An attorney’s view: How non-profits can navigate spending decisions in the current markets
2022’s triple-whammy of elevated inflation, rising rates and stomach-churning market volatility is proving to be a major obstacle for organizations worldwide—and non-profits are no exception. Already hamstrung by the COVID-19 pandemic, which led to a notable decline in both corporate and individual donations at the same time that demand for social services soared, this year’s rocky start has only exacerbated the financial pressures facing charitable organizations.
To shed more light on the specific challenges impacting non-profits today, as well as potential solutions, Samantha Foster, our managing director focusing on non-profits, recently sat down with veteran non-profit attorney Michele McKinnon. A partner at the global law firm of McGuireWoods, McKinnon has more than 35 years of experience representing public charities and private foundations in federal tax and governance matters.
Below is a summary of their conversation, with answers edited for length and clarity.
Samantha Foster: Unfortunately, 2022 seems to be adding insult to injury for non-profits already struggling to recover from the financial impacts of COVID-19. Are the non-profits you work with facing pressures from inflation and market volatility?
Michele McKinnon: Undoubtedly, yes—and in some ways, the impacts are even worse than what we saw during the height of COVID-19. The pandemic hurt non-profits because donations simply didn’t go as far, due to the increased need for services—yet we still saw substantial donations from wealthy individuals who did very well, financially speaking, during the pandemic. After all, the S&P 500 Index was up over 26% last year.
2022, of course, has been a very different animal. At the time of this interview, the U.S. equity benchmark is off roughly 15% from its early January high, while inflation is up over 8% on an annual basis. Not surprisingly, when markets are dropping and the cost of everyday items is skyrocketing, people are much less likely to open their pocketbooks to non-profits. Each of these factors alone would generally signal a rough road ahead for non-profits, but the combination of the two is making the situation that much more difficult.
Samantha Foster: Pricing pressures and declining markets clearly affect corporate and individual willingness to donate. Have you seen similar impacts on non-profits’ willingness to spend their endowments?
Michele McKinnon: Absolutely. During periods of market volatility, many non-profits become reluctant to spend their endowment funds. This is understandable, as it’s only human nature to want to sock away money during times of uncertainty. Certain organizations increase spending—for instance, a foundation serving the homeless—during times of market volatility. But the bottom line is that these organizations still have to operate—and that requires spending money.
Samantha Foster: You work with many non-profits on tax issues and spending. How has the typical endowment spending percentage rate changed in the last 20 years?
Michele McKinnon: It used to be around 5%, but in the past decade or two, the typical spending rate has dropped to roughly 4%-4.5%. This is largely a result of the Great Financial Crisis (GFC), which caused organizations to cut back on overall expenditures. Despite the subsequent economic recovery in the 2010s, non-profit spending levels have never really returned to pre-GFC norms.
Samantha Foster: With inflation at multi-decade highs, non-profits may be considering increasing their spending rates to cover rising administrative and services costs. There are minimums and maximums to non-profit endowment spending. Can you give a quick summary of UPMIFA and the maximum spending percentage for non-profits?
Michele McKinnon: 49 states (all except Pennsylvania) and the District of Columbia follow the guidelines set forth in the Uniform Prudent Management of Institutional Funds Act (UPMIFA), which essentially allows non-profits to determine an appropriate spending rate by taking into account a variety of factors, including the needs of the non-profit, market conditions, and, of course, long-term preservation of the purchasing power of the fund.
UPMIFA contained an optional provision that deems spending rates above 7% to be imprudent. But most states have not enacted this optional provision. Despite the failure of most states to adopt this upper limit, I think many non-profits would tread carefully before exceeding a 7% spend rate. I recommend that tax-exempt organizations review the applicable UPMIFA rules in their state before making any adjustments to spending policy.
Samantha Foster: There is a balance between the current use of funds and the long-term wealth transfer of an endowment. Is it legally prudent for non-profit organizations to increase their spending budgets, given both the long-term needs of the organization and potentially low investment returns?
Michele McKinnon: This is the question of the day for many organizations, and the answer isn’t an easy one. It all boils down to what the organization determines is a higher priority: the long-term preservation of its endowment fund or the survival of the organization itself. It’s worth pointing out that there are no rules about how the income from an unrestricted endowment fund can be spent.
In other words, it’s up to the organization to determine how much unrestricted money should be allocated to administrative costs versus charitable costs, for instance. Of course, endowment funds that are restricted by the donor must be used in accordance with these restrictions. A non-profit should always avoid using restricted funds for other purposes, even when tempted to do so to keep the organization afloat.
Samantha Foster: Can you offer any guidance as to how a non-profit might determine the appropriate balance between administrative costs and charitable (or mission-driven) costs?
Michele McKinnon: It really depends on the goals of the organization. If an organization’s mission is to provide a service—for example, a food bank’s mission is to provide free meals to those in need—then its administrative costs will generally be lower than its charitable costs. On the flip side, if an organization’s mission is to fund a cause—for example, curing cancer—it’s the actual work of the employees (i.e., research) that typically furthers the mission. In that instance, it’s probably more appropriate for the organization to incur higher administrative costs in the form of staff salaries and other expenses.
It’s important to note that there are watchdog groups that monitor an organization’s operational spend versus its charitable spend—and that the results of their reporting can impact donor giving. This is yet another reason why changes to an organization’s spending policy warrant careful and deliberate consideration.
Samantha Foster: We discussed maximum spending percentage rates. What about minimum spending rules for non-profits?
Michele McKinnon: There are no minimum spending rules for most public charities. Most endowments, however, by their very definition, will only allow the income earned on investments to be spent (with the principal left untouched). Under UPMIFA, however, income is defined as the spending rate adopted by the charity. In this vein, many gift agreements come with a clause that the donation should be reinvested if the money isn’t needed at the time. For instance, if an individual donates endowed money to be used for a professorship at a university, but the professorship is vacant, the money typically must be re-invested until the professorship is filled.
Charitable organizations that are classified as private foundations are required to distribute essentially 5% of their investment or non-charitable use assets each year for charitable purposes (typically in the form of grants or contributions to other charities). Private foundations are typically funded by an individual, family, or corporation and do not generally receive contributions from the general public. The distribution requirements imposed on private foundations are derived from the special federal tax rules that apply to charities classified as private foundations.
Samantha Foster: What if an organization has designated or restricted funds that are not being used—money that’s essentially sitting in the corner and gathering dust because it cannot currently be used for the purposes specified by the donor? Is there a way for non-profits to tap into these funds, especially considering today’s market backdrop?
Michele McKinnon: There is. Non-profits can start by reaching out to the donor directly to request the donor’s consent to modify the restrictions imposed on the use of the funds. However, in many instances, the donor may be deceased, which means the matter must be handled by either the courts or the state attorney general. In either case, the party assigned to the matter is tasked with doing its best to match the donor’s intent.
UPMIFA sets forth specific rules allowing modification of donor restrictions if certain conditions are met. Every charity should examine whether there are funds that are no longer able to be used for the purposes for which they were contributed, and should explore whether UPMIFA offers a process for seeking a modification of a donor’s restrictions.
Samantha Foster: What other options exist for non-profits that need to increase their expenditures in today’s difficult financial environment?
Michele McKinnon: One option is for organizations to tap into what’s known as board-designated endowment funds. This is a pot of money originally created by pooling together general donations—in other words, gifts with no donor restrictions to limit the purpose or amount spent—that the board later decided to treat as an endowment. A board has the power to undo this designation and spend the money as it sees fit—without the approval of a court. This may be a worthwhile option for non-profits to consider during times of financial hardship like today.