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What is an Endowment?

definition

An endowment is a financial tool that a nonprofit organization can use to accept financial donations to invest through a fund.

🤔 Understanding endowments

Endowments are standard tools for organizations — Think universities, museums, foundations, churches, charities, and hospitals — to raise money, often for charitable purposes. Money from an endowment donation goes into an endowment fund. Nonprofit organizations don’t usually spend the money in an endowment fund (there are some exceptions to this). Instead, they invest the money. Using the interest and profits earned from the investments, the organization can support charitable efforts. The goal of an endowment fund is to grow its investment to spend money on causes and projects that are priorities for the organization and its donors.

example

Some of the most common examples of endowments are those created by universities. For example, Harvard University manages the largest university endowment fund in the United States, with a total of $39B as of the start of 2019. When an endowment yields returns, an organization may use the money to pay for student scholarships and financial aid.

Takeaway

An endowment is like a high-interest savings account…

There’s a catch, though. You can’t spend the money you put into your savings account. Instead, you can only spend the money you have earned in interest. The good news is that the money you initially put in should always be there earning interest.

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How does an endowment work?
What are the types of endowments?
How do you start an endowment?
What are some pros and cons of endowments?
What is the difference between an endowment and a foundation?

How does an endowment work?

In theory, any nonprofit organization can set up an endowment. However, endowments are most common among universities, museums, and hospitals. An endowment accepts donations, and they’re usually created for a specific purpose. Unlike many other charitable donations, organizations with endowment funds do not spend the donations themselves. Instead, they use an endowment fund as an investment tool. The organization may hire a fund manager to choose where to invest the fund. If and when the endowment fund yields returns, usually in the form of interest and dividends, the organization will often use the returns to pay for expenses — These could be administrative or related to a charitable purpose.

Not all endowments are the same. Each type of endowment may be regulated by its own set of rules. For example, some endowments might allow an organization to spend some of the principal if they choose, while others may completely prohibit it. Likewise, some endowments might allow the organization full discretion over where they spend the money, while others might set specific restrictions.

What are the types of endowments?

There are four types of endowments:

  1. Unrestricted
  2. Restricted
  3. Term
  4. Quasi

Unrestricted endowments grant total discretion to the organization. In this arrangement, the organization managing the fund can choose what to do with both the principal amount and the returns — Where to invest the fund, how much to save, how much to spend, and for what purpose.

Restricted endowments come with a lot more limitations than unrestricted ones. For example, an organization with a restricted endowment cannot spend the principal (at least not if the endowment is permanently restricted). They’re only allowed to spend the returns from the investments. Even then, the profits can only be spent as the donor wishes them to be spent.

An organization with a term endowment must hold the principal in the fund for a set period of time. Once that period has passed, the organization is free to withdraw and spend from the principal.

Quasi endowments are donations that serve a specific purpose. Usually, the principal remains in the fund, while the earnings are spent on whatever cause the donor wishes. Typically the donor stipulates the purpose of the endowment ahead of time. For example, a donor might gift an endowment to a university under an agreement that they will only use it for scholarships.

How do you start an endowment?

You often hear about endowments within universities endowments, but in theory any nonprofit organization can set one up. Typically, an organization’s board of directors must first agree to set up an endowment, then sign off on a set of rules, such as the type of endowment and any restrictions, investment guidelines, and a name for the fund.

Some community foundations exist to help local nonprofit organizations establish endowment funds. Depending on your ability to hire a financial advisor, a foundation may also be able to manage the fund for you. Whether or not you hire a foundation to help, you may need to hire an accountant and an attorney to ensure your fund is set up correctly and follows the legal guidelines.

How much money do you need for an endowment?

There’s no hard-and-fast rule for how much money you need to start or manage an endowment. As is true for any investment strategy, it’s a good idea to plan ahead: Determine how soon you need to spend from the endowment and how much you’ll need to withdraw each fiscal year. Most endowments have a return of about 5% annually. Based on that return percentage and the amount you want the fund to earn each year, you can estimate how much you’ll need to start the fund.

Let’s say your nonprofit organization has an operating budget of $500,000 per year, and you want the endowment to pay for 10% of the operating budget. That means you want your endowment to see a return of $50,000 per year. To see $50,000 in returns each year with an average of 5%, you would need $1M in your fund.

How do you manage an endowment?

The goal of an endowment is to reinvest donations so the organization can spend the fund’s earnings while allowing the principal investment to continue to grow. As you can imagine, managing an endowment is a big responsibility, so it’s vital to entrust the task to the right person. Most organizations with large endowments hire a fund manager or financial advisor whose job it is to invest the money in stocks, bonds, and funds according to the endowment’s goals and constraints.

Can you spend an endowment?

The general intention behind endowments is that the principal amount should not be spent (with the exception of an unrestricted fund, in which you could spend the principal). Instead, the money in the fund is invested. For the most part, the interest and dividends that the investments earn is the only money that the organization can spend. This makes endowments far more sustainable than a charity relying solely on incoming donations, because the principal amount can continue to earn money for the organization for years to come.

Often, organizations with endowments will have a target amount of money they want to withdraw and spend from the returns each year. If their investment earns more than the target amount, then the surplus is usually reinvested into the fund. If the investment earns less than targeted, an organization might withdraw some of the principal to make up for the shortfall — Typically this option is only allowed under an unrestricted endowment fund. If an organization with a restricted endowment sees a shortfall one year, they may be faced with the tough decision of cutting costs, ending a program, or reducing their staff.

What else do I need to know about starting an endowment?

If you manage an endowment, it’s important and often required that you understand the donors’ intentions. An unrestricted endowment that’s entirely at the discretion of the organization is a very different animal than a quasi or restricted endowment that allows you to spend only on what the donor dictates. If you as an organization feel strongly about being able to access the principal money or use the returns at your discretion, then you’ll want to have an unrestricted endowment or go another route altogether.

It’s also essential to understand the goals of the organization. An endowment consists of a lot of money sitting in an investment account. For a small nonprofit organization with numerous urgent needs, it might be hard to justify letting a large sum of money sit untouched for a long period of time.

What are some pros and cons of endowments?

Endowments can be an excellent tool for nonprofit organizations to earn ongoing income from donations for operating expenses, without relying solely on new contributions. Once an endowment fund gets going, the organization will eventually see returns (assuming it is invested properly and the market conditions are favorable). At their best, an endowment can provide stability to an organization that might otherwise deal with inconsistent donations and an unstable budget. Think of it as an emergency fund for charities.

Endowments are also somewhat of a status symbol. An organization with an endowment might attract or impress potential donors. After all, organizations don’t usually establish endowments unless they have a lot of money and plan to be around for a long time.

At the same time, endowments aren’t without their disadvantages. The way endowed funds are spent can be controversial, for example. Some endowments, including those managed by universities like Harvard and Yale, have been criticized for continuing to raise student tuition while having tens of billions of dollars in their endowments.

For a charitable organization, the primary goal is typically to address an urgent societal need, from feeding the hungry to improving access to quality education. People who donate to charitable organizations are more likely to want the money going toward an immediate cause, not into an endowment to sit for years or decades. And for a small organization running a lean budget, the start-up costs of an endowment may be a barrier.

Another important thing to note is that endowments, like any other investment, are vulnerable to market conditions — The investment will grow or shrink depending on market performance.

What is the difference between an endowment and a foundation?

A foundation is a type of tax-exempt organization that serves a charitable cause, often by awarding grants. Endowments and foundations are similar in that both can serve as investment vehicles for private or public charitable donations. But they differ in several ways, including their goals and how they operate.

For example, endowments are meant to exist for a long, long period of time. Think about university endowments that have existed for well over a century. The original creators or donors may no longer be around, but the endowment lives on. Foundations, by comparison, may be shorter-lived.

Foundations typically don’t have the restrictions that endowments do. While an endowment might exist to fund one specific purpose (scholarships, for example), a foundation typically has more discretion as to where it spends its money.

That said, foundations are not without restrictions; they’re bound to comply with tax and other regulations governing tax-exempt organizations. For example, private foundations are required to distribute 5% of their assets’ fair market value each year to maintain their tax-exempt status.

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