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Up to Speed on UPMIFA

Adoption of the Uniform Prudent Management of Institutional Funds Act would bring changes to institutional financial reporting. Also involved would be new prudence standards for charitable funds management and investment and for endowment spending.

By

Financial Reporting Implications of UPMIFA

Susan E. Budak, Schaumburg, Illinois, is a consultant to NACUBO and co-author of the Financial Accounting and Reporting Manual for Higher Education (FARM).

UPMIFA Prudence Standards

Brent Bentrim is managing director of Carolopolis Family Wealth Management, Inc., Charleston, South Carolina.

At its July 2006 annual meeting, the National Conference of Commissioners on Uniform State Laws (NCCUSL) approved the Uniform Prudent Management of Institutional Funds Act (UPMIFA). Like its predecessor, the Uniform Management of Institutional Funds Act (UMIFA), the revised act provides statutory guidelines for management, investment, and expenditure of endowment funds held by charitable institutions, which apply in the absence of explicit donor stipulations about those activities. The reasons for revising UMIFA are threefold:

1. UPMIFA modernizes the rules governing expenditures from endowment funds, both to provide stricter guidelines on spending from endowment funds and to give institutions the ability to cope more easily with fluctuations in the value of the endowment.

2. UPMIFA updates the rules governing the release and modification of restrictions on charitable funds by adopting the approach taken in the Uniform Trust Code (2005) for modifying charitable trusts.

3. UPMIFA modernizes the prudence standards for the management and investment of charitable funds and for endowment spending by adopting language similar to the Uniform Prudent Investors Act (1994) and the Revised Model Nonprofit Corporation Act (1987).

A uniform act is a model for legislation that will help standardize laws throughout the United States. After receiving NCCUSL’s seal of approval, a uniform act is officially promulgated by the commissioners to be adopted, in whole or in part, by the individual states. Because the modernization of the rules is generally beneficial to institutions, NACUBO is encouraging states to adopt UPMIFA. Eleven jurisdictions (Connecticut, Idaho, Indiana, Montana, Nebraska, Nevada, Oklahoma, South Dakota, Texas, the U.S. Virgin Islands, and Utah) have already introduced bills for its adoption.

The two articles that follow discuss the implications of the changes inherent in adopting UPMIFA. The first article explains financial reporting implications—the first two of the three changes listed above. The third change, the modernization of the prudence standards, is discussed in the second article. While this third change has few, if any, financial reporting implications for institutions, it is significant because it would ensure that standards for managing and investing institutional funds are and should be the same regardless of whether a charitable organization is organized as a trust, a nonprofit corporation, or some other entity.

Financial Reporting Implications of UPMIFA

The issuance of the Financial Accounting Standards Board’s  Statement No. 117, Financial Statements of Not-for-Profit Organizations (SFAS 117), in 1993, and FASB Statement No. 124, Accounting for Certain Investments of Not-for-Profit Organizations (SFAS 124), two years later, caused major upheaval in how institutions report endowment funds in their financial statements. The issuance of  Statement No. 35, Basic Financial Statements—and Management’s Discussion and Analysis—for Public Colleges and Universities by the Governmental Accounting Standards Board (GASB), wrought similar major changes for public institutions. The adoption of the Uniform Prudent Management of Institutional Funds Act (UPMIFA) has the potential to cause additional significant changes in the way in which financial statements provide information about endowment funds.

Expenditures From Endowment Funds

UPMIFA changes the endowment spending rule of the Uniform Management of Institutional Funds Act (UMIFA) by eliminating the concept of “historic dollar value,” thereby increasing an institution’s ability to apply a total-return spending rate to its funds. (Historic dollar value generally is the original gift amount plus any increases required by the donor to be maintained permanently.) Under UMIFA, a charity can only spend amounts above historic dollar value that the institution determines to be prudent. UMIFA does not provide clear answers to questions that arise when the value of an endowment fund drops below historic dollar value. Thus, institutions received conflicting advice when the market headed downward in 2000.

UPMIFA replaces the historic dollar value approach for expenditure of endowment funds with a new standard of prudence that applies to the decision-making process of the governing board. Section 4 states: “Subject to the intent of a donor expressed in the gift instrument, an institution may appropriate for expenditure or accumulate so much of an endowment fund as the institution determines is prudent for the uses, benefits, purposes, and duration for which the endowment fund is established.” Therefore, an institution may apply its spending rate even though its application will cause the value of the fund to fall beneath its historic dollar value. This gives an institution more spending flexibility during market downturns.

The prefatory note to UPMIFA explains that historic dollar value is an arbitrary number that becomes meaningless as years pass. The note states: “Assuming reasonable long-term investment success, the value of the typical fund will be well above historic dollar value, and historic dollar value will no longer represent the purchasing power of the original gift. Without better guidance on spending the increase in value of the fund, historic dollar value does not provide adequate protection for the fund.” 

UPMIFA’s intent is not to allow a governing board to convert an endowment fund into a totally expendable fund, but rather to encourage the governing board to preserve the purchasing power of the current value of an endowment fund while being responsive to the needs of the institution during short-term fluctuations in the value of the fund. When applying the UPMIFA standard, acting prudently and in good faith, the governing board must consider a number of factors in deciding how much to distribute from an endowment fund. Those factors include 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 total return from income and appreciation of the investments, the institution’s investment policies, and the availability of other resources.

However, UPMIFA does not have any specific requirement to preserve the purchasing power or to set aside any amount permanently. According to the National Conference of Commissioners on Uniform State Laws (NCCUSL) comments to Section 4: “Although the act does not require that a specific amount be set aside as “principal,” the act assumes that the charity will act to preserve ‘principal’ (i.e., to maintain the purchasing power of the amounts contributed to the fund) while spending ‘income’ (i.e. making a distribution each year that represents a reasonable spending rate, given investment performance and general economic conditions). Thus, an institution should monitor principal in an accounting sense, identifying the original value of the fund (the historic dollar value) and the increases in value necessary to maintain the purchasing power of the fund.”

However, the commissioners’ comments rarely are included in the legislation that is passed in a state, and it is unclear whether those comments will have any standing in the interpretation of UPMIFA if the comments are not included. Without clear language in the legislation adopted by a state, the law could be interpreted as not requiring any portion of an endowment gift to be retained permanently—not the purchasing-power-adjusted gift or the gift itself. Thus, UPMIFA has the potential to change the classification of net assets of endowment funds held by institutions within the adopting state.

Independent institutions and foundations following FASB standards. For independent institutions and foundations following FASB standards, the applicable accounting standards are found in SFAS 117 and SFAS 124. Those standards define an endowment and address fund appreciation, income, and donor restrictions. In the endowment definition in paragraph 168 of SFAS 117, paragraph 22 of SFAS 117, and paragraph 11 of SFAS 124, FASB allowed governing boards to determine that some part of the endowment fund appreciation had to be maintained permanently. In fact, in the example provided in Appendix C of SFAS 117, the governing board made such a determination and retained a portion of gains permanently.

When implementing the accounting standards, the institutions, the foundations, their attorneys, and their auditors ultimately decided that because net appreciation was expendable under their UMIFA-based state laws, it could not be reported in permanently restricted net assets. No one (governing board or auditor) wanted to be in the situation of reporting an amount as permanently restricted and showing in the financial statements of a future year that it had been spent. By representing in the financial statements that the law requires the organization to keep an amount intact and maintain it in perpetuity, and then later spending that amount (or a portion thereof) without any change in the law or in cases coming before the courts to change the interpretation of that law, it could be construed by readers of the financial statements that (at best) the governing board is not intelligent in fulfilling its fiduciary responsibilities, or that (at worst) the governing board has done something illegal. 

So, even though the FASB accounting standards permit an amount to be reported as permanently restricted net assets should the governing board determine that law requires some portion of endowment gains to be maintained, most institutions have reported only historic dollar value as the permanently restricted portion of an endowment fund. Adoption of UPMIFA raises the following financial reporting questions:

  • Does the elimination of historic dollar value mean the elimination of permanently restricted net assets for endowment funds in states that adopt UPMIFA unless the donor has explicitly said that some amount must be maintained permanently?
  • In the absence of an explicit donor restriction, is there a way to interpret the relevant law as requiring the institution to retain permanently some portion of an endowment fund so that that amount can be reported in permanently restricted net assets?

Public institutions. For public institutions and foundations following GASB standards, the applicable accounting standards are found in paragraphs 35 and 53 of GASB Statement No. 34, Basic Financial Statements—and Management’s Discussion and Analysis—for State and Local Governments. In addition, Paragraph 320.31 of NACUBO’s Financial Accounting and Reporting Manual for Higher Education (FARM) provides higher education industry guidance as follows: “The primary component of a public institution’s restricted nonexpendable net assets is its endowment funds. To be classified as nonexpendable, the funds can never be spent for operating or capital purposes. They are required to be invested and retained in perpetuity and the income used to fund costs in accordance with the external restrictions, if any.

“An institution needs to analyze its endowment funds to determine whether all or a portion of the funds are nonexpendable. Generally, the corpus of the endowment is nonexpendable while, in states that follow some variation of the Uniform Management of Institutional Funds Act, appreciation is generally expendable. Depending on state law, a portion of the endowment fund’s appreciation may also be nonexpendable. For example, a few states require that an annual amount of the fund’s appreciation equal to the increase in the Consumer Price Index be added to the fund’s corpus.

“Amounts that are available to be spent should be classified as either restricted expendable or unrestricted net assets. A few states limit the endowment fund’s appreciation that may be spent in a year. Since ultimately these funds will be available to be spent, they should be classified as restricted expendable net assets.”

Because historic dollar value is used to determine the portion of an endowment fund that must be retained permanently (that is, restricted unexpendable net assets), adoption of UPMIFA in a state raises the same financial reporting question for public institutions as it does for independent institutions: Does the elimination of historic dollar value mean the elimination of restricted unexpendable net assets for endowment funds in states that adopt UPMIFA unless the donor has explicitly said that some amount must be maintained permanently?

The provision, also in Section 4 of UPMIFA, that “unless stated otherwise in the gift instrument, the assets in an endowment fund are donor-restricted assets until appropriated for expenditure by the institution” raises a second question for public institutions: Does that provision mean that unless the donor states otherwise, net appreciation of an endowment will be restricted even if the donor has not specified a restriction as to use of income?

Both UMIFA and UPMIFA state that the net appreciation of an endowment fund is to be used for the uses and purposes for which the endowment fund is established. Thus, if the donor does not restrict the use of the endowment’s income, the fund’s net appreciation is both unrestricted and expendable at some future date. By adding the provision that the assets are donor restricted until appropriated, UPMIFA may be adding a time restriction to those assets that expires when the governing board appropriates the net assets for expenditure. Because the FASB has specifically rejected the argument that the need for an act of appropriation causes a time restriction (paragraph 127 of SFAS 117), and because the FASB’s definition of restricted net assets differs from the GASB’s, the question of whether all net appreciation of an endowment fund is subject to a time restriction arises only for public institutions.

Optional provision for a presumption of imprudence. UPMIFA also includes an optional provision that creates a rebuttable presumption that an appropriation for expenditure exceeding 7 percent of the fair market value of an endowment fund is imprudent. The provision is optional because the NCCUSL drafting committee was divided on whether the provision was wise. As the commissioners’ comments to Section 4 explain: “Those in favor of the presumption of imprudence argued that the presumption would curb the temptation that a charity might have to spend endowment assets too rapidly. Although the presumption would be rebuttable, and spending above the identified percentage might, in some years and for some charities, be prudent, institutions would likely be reluctant to authorize spending above 7 percent. In addition, the presumption would give the attorney general a benchmark of sorts.

“A variety of considerations cut against including a presumption of imprudence in the statute. A fixed percentage in the statute might be perceived as a safe harbor that could lead institutions to spend more than is prudent. Although the provision should not be read to imply that spending below 7 percent would be considered prudent, some charities might interpret the statute in that way. Decision makers might be pressured to spend up to the percentage, and in doing so spend more than is prudent, without adequate review of the prudence factors as required under the act.”

The inclusion of the rebuttable presumption of imprudence when a state adopts UPMIFA raises the question of whether that provision creates a time restriction on net appreciation in excess of the 7 percent maximum. Massachusetts, New Hampshire, and New Mexico have similar language in their laws now, but those states currently are not interpreting that language consistently. Because FASB standards reflect time restrictions as restricted net assets and GASB standards reflect legal restrictions as restricted net assets, the imprudence provision raises classification questions for independent institutions, public institutions, and their foundations.

Releasing and Modifying Restrictions

More on UPMIFA

See the following Web sites for additional information on the Uniform Prudent Management of Institutional Funds Act:

  • To determine state statutes for UMIFA-based legislation, go to www.law.cornell.edu/uniform/vol7.html#infnd.
  • For the text of UPMIFA, with the prefatory note and comments, go to www.law.upenn.edu/bll/ulc/umoifa/2006final_act.htm.
  • The FASB provides further explanation of its endowment standards in paragraphs 120-132 of SFAS 117 and paragraphs 65-82 of SFAS 124. Those statements are available at www.fasb.org/st.
  • Financial Accounting and Reporting Manual for Higher Education (FARM) paragraph 504.15 discusses the interpretation of UMIFA by independent institutions and foundations that follow FASB standards. NACUBO members can access FARM at www.nacubo.org/x1671.xml.

Currently, UMIFA permits an institution to modify a donor’s restriction on an endowment fund if the donor consents or the court approves. Subsection 6(d) of UPMIFA adds another avenue to release or modify a donor’s restriction. The new provision would permit an institution, after giving notice to the state attorney general, to modify a donor’s restriction on its own for small funds that have existed for a substantial period. The provision is intended to address the problem that under some circumstances, a donor might be deceased or otherwise unavailable to release a restriction; yet, that restriction no longer makes sense and the cost of a judicial proceeding would be too great to pursue a change in the restriction. Certain text is placed in brackets so that an enacting jurisdiction can designate different requirements if it so desires. 

Independent institutions and foundations reporting under FASB standards generally would not need to report a reclassification in the statement of activities when Subsection 6(d) was utilized because the property must be used in a manner consistent with the purposes expressed in the gift instrument. Thus, it is unlikely that net assets stipulated by a donor to be retained in perpetuity would become immediately expendable (that is, permanently restricted net assets would become temporarily restricted or unrestricted) or that temporarily restricted net assets would be released of all restrictions (rather, a similar restriction would be substituted). Because the change in the fund’s purpose would substitute a restriction that was easier to meet, a reclassification from temporarily restricted net assets to unrestricted net assets in a future year would be expected unless the substituted restriction were a permanent one.

For the same reasons, public institutions and foundations reporting under GASB standards would not immediately reclassify net assets. Only if the use of Subsection 6(d) immediately removed all restrictions or substituted temporary (expendable) restrictions for permanent (unexpendable) ones would it be appropriate to report a reclassification in the statement of activities (FASB) or to reclassify the net assets on the balance sheet (GASB).

Looking Ahead

It is unclear how UPMIFA’s adoption would affect the classification of an endowment fund’s net assets. Some believe that removing historic dollar value as an amount that must be maintained in perpetuity has the potential of eliminating all permanently restricted net assets of an endowment fund unless the donor explicitly required some portion of the endowment fund to be retained permanently. Others believe that the revisions regarding prudence increase a governing board’s legal responsibility to preserve the purchasing power of the endowment fund and have the potential of increasing the amount of permanently restricted net assets. Further, some believe that including a presumption of imprudence for spending more than 7 percent of a rolling average of an endowment fund’s fair market value has the potential of creating a time restriction on the remaining endowment value, because that remainder is unavailable for spending under ordinary circumstances. 

As a first step in addressing the questions, NACUBO’s Accounting Principles Council met with the FASB and GASB members and staff to inform them of the possibility that UPMIFA would soon be adopted in some states. The council asked the boards to help in interpreting the current standards or to issue new standards that specifically consider the provisions of UPMIFA. The FASB and the GASB staff members agreed to work together with the council to understand UPMIFA’s provisions and to determine how best to avoid diversity in practice as UPMIFA is adopted.

UPMIFA Prudence Standards

First promulgated in 1972 and currently adopted in 47 jurisdictions, the Uniform Management of Institutional Funds Act (UMIFA) has long established the basic rules regarding the management of charitable endowments. As currently written into state law, UMIFA has glaring gaps in its ability to properly undertake the tenets of modern portfolio theory. The proposed Uniform Prudent Management of Institutional Funds Act (UPMIFA) directs those responsible for managing and investing an institution’s funds to act as would a prudent investor, using a portfolio approach in making investments and considering the risk and return objectives of the fund.

Among the significant changes made by UPMIFA is the incorporation of several key concepts from the Uniform Prudent Investor Act (UPIA), which has been adopted in more than 40 states. UPMIFA incorporates and applies to nonprofit organizations the prudence standards of UPIA, which was last revised in 1994. Under UPMIFA, endowment fund managers must use the care of an ordinarily prudent person in a like position under similar circumstances. Managers are obligated to minimize costs to the fund and to investigate the accuracy of information provided to them by others. Investment decisions are to be made in the context of the portfolio as a whole and should take into account the fund’s risk and return objectives. Diversification would generally be required. UPMIFA also updates the rules that affect fiduciaries.

Fiduciaries and Their Responsibilities

It is important to recognize that chief investment officers and investment committee members are fiduciaries. Simply put, the term fiduciary applies to those who have legal responsibility for managing someone else’s money—in this case, foundation or endowment assets. A fiduciary is required by laws (which may vary by jurisdiction) to always act in the best interests of his or her client. Not only are many fiduciaries unaware of their legal responsibilities, they may also fail to recognize that such a breach may hold them personally liable.

As a fiduciary, you are not held accountable for less than desirable outcomes (i.e., should an endowment suffer significant losses) but instead for procedural prudence, or the process by which decisions are made. The following language, taken from the prefatory note to UPMIFA, further explains what is different about UPMIFA’s fiduciary responsibilities as compared to UMIFA: “Among the expressly enumerated prudence factors in UPMIFA is ‘the preservation of the endowment fund,’ a standard not articulated in UMIFA. 

“In addition to identifying factors that a charity must consider in making management and investment decisions, UPMIFA requires a charity and those who manage and invest its funds to:

  • give primary consideration to donor intent as expressed in a gift instrument;
  • act in good faith, with the care an ordinarily prudent person would exercise;
  • incur only reasonable costs in investing and managing charitable funds;
  • make a reasonable effort to verify relevant facts;
  • make decisions about each asset in the context of the portfolio of investments, as part of an overall investment strategy;
  • diversify investments unless, due to special circumstances, the purposes of the fund are better served without diversification;
  • dispose of unsuitable assets; and,
  • in general, develop an investment strategy appropriate for the fund and the charity.”

UMIFA did not articulate these requirements. Thus, UPMIFA strengthens the rules governing management and investment decision making by charities and provides more guidance for those who manage and invest the funds.

Others Who Might Be Fiduciaries

Changes in the laws governing the differences between investment advisors and commissioned brokers have made it difficult to determine who has fiduciary responsibility. When Congress passed the Investment Advisors Act of 1940, it intended to increase investor protection by clearly delineating between stock brokerage firms that buy or sell securities for a commission and investment advisors who offer advice. The main goal of the act was to hold investment advisors to a fiduciary standard with respect to their interaction with clients. This model worked well for most of the second half of the 20th century, because the investing public, including endowments and foundations, were acutely aware of the difference between a commissioned sales person and a fee-based advisor or consultant.

As technology and the Internet began to rapidly and cost effectively encroach upon the stock brokerage industry’s core profit drivers—information and securities transactions—broker-dealers sought to expand to a more holistic service model and began to also register their brokers as investments advisors. Comprehending the liability of having their registered representatives held to a fiduciary standard, Merrill Lynch sought and obtained a no-action letter from the U.S. Securities and Exchange Commission (SEC) to exempt its registered representatives from being considered as investment advisors because the “advice was purely incidental to the core business of securities transactions.” The SEC released a statement, known widely as the Merrill Lynch Rule, in which certain broker-dealers are deemed not to be investment advisors.

Because federal law requires an investment advisor, but not a broker-dealer, to perform the care and loyalty duties of a fiduciary, understanding who has fiduciary responsibilities is no longer as simple as considering whether the individual charges a commission or a fee, nor does an “investment intermediary” title hold. Today, thousands of exempted representatives hold themselves out as investment advisors and market themselves as consultants compensated by fee for advice. For the fiduciary, this creates a “process documentation” challenge, leaving the investment committee, trustees, and chief investment officer accountable for every step of the process.

The 2006 NACUBO Endowment Study indicates that nearly 75 percent of respondents use investment consultants. Understanding that you are a fiduciary who may be held personally liable, the most important question you should ask your endowment’s investment consultants is: Do you have a legal obligation to act in the endowment’s best interest?

Although the SEC seems to be in conflicting roles, exempting some consultants while reporting on the malfeasances of others, the commission is actively seeking to assist individual investors and fiduciaries with tools to make appropriate decisions regarding consultants (see sidebar, “Key Questions to Ask Consultants”).

Special Considerations for Endowments of Less Than $50 Million

Key Questions to Ask Consultants

The U.S. Securities and Exchange Commission recommends that fiduciaries ask consultants a series of key questions.

  1. Do you or a related company have relationships with money managers that you recommend, consider for recommendation, or otherwise mention (to the endowment) for consideration? If so, describe those relationships.
  2. Do you or a related company receive any payments from money managers you recommend, consider for recommendation, or otherwise mention to the endowment for consideration? If so, what is the extent of these payments in relation to your other income (revenue)?
  3. Do you have any policies or procedures to address conflicts of interest or to prevent these payments or relationships from being considered when you provide advice to your clients?
  4. If you allow endowments to pay your consulting fees using the plan’s brokerage commissions, do you monitor the amount of commissions paid and alert plans when consulting fees have been paid in full? If not, how can an endowment make sure it does not overpay its consulting fees?
  5. If you allow endowments to pay your consulting fees using the endowment’s brokerage commissions, what steps do you take to ensure that the endowment receives the best execution for its securities trades?
  6. Do you have any arrangements with broker-dealers under which you or a related company will benefit if money managers place trades for their clients with such broker-dealers?
  7. If you are hired, will you acknowledge in writing that you have a fiduciary obligation as an investment adviser to the endowment while providing the consulting services we are seeking?
  8. What percentage of your clients use money managers, investment funds, brokerage services, or other service providers from whom you receive fees?

Bank trust departments typically market their fiduciary services as a single, often local, portfolio manager. A professional money manager may certainly lend a sense of credibility and prestige to an endowment; however, the local portfolio manager may only be allowed to implement a single investment strategy or model portfolio, making it difficult for the endowment fiduciaries to meet the new burden of proper diversification. Another headache for the fiduciaries is that perceived cost savings may be lost in the requirement to verify the portfolio’s performance (as they are self-reported) and then determine, based upon the model implemented, whether the trust department is superior to the thousands of other investment managers available. When relying on a single investment manager, the endowment must on a regular basis (at least semi-annually) undertake and document the process by which the decision to engage the sole investment manager was made and how the manager is evaluated and performance is verified.

Registered representatives of broker-dealers offer bundled solutions known as “separately managed accounts” or “mutual fund wrap programs” designed to assist the endowment in undertaking procedural prudence. For a single fee, an endowment receives money-manager due diligence and an investment policy statement and pays no further commissions or loads on mutual funds. (Applicable money manager and mutual fund expenses still apply.) Such bundling or wrapping of fees is unfortunately fraught with potential conflicts of interest.

Separately managed accounts promise to offer endowments the same access to professional money managers who typically would only manage portfolios of $5 million–$25 million minimums. The money managers, through a separate account segregated from other assets, buy and sell individual securities on the client’s behalf. The prestige that may come with having access to a money manager may also come with high costs. The endowment must pay the investment manager, the broker-dealer, and then the registered representative as a solicitor or intermediary. While the registered representative takes no part in the monitoring or interaction with the investment managers, he or she still receives a hefty “solicitor” fee that averages 1 percent of the endowment’s assets. And, while the registered representative may assist the endowment with its asset allocation decision or specific investment managers, he or she is legally seen only as someone who solicits the services of the money manager and the broker-dealer’s due diligence department on behalf of the endowment and therefore is not accountable for any recommendations the endowment may act upon. Because this arrangement of paying a solicitor does not provide any benefit or fiduciary protection to the endowment, it would be difficult to justify as appropriate or reasonable under UPMIFA.

Getting Ready for UPMIFA

The revised UPMIFA, which is currently being circulated among the states for adoption, adds more modern prudence standards to the law and may require higher education institutions to review and update fiduciary practices. In the meantime, institutions have an excellent opportunity to audit current practices and procedures with regard to the new act. Such reviews, when conducted by a state or SEC-only Registered Investment Advisor, typically uncover cost savings to an endowment and specific means to shield its fiduciaries from personal liability.