricted. Endowment funds generally are established by donor-restricted gifts and bequests to provide a permanent endowment, which is to provide a permanent source of income, or a term endowment, which is to provide income for a specified period. The principal of a permanent endowment must be maintained permanently—not used up, expended, or otherwise exhausted—and is classified as permanently restricted net assets. The principal of a term endowment must be maintained for a specified term and is classified as temporarily restricted net assets. An organization’s governing board may earmark a portion of its unrestricted net assets as a board-designated endowment (sometimes called funds functioning as endowment or quasi-endowment funds) to be invested to provide income for a long but unspecified period. The principal of a board-designated endowment, which results from an internal designation, is not donor restricted and is classified as unrestricted net assets.
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From the above definition given in FAS 117, the following four categories of endowment funds emerge:
Permanently Restricted or True Endowment Temporarily Restricted or Term Endowment Quasi Endowment Unrestricted Endowment.
Permanently restricted endowment funds are targeted for some specific purpose or cause. In this type of fund, the principal amount cannot be spent and only the income from that amount can be used for a specific purpose or cause. In permanently restricted endowment funds, restrictions on the use of funds are put in place by the donors. These are also called true endowment funds. In case of some nonprofits, permanently restricted endowment funds make up a significant proportion of the total endowment fund. For example, approximately three-quarters (74 per cent) of Yale’s endowment fund constitute true endowment and gifts restricted by donors to provide long term funding for specified purposes. These purposes include: fund professorship, teaching and lectureship (24 per cent), scholarships, fellowships, and prizes (17 per cent), maintenance (4 per cent), books (3 per cent) and miscellaneous specified purposes (26 per cent) 2 . In other cases, however, the proportion of permanent funds may be less. Harvard, for example, holds only 23 per cent (2012 annual report, Note 10) of its endowment funds as permanently restricted funds.
Temporarily restricted endowment funds are the same as true endowment funds except that after a specified period of time or after the occurrence of a specific event, the principal amount may also be released in all or in parts, according to the demands of the donor. These types of funds are also referred to as term endowment funds. The majority (approx. 60 per cent) of Harvard’s endowment funds are disclosed as temporarily restricted.
In quasi endowments, the management of non-profits imposes restrictions on the use of funds. The purpose of these kinds of funds is to serve new projects, to support existing programmes or to serve as a reserve fund for emergency needs. For example, an educational institution can impose a restriction that income from this fund can only be used for academic scholarships for full-time students. For example, about one-quarter (26 per cent) of Yale’s endowment fund represents quasi endowment. 6 per cent of this fund benefits the overall university while the remaining funds were focused on specific units like Faculty of Arts and Sciences (9.6 per cent), the professional schools (6.8 per cent), the library (1.8 per cent) and other units (1.8 per cent) 3 .
Unrestricted endowment funds give the organization maximum flexibility for use of funds. Usually the board supervises these funds. The source of funding in this kind of endowment includes unrestricted donations and funds from internal sources.
The Establishment and Financial Management of Endowment Funds
When creating an endowment fund and in order to ensure its effective financial management, it is beneficial to follow certain guidelines. These guidelines emerge either from statutory requirements or practices of other well managed endowment funds. These guidelines can be broadly divided into two key areas:
Establishing the endowment fund and Financial Management of the fund.
Establishing the Endowment Fund
Two factors are of immense importance when establishing an endowment fund: the vision of the fund and its legal/governance structure. As we will see in the next section, both of these factors have a strong bearing on the financial management of endowment funds.
The creation of an endowment must be supported by a vision and/or strategic objectives. The Harvard Management Company (HMC), for example, was set up with a mission to ‘Produce long-term investment results to support the educational and research goals of the University’ 4 whilst the Yale Endowment Fund was set up with the objective of ‘supporting today’s scholars with annual spending distributions while promising to maintain support for generations to come’ 5 .
The second important factor at the time of creation of the fund is its legal form and governance structure. At the time of creation of an endowment fund, a fund management body is usually set up to oversee the activities of the fund. The structure of this body can take up various forms. It may either be a separate legal entity or alternatively, it can be set up as a committee within an existing nonprofit.
For example, Harvard University set up an incorporated company, known as HMC in 1974 to manage its endowment fund. The objective of HMC is to fund the educational and research needs of Harvard University by generating stronger results. Similar models for creating endowment funds can also be seen in Pakistan. The Punjab Education Endowment Fund takes the legal form of a corporation. It has been established under section 42 of the Companies Ordinance, 1984 as a company limited by guarantee. The structure and management of the fund is therefore, governed by corporate legislation in Pakistan 6 .
Alternatively, an existing NPO may establish an endowment fund without separately registering it as an independent nonprofit. In this case, the non-profit creating the endowment can form a dedicated management body within the organization to look after the endowment affairs. The financial results of the fund are shown within those of the main entity, however, they are separately disclosed so that the performance of the fund is visible to stakeholders. Yale University follows this model. It has formed a committee known as the Yale Corporation Investment, which looks after the endowment activities. In Pakistan, many NPOs operate endowments in this manner, for example, Shaukat Khanum Memorial Cancer Hospital & Research Centre has a separate committee for the financial management of their endowment fund with the objective to ‘generate income for the operating expenses of Shaukat Khanum Memorial Cancer Hospital & Research Centre’ 7 .
Tables 1 and 2 list some of the largest endowment funds of charitable organizations in the United States and also specifically within the education sector.
Financial Management of Endowment Fund
The financial management of endowment funds involves the following four distinct but inter-related activities: (i) selecting investment managers, (ii) creating targets for returns and corresponding risks, (iii) investment portfolio and iv) payout policy. These activities are discussed further below:
List of Charitable Organizations with the Largest Endowment Funds in the United States
The first step involves selecting an investment management company or an investment manager and determining the extent to which the fund’s owner would interfere in determining asset allocations through cooperation with this manager. For example, since 1975 Yale’s endowment has been managed by the Yale Corporation Investment Committee. This committee meets quarterly and comprises nine investment management specialists as well as at least three other personnel associated with Yale University. The functions of the committee include ‘reviewing the asset allocation policies, endowment performance, and strategies proposed by Investment Office staff…[and approving] guidelines for investment of the endowment portfolio, specifying investment objectives, spending policy, and approaches for the investment of each asset category’ (Endowment Report, 2012). The Harvard endowment, as mentioned above, is managed by HMC. HMC is governed by a Board of Directors which is appointed by the President and Fellows of Harvard College. The Board has considerable financial market expertise and includes individuals with expertise in various asset classes as well as managers of leading investment management firms. They also have, in some capacity, ties with the university. In addition, finance and support staffs of approximately 200 people are also employed by HMC 8 .
List of Educational Institutions with the Largest Endowment Funds in the United States
The second step in financial management involves creating targets for returns and corresponding level of acceptable risks for the fund. In the year 2011, Harvard University set a benchmark of 20.2 per cent return on its endowment fund. The University exceeded its bench mark by 1.2 per cent as the endowment earned a return of 21.4 per cent 9 . Similarly in 2011, Yale University earned a return of 14.2 per cent against a target return of 6.3 per cent. 10 These target returns are set against targeted acceptable levels of risks.
The third, and perhaps the most important activity, involves the selection of the actual investment pattern for the fund. This activity entails selection of the type of assets or investment that should be included in the portfolio for an acceptable level of investment risk and target returns. Tables 3 and 4 show some investment patterns related to different nonprofit organizations. Table 3 shows asset allocations for 470 higher education institutions in the United States. This table shows that institutions with large endowment sizes are likely to invest more in what is known as ‘alternative assets’, while institutions with smaller endowments are more inclined towards investing in domestic equities. ‘Alternative assets’ are investments in under researched markets with high risk and high returns. These are less efficient markets as compared to the traditional markets. These markets offer absolute returns with less correlation to public markets and can be exploited with active portfolio management. Table 4 then further segregates the alternative assets mix. According to this table, private equity and marketable alternative strategies represent the biggest share of investment allocation plus an increasing trend to invest in venture capital can also be observed.
Global Investment Patterns of Endowment Funds—Asset Allocations for Fiscal Years 2008–2010
Global Investment Patterns of Endowment Funds—Alternative Strategies Asset Mix for Fiscal Years 2009 and 2010
In the US, guidance on the investment of funds held by NPOs was initially provided by the Uniform Management of Invested Funds Act, 1972 (UMIFA). This was later updated by the Uniform Prudent Management of Invested Funds Act, 2006 (UPMIFA). These Acts provided some much needed direction in relation to both the investment of funds as well as the expenditure of the income and appreciation. A discussion on the latter is given below when discussing the payout from the fund. In relation to investments, the basic guidance was that funds should be invested prudently in diversified investments which grew in value and also generated income. Prior to 1972, the opportunities for investments by endowments were very restricted. Through UMIFA, the doors of modern portfolio management were opened for charitable organizations. UMIFA allowed investments in any kind of assets and allowed the pooling of endowment funds for investment purposes. The Act also permitted the governing board of endowment funds to entrust investment decisions to a third party if proper business care and prudence is exercised. In 2006, UPMIFA further explained prudence and stated that investment must be made ‘in good faith and with the care an ordinarily prudent person in a like position would exercise under similar circumstances.’ In relation to investment costs, it allows ‘only costs that are appropriate and reasonable.’ 11
Financial Management of Endowment Fund of Harvard University—Policy Portfolio
For instance, In July 1990, Yale became the first institutional investor to adopt absolute investment return strategies with a target allocation of 15 per cent 12 . A shift in investment policy can also be observed from Yale endowment fund reports. In 1991, 53 per cent of Yale’s endowment fund was dedicated to only U.S. stocks, bonds and cash. In 2011 only 11 per cent of this fund was invested in domestic securities and 89 per cent of this fund was classified into alternative assets, that is, natural resources, private equity, real estate and absolute return strategies 13 .
Table 5 depicts policy portfolio of HMC with a comparison of portfolios in 1995, 2005 and 2012. A shift in the investment pattern can also be observed here, as investment in domestic equity has decreased from 38 per cent in 1995 to 12 per cent in 2012. Investment in commodities has increased to 14 per cent in 2012 from 6 per cent in 1995. Investment in domestic and foreign bonds has decreased from 20 per cent in 1995 to 7 per cent in 2012. The table also shows investment in absolute return which amounted to 16 per cent of the total portfolio in 2012.
The fourth important activity for effective financial management of endowment funds involves the payout (or ‘spending’) policy that is, the percentage of the endowment income which should be withdrawn annually and transferred to the operational budget or for one-time or time-limited strategic purposes. In order to determine an appropriate payout percentage for the NPO, careful consideration is needed by the Board, since the trade-off between funding operational and strategic expenses and the need to maintain the endowment at a level necessary to ensure growth in future income earning ability has to be managed carefully and effectively. In the United States, guidance to investment managers on determining an appropriate payout rule was initially available under the UMIFA. One of the main objectives is to ensure that the payout policy does not ‘eat into’ the principle amount. The general idea put forward by UMIFA for spending (in the case of permanent endowments) was to maintain the principal of the fund in perpetuity at its ‘historic dollar value’ (HDV) 14 . As long as the HDV is retained, then ‘prudent’ expenditure of the income, together with any realized and unrealized appreciation of assets would be available for disbursement either without restriction or subject to donor requirements. This was a huge advancement of legislative practice in the US, which had prior to this only allowed the expenditure of any endowment income (that is, interest and dividends) for programme purposes.
Post 2006, when UMIFA was replaced by UPMIFA, the updated legislation eliminated the concept of HDV entirely. Instead it provided more guidance on the term ‘prudent’. Section 4 of UPMIFA states:
UPMIFA therefore, gives the maximum priority to the intentions of donors when determining the payout. The section goes on to emphasize ‘good faith’ by the institution when deciding on the appropriation or accumulation of the funds and dictates the following seven prudence factors which should be considered when making such decisions. These are
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the duration and preservation of the endowment fund;
the purposes of the institution and the endowment fund;
general economic conditions;
the possible effect of inflation or deflation;
the expected total return from income and the appreciation of investments;
other resources of the institution and
the investment policy of the institution.
An appropriation percentage is not specified by UPMIFA for the annual spending; however, in order to avoid the possibility of excessive expenditure, the law does contain a provision which states that it would generally be assumed (this is a rebuttable presumption) that a payout of greater than 7 per cent of the market value of the endowment fund is imprudent 16 . Harvard’s payout rate for 2012 was 5.5 per cent in line with the University’s targeted payout rate range of 5.0–5.5 per cent 17 . Yale’s targeted and actual payout for 2012 was in the region of 5–6 per cent (Yale Endowment Update, 2012).
Accounting for Endowment Funds and their Related Disclosures
In the United States, FASB has issued different Financial Accounting Standards (FAS) regarding financial reporting for nonprofit organizations. These include, FAS 116 (Accounting for Contributions Received and Contributions Made) and FAS 117 (Financial Statements of NPOs). FAS 116 establishes standards for financial accounting and reporting related to all entities that receive or make contributions. It requires NPOs to differentiate among contributions received that increase permanently restricted, temporarily restricted and unrestricted net assets. It also requires such organizations to disclose the amount, source, purpose and duration of restricted funds. In addition, it also provides guidelines on how to distinguish between contributions in cash, in services, in intangible and/or in tangible assets, in financial statements of NPOs.
FAS 117 established standards for general-purpose external financial statements provided by a not-for-profit organization. Its objective is to enhance the ‘relevance, understandability and comparability’ 18 of financial statements issued by those organizations. The standard requires that all NPOs should provide a statement of financial position, in order to report amounts for the organization’s total assets, liabilities and net assets; a statement of activities, to report the change in an organization’s net assets; and a usual statement of cash flows. It requires that the amounts for each of the three classes of net assets, that is, permanently restricted, temporarily restricted, and unrestricted, be displayed in the statement of financial position and that the amounts of change in each of those classes of net assets be displayed in a statement of activities. In addition, this standard also requires classification of an organization’s net assets, revenues, expenses, gains, and losses based on the existence or absence of donor-imposed restrictions. FAS 117 also considered UPMIFA as binding, and as an authority for endowment fund accounting. Hence, both the standard and law should be studied and implemented simultaneously by NPOs.
In August 2008, FASB issued FAS No. 117-1, ‘Endowments of Not-for-Profit Organizations: Net Asset Classifications of Funds Subject to an Enacted Version of the Uniform Prudent Management of Institutional Funds Act, and Enhanced Disclosures for All Endowment Funds’. This is applicable to all NPOs and specifies the following basic disclosures:
a description of the governing board’s understanding of the applicable law (UMIFA or UPMIFA); a description of the NPO’s spending policy, as well as its investment policy; the composition of ‘endowment’ (both ‘true’ or donor specified funds and board-designated funds), by class of net assets and a ‘roll-forward’ of each period’s activity in the endowment funds, by class of net assets, showing contributions, investment appreciation and depreciation, investment earnings, expenditures or fund distributions, and any reclassifications.
All of the disclosures must be retroactive, providing the information for all periods presented in the NPO’s financial statements.
In Pakistan, the ICAP has issued accounting and financial reporting guidelines for NPOs. These guidelines do not, however, cover in detail the accounting requirements of endowment funds. The only reference made to endowment fund accounting is that ‘as a restricted fund, the endowment fund should, in any event, be separately accounted for in the financial statements’ (para 2.12).
As mentioned before, in the US, the non-profit industry is very well established. This in turn means that stakeholders expect good fund managers to disclose information about the performance of the funds over and above the minimum legal requirements. Such ‘voluntary’ disclosure, especially by well managed endowment funds, becomes a reference point for all other endowment fund managers. These voluntary disclosures include management commentary about endowment fund, historical context, benchmarks, performance, future outlook and a separate detailed document on endowment fund updates (Section ‘Other Relevant Disclosures of Harvard University’ Source: Disclosures of Harvard University).
Other Relevant Disclosures of Harvard University
Net assets, as shown on its Balance Sheet, are segregated between General Operating Account (GOA), Endowment Fund and Split Interest Agreements. Furthermore, all three of these are sub-divided into Restricted, Temporarily Restricted and Permanently Restricted Funds.
Fair value of the entire endowment fund along with its department-wise break-down.
Total book value of the endowment fund.
Endowment returns made available for operations, as included in the Statement of Changes in Net Assets of GOA.
Transfers between GOA and endowment fund, as included in the Statement of Changes in Net Assets of GOA.
A detailed Statement of Changes in Net Assets of Endowment Fund.
A separate document called, ‘Harvard Management Company Endowment Report’ entailing, introduction of their endowment fund, historic investment return, benchmarks, actual performance of different asset classes, policy portfolio and long-term expected return.
Management commentary about endowment fund and its investment return.