UPMIFA – Still Prudent After All These Years?, 0520 SCBJ, RIBJ, 68 RI Bar J., No. 6, Pg. 7

• Author: Peter J. Miniati, JD, CFP®
• Position: Vol. 68 6 Pg. 7

UPMIFA – Still Prudent After All These Years?

No. Vol. 68 No. 6 Pg. 7

Rhode Island Bar Journal

June, 2020

May, 2020

Peter J. Miniati, JD, CFP^®

Rhode Island is home to over 3,400 public charities, and the missions of many of these organizations are supported by annual distributions from an endowment fund.^[1] R.I. Gen. Laws § 18-12 is the Rhode Island Uniform Prudent Management of Institutional Funds Act (“UPMIFA” or the “Act”), and it characterizes endowment funds as funds having a charitable purpose which are not wholly expendable by the charitable institution on a current basis.^[2] Since its passage in 2009, UPMIFA has prescribed the standard of conduct and rules of construction for investing, managing, accumulating and spending such funds. The Act imposes the fiduciary duties of loyalty, care, and obedience on charities and their governing boards. Given the increased focus on public institution transparency and the variability of investment returns before and since UPMIFA’s passage, an update and review of recommended practices may be worthwhile in the current investment environment.

Background

Every state but Pennsylvania adopted a version of the Uniform Law Commissioners’ Uniform Prudent Management of Institutional Funds Act^[3] (the “Model Act”) between 2007 (by thirteen states, including Connecticut) and 2012 (by Mississippi).^[4] Rhode Island and Massachusetts adopted versions of UPMIFA in 2009 and the timing is noteworthy – it included a period in which major financial markets lost more than 30% of their value. The year and the decade were featured on Time Magazine’s 2009 year-end cover titled “The Decade from Hell: 9/11. Earthquakes. Epidemics. Two stock-market meltdowns.”^[5]

During that period, The National Association of College and University Business Officers (NACUBO) reported that the values of endowments at Harvard University and Yale University each declined by 30% in just one year–from June 30, 2008 to June 30, 2009.^[6] Harvard’s endowment fell from $36.5 billion to $25.6 billion between those dates, and, at June 30, 2018, its market value equaled $38.3 billion, up only 4.9% from its fiscal year-end balance eleven years prior.^[7]

As the largest university endowment, Harvard’s practices are newsworthy, and its twin investment goals are identical to those of Rhode Island nonprofits: “the need to fund the operating budget with a stable and predictable distribution, and the obligation to maintain the long-term value of endowment assets after accounting for inflation.”^[8] As the oldest endowment, Harvard has wrestled with such issues for over 400 years, and, presumably, its operating budget was cut when “the bottom fell out of the stock market: a cow worth 20 pounds in the spring of 1640 fetched but 8 pounds in December and 4 pounds in June of 1641.”^[9]

Current Law

UPMIFA guides Rhode Island charities in balancing endowment goals of supporting current programs and preserving endowment values. At R.I. Gen. Laws § 18-12.1-3 (e), UPMIFA reads “Except as otherwise provided by a gift instrument, the following rules apply: (1) In managing and investing an institutional fund, the following factors, if relevant, must be considered: (i) General economic conditions; (ii) The possible effect of inflation or deflation; (iii) The expected tax consequences, if any, of investment decisions or strategies; (iv) The role that each investment or course of action plays within the overall investment portfolio of the fund; (v) The expected total return from income and the appreciation of investments; (vi) Other resources of the institution; (vii) The needs of the institution and the fund to make distributions and to preserve capital; and (viii) An asset’s special relationship or special value, if any, to the charitable purposes of the institution.”

Prior Law

Rhode Island UPMIFA added the “P,” for “Prudence,” to “UMIFA” (the Uniform Management of Institutional Funds Act), the law it replaced. From 1972 to 2009, UMIFA’s standards permitted an endowment to spend the amount of appreciation above the Historic Dollar Value (“HDV”), but could make no expenditures when values were “underwater,” or below HDV, which UMIFA defined as the value of the gift at the time of donation. Rhode Island’s UMIFA further required nonprofits to maintain permanent endowments at the donated value adjusted for inflation.^[10]

UPMIFA eliminated the HDV (also known as “historic gift value”) “floor” in favor of guidance on “prudent” behavior. A charity may now spend from an endowment even if the market value is less than the donor’s original gift – as long as the governing board determines the action to be prudent per the factors enumerated in UPMIFA, or if such spending is authorized by the donor in the gift instrument.^[11]

Before UMIFA and then UPMIFA, state law favored a presumption that assets donated to a charity should hold their value in perpetuity, and spending and investment decisions were made accordingly. Through the 1960s, the traditional approach was to preserve endowments by spending only “income” from investments. “Income” was understood to mean dividends, interest and rents but did not include the appreciation of asset values. So, endowments of that era were considered prudent if they excluded investments in growth assets, which is the opposite of current law and best-practices.^[12] The historical practice of spending “income” and preserving principal was changed to adopt investment principles espoused by Nobel Prize winning economist Harry Markowitz and other leading academics of that time.^[13] Markowitz’s Modern Portfolio Theory (“MPT”) emphasized risk management of the portfolio as a whole, correlation among securities, and diversification.

MPT considers that a rational investor would choose to maximize return and minimize risk. In contrast, an “income-only” pre-UMIFA investor is forced to accept lower levels of expected return at the same risk level, which is an “inefficient portfolio” – a fundamental error under MPT. Such a portfolio would need to spend income toward a larger percentage of income-producing investments while the purchasing power of the income shrinks due to inflation. “Income-only” investing could also lead investors to buy bonds with longer duration (which are subject to greater declines at times of rising interest rates) or those with lower credit quality (and higher default risk), which increases risk to an endowment and lowers expected returns.

Diversification

Markowitz’s theory holds that an efficient portfolio is one where diversification can lower the portfolio’s risk for a given return expectation (alternatively, no additional expected return can be gained without increasing the risk of the portfolio). Diversification simply seeks to avoid the proverbial result from “putting all of your eggs in one basket.” It is the process of allocating capital in such a way to reduce the exposure to any one particular asset or risk by investing in a variety of assets. If various asset prices are not perfectly correlated (i.e., they do not change in perfect synchrony), a diversified portfolio will have less variance (risk) than the weighted average of its constituent assets, and theoretically less volatility than the least volatile of its individual investments. As a risk management concept, this dates to biblical times, for Ecclesiastes advises one to “divide your investments among many places for you do not know what risks might lie ahead.”^[14] UPMIFA provides that “an institution shall diversify the investments of an institutional fund”^[15] and elsewhere it incorporates other MPT concepts, including “total return,” in the language of the Act.

Total Return

To produce both an ever-increasing income stream and an increase in principal value, a portfolio must have sufficient growth and a mechanism to harvest that growth.^[16] UPMIFA § 18-12.1-3 (e) (v) requires nonprofit boards to consider “total return from income and (italics added) the appreciation of investments,” and it serves to provide a means by which an endowment may appropriate portfolio growth. Growth, or appreciation in asset values, comes primarily from risk assets including stocks. These investments are more volatile in the short term but have produced greater returns over long time horizons and full market cycles. Managers of institutional funds seek to optimize their asset allocation, which is the percentages of the portfolio devoted to income-producing and growth assets.

Asset allocation should drive spending, rather than the reverse. The old “income-only” endowment approach...