What Is an Endowment and How Does It Work?
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Summary:
An endowment is a type of fund created by nonprofits or universities that help ensure financial stability. For most endowments, the principal (or corpus) remains untouched and instead is invested into various assets. The organization then uses whatever investment income they earn from their assets. To maintain the principal amount, endowments have strict policies that outline the annual spending limits and how the organization can use the funds.
Many nonprofit and private institutions create endowment funds to support their long-term finances. Endowments offer a consistent source of income for organizations to ensure stability and help with operating costs. Many organizations, ranging from universities to private foundations, create endowments for specific purposes.
While endowments act as a great source of financial assistance, they also pose some drawbacks to the organization. In this article, we’ll discuss the different kinds of endowments available, the restrictions enforced, and both the risks and benefits of creating an endowment.
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What is an endowment?
An endowment is given as donations of money or property to support nonprofit organizations’ financial health and operations. The endowment is invested income designated for specific purposes.
It is also considered the sum of an organization’s investable assets, also viewed as the “principal” or “corpus.” The principal is the money donated to the endowment. An endowment may be used for operational or program purposes as requested by the donor. Institutions typically do not touch the principal amount of an endowment and use the earned interest on operations.
How does an endowment work?
Most private or nonprofit institutions—such as colleges, universities, health care organizations, religious organizations, museums, and libraries—use endowments. They are set up as trusts, private foundations, or public charities to grow future assets. For instance, private foundations, such as the San Diego Foundation, use endowed funds to donate to charitable causes.
When initially created, endowments have guidelines or policies, such as a trust instrument that outlines the use of the funds. The funds accessible to the organization are contingent on the endowment’s size and how it’s invested. Some organizations may use an investment firm to administer the endowment.
By investing endowment funds and only using the interest earned, the fund’s value grows over time and allows the organization to use those funds for years. Because of this, endowments convey stability and long-term financial health to the community.
Types of endowments
Not all endowments are created equal. Though some funds may be spent as the institution wishes, most endowments have strict rules set up by the donor or institution’s board of directors.
- Unrestricted endowment. An unrestricted endowment allows the institution to save, invest, or spend the endowment funds at the institution’s discretion.
- Restricted endowment. Also called a true endowment, this is the most common type for colleges and universities. The donations for the endowment go into funds, and only the interest on the financial assets can be used. Restricted endowments aim to last forever, so the principal remains intact in perpetuity. The organization can use the earnings only per the donor’s wishes.
- Term endowment. Unlike other endowments, a term endowment is not designed to last forever. Instead, organizations can spend the principal only after a certain period of time or until after a specific event occurs.
- Quasi-endowment. A quasi-endowment is funded and regulated by a board of directors rather than an individual donor. This form of endowment fund is considered unrestricted, as it isn’t controlled by anyone outside of the organization. The board of directors may elect to use both the interest and principal as they please.
Policies of endowments
Most endowment funds have three policies that nonprofit or private institutions must follow regarding investing, withdrawing, and using.
Investment policy
The investment policy explains what investments the endowment manager is allowed to make. Endowments have particular investment policies in their legal framework to ensure that the organization administers the fund for the long term.
Endowment funds can have smaller funds for investing in securities or asset classes. However, organizations typically dedicate endowments to long-term goals.
Withdrawal policy
The withdrawal policy outlines the amount the institution can take from the fund. Organizations determine the policy based on the organization’s needs or the amount in the endowment.
Endowments generally have an annual limit for withdrawal. This withdrawal limit is usually low because organizations create institutional endowments for lasting in perpetuity.
Usage policy
The usage policy establishes what the organizations can use the funds for and ensures that it spends the funds for appropriate and practical purposes.
Endowments can have many functions. University endowments can support departments, financial aid, funding chair positions, or endowed professorships. Educational institutions can also use endowments to set up departments or programs in private universities.
Pro Tip
Organizations cannot break the terms of an endowment. If an institution is near bankruptcy, a court can declare a cy pres doctrine that allows the institution to use the endowment to improve its financial health.
Requirements for endowments
Endowment gifts must stay in an invested endowment account, and an agreed-upon percentage of the donation can be spent each year. Endowment gifts may support general operating expenses, but they can also be restricted to ensure the longevity of specific programs or projects.
Typically the goals of the endowment are to grow the fund through reinvestments and finance the institution’s operations. Teams managing endowments must establish goals, create withdrawal and asset distribution policies, and manage risks.
Private non-operating foundations, including grantmaking foundations, must pay an annual percentage of their investment income on their endowments for charitable purposes to maintain their tax-exempt status.
Private foundation and public charity endowments
A person or family can create a private foundation to allocate money for charitable causes. The money is considered the foundation’s endowment.
Public charities have endowments funded by donors. It is common for large, established organizations such as museums, universities, and hospitals to have them.
Endowments and higher education
Many American universities have some of the most significant endowments. The community can measure a school’s financial health through its endowment size. It gives colleges and universities the ability to support their operating costs and provides stability for unforeseen expenses. Higher education institutions, such as Harvard University, have successfully grown robust endowment funds.
The pros and cons of endowment funds
Though endowments often provide a reliable and long-lasting form of funding, the funds’ restrictions can cause some difficulties. Before developing an endowment fund for your university or nonprofit organization, consider these risks and benefits.
FAQs
What is the difference between an endowment and a donation?
An endowment and a donation are similar as they are given to an institution by a donor. However, an endowment fund is a significant entity bestowed by individual donors or an organization, while a donation is a voluntary gift or contribution to charitable causes.
In other words, an endowment may be made up of multiple, smaller donations that last for a significant period of time.
What is the difference between a grant and an endowment?
Grants are funding given to an organization from a foundation or government, designated for particular purposes, and often can’t be used to support overall operating costs. Overall, the endowment funds support the organization’s financial health and operating costs.
How does an endowment make money?
Endowment funds make money through investing the charitable donations previously received. Through the endowment, organizations invest in many things such as private equity investments, bonds, real estate, equities, and hedge funds.
What is the corpus of an endowment?
The corpus, also known as the principal, is all the money given to the endowment. The corpus generally stays intact in the fund and continues to produce interest through the endowment’s investments.
Key takeaways
- An endowment is a large sum of donated funds, often given to a university, nonprofit, or private organization.
- There are four major types of endowments: unrestricted, restricted (or true), term, and quasi-endowments.
- In order to consistently use endowment funds, most endowment funds are invested into a variety of assets and have strict withdrawal and usage regulations. This includes an annual withdrawal limit, which is often a small amount.
- By only using the investment income, the endowment principal (or corpus) remains untouched and continues to grow the endowment’s value.
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