COVID-19 & the Potential Impacts on Investment Spending Rates of NFPs
In March 2020, the World Health Organization declared the SARS-CoV-2 virus and the incidence of COVID-19 (COVID-19) a pandemic. Since that time, COVID-19’s effect has been far reaching and devastating within the U.S., including the S&P 500 decline of approximately 20 percent from December 31, 2019, through March 31, 2020. Nonprofit (NFP) entities are worrying about their employees’ health, innovating new ways to carry out their missions while practicing social distancing, making sure they have adequate cash flow and considering the effect this pandemic will have on their financial reporting.
Market Performance Impact on Spending Rates of NFPs
Many NFPs have donor and board-designated endowments. Under the Uniform Prudent Management of Institutional Funds Act (UPMIFA)1, spending rates are typically used by NFPs for their endowments. The spending is often calculated using quarterly investment values over a period of time, ranging from the prior 12 quarters to the prior 20 quarters. The purpose of using a spending rate over a period of time is to allow some averaging to occur, creating a “smoothed” calculated spending amount.
For NFPs with endowments that didn’t use prior quarters’ investment balances to calculate their draw, available funds under their spending rate fluctuate with the market. Therefore, when the market drops, the spending rate also drops by a comparable percent unless the NFP upwardly adjusts its spending rate. This is typically not advisable because of the long-term effect on future endowment draws.
For example, a $50 million endowment dropping to $40 million is a drop of 20 percent. If the NFP used a 5 percent spending rate and didn’t use a quarterly calculation, the $2.5 million draw would drop to $2 million or a drop of $500,000 or 20 percent. That could significantly affect the NFP’s budget unless the endowment draw only made up a small percentage of the NFP’s operating budget.
The use of quarterly values to calculate the draw helps reduce the effect of significant upside and downside moves in the market. If the NFP uses a trailing 12-month calculation, a simple 20 percent decrease in one quarter would only decrease the spending rate by .08 percent. If the same NFP from the previous example had a constant $50 million endowment for the prior 11 quarters and it then dropped by 20 percent to $40 million, the spending rate would drop from $2.5 million to $2.458 million, or a decrease of approximately 1.7 percent. This is simply because the decrease is only a one-twelfth effect. If it was a five-year spending rate, it would be over 20 quarters and the effect would only be 1 percent.
Liquidation of Investments for Endowment Draws
Using a spending rate over the long run avoids significant swings in the endowment draws. However, an NFP must still make decisions about which investments to liquidate to cover its draw. Depending on the endowment’s asset allocation, that may be a difficult decision. Selling investments during a down market to satisfy an endowment draw or a capital call makes it harder for the endowment to recover when the market rebounds. Things to consider include:
- Does the NFP have ample short-term investments to use for the endowment draw to avoid the need to liquidate equity investments during poor performance times?
- Does it have significant alternative investments with future capital commitments that may need to be funded? If it has funding needs for the alternative investments, is there ample liquidity in the portfolio to cover those needs?
An NFP has a few options to create the needed liquidity:
- It could choose to liquidate certain short-term or fixed-income investments and avoid liquidating equity investments to cover its spending amounts needed to cover its spending rate and its capital commitments.
- It could choose to borrow from a line of credit and not liquidate any of its investments to cover those commitments (the low interest rate environment has created an inexpensive way to obtain funds).
- It could choose to reduce the spending from its endowment and simultaneously reduce its budget.
It also could choose to do a combination of these actions. During the 2008 recession, NFPs used all of these options.
BKD has created a COVID-19 Resource Center to help disseminate important tax and accounting information for our clients and friends as we evaluate ways to mitigate the inevitable financial effects. We’ll keep you up to date with relevant news, tax and compliance changes, new regulations and anything else we believe you need to know.
The views expressed above don’t constitute professional advice. You shouldn’t act on the information contained in this BKD Thoughtware® article without obtaining professional advice.
As with most topics related to COVID-19, changes are being made rapidly. Please note that this information is current as of the date of publication. To connect on this or other accounting matters affecting NFPs, reach out to your BKD Trusted Advisor™ or use the Contact Us form below.
1 UPMIFA has been adopted by all states other than Pennsylvania. ↩