All About Endowment

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graph representing Endowment

For nonprofit organizations and institutions, endowments can be a reliable source of unrestricted operating support or a welcome source of support for restricted purposes.

Endowment gifts are coveted by nonprofits because they offer the promise of recurring income, and because they show that donors have confidence in the nonprofit’s future.

Endowment vs. Quasi Endowment

What is endowment? “Endowment” describes the corpus of funds maintained permanently for a nonprofit’s benefit. Typically, endowment gifts are given with the provision that the donated sum remains intact and invested in perpetuity. Donors may allow earnings from the invested endowment to be used for general (“unrestricted”) purposes, or they may designate the endowment for specific (“restricted”) purposes – for example, to underwrite research, pay for a salaried position, or support a program.

What is quasi endowment? “Quasi endowment” describes the funds that a nonprofit sets aside to function like a permanent endowment, invested to generate a return. Quasi endowment may originate as a reserve fund formed with annual budget surpluses, or from bequests, exceptional gifts, or the sale of an asset such as real estate. Quasi endowment is typically designated as such by the nonprofit’s governing body or management; quasi endowment is impermanent because it can be “undesignated” just the same.

Generating a Return

Employing endowment to generate a return

Set a spending rate. Invested prudently and purposefully, endowment or quasi endowment funds can generate a return that allows a nonprofit to count on a predictable income stream to underwrite a portion of annual operating expenses, or for specific (“restricted”) purposes. The board sets an annual spending rate, typically in the range of 3% to 5% of the endowment’s value; responsible boards look to generate a somewhat higher return than the spending rate to cover investment fees and keep pace with inflation. A targeted annual return of 6%-7% is needed just to “tread water” if a nonprofit wants to spend as much as 5% of the endowment’s value annually. A lower spend rate allows the endowment to grow over time.

Allow for market dips. Investment income naturally fluctuates from year to year as investment returns reflect market performance and the composition of the investment portfolio. To reduce the impact of market dips and blips, the endowment’s value should be calculated as the mean or average value of total invested funds for a period of trailing years or quarters. A “best-practice” is a calculation based on a five-year “rolling average” of returns recorded quarterly. The spending rate and the calculation of endowment value should be closely tied to both the short- and long-term needs that the board and executives foresee.

Endowment Policies

Set policy. Decisions around the quarterly or annual spending rate that a nonprofit chooses to employ (a percentage of the endowment’s total value), and how the endowment’s value is calculated, are policies set by the governing board. The board also sets policy on how endowment and quasi endowment funds should be invested and the conditions under which these policies may be altered. The goal is generally to ensure that endowment corpus or “principal” is preserved so it provides a permanent benefit.

Delegate to a qualified committee. The Investment Policy and Endowment Spending Policy are generally crafted by an Investment Committee of the governing board and then voted on by the full board. It’s smart for the Investment Committee to be composed of individuals with a solid understanding of financial markets and investment strategies, and an ability to ask penetrating questions and offer guidance based on an understanding of market trends so that good decisions are made…and so the board as a whole has confidence in the Investment Committee’s guidance.

Investing Endowment

Invest with strategy. The investment strategy for endowment funds should be closely tied to a nonprofit’s short- and long-term goals and – as with any individual investor – the tolerance for risk that the board is willing to accept. The Investment Committee must understand how the nonprofit wishes the endowment to function; for example, to generate income that can be drawn regularly and consistently for operating expenses, or to build up over time for use, periodically, for special projects or initiatives. A typical asset mix (just as in a personal investment portfolio) would include stocks, mutual and index funds, bonds and cash or cash-equivalents, but may also include other investment vehicles such as private equity.

Consider your investments. Some nonprofits are prescriptive about their investments. They may choose to filter out stocks from industries like tobacco, weapons or fossil fuels, or certain pharmaceutical companies. The resulting portfolio might be called “mission compatible.” More targeted, “mission-aligned” investments – referred to as “social impact” or “program-related” investments and collectively as “impact investment” – is a practice more commonly employed by individual investors and foundations, but nonprofit organizations and institutions can use it too. Impact investing helps ensure a social benefit or positive environmental impact along with a financial return.

Protecting Endowment

Be cautious. It may be tempting for a board to borrow from permanent endowment or dig into quasi endowment when there is a budget gap to plug or a new program area that requires funding. Especially when a board designates funds to form quasi endowment, there is ever the opportunity to un-designate those very funds for short-term needs. There’s also risk when money is moved around from one asset class to another, betting on the likelihood of a stronger return when the market suggests that a particular asset class is on the rise.

Install safeguards. The board-approved Investment Policy is where rules are set for making decisions around the disposition of endowment or quasi endowment. The policy should help protect the endowment. For example, the policy may allow the Investment Committee certain leeway in adjusting the asset mix within certain guidelines to take advantage of the promise of a higher return-on-investment (say the relative percentage of equities, cash equivalents and so on). But a strong Investment Policy should also require a vote of the full board (not just the Investment Committee) for any significant shift – say, more than 10%. The Investment Policy should also require that an affirmative vote of the Investment Committee be followed by an affirmative vote of the full board if any portion of quasi endowment is to be used, say, for budget relief or any other purpose. While a nonprofit may occasionally need access to endowment funds for emergency purposes, policy language should assure everyone that board-designated endowment is intended to remain in place in perpetuity, and permanent endowment is well-protected.

Choosing Guidance

Seek expert counsel. Like any individual or foundation with invested assets, nonprofits have a range of choices around whom to entrust with, and where to place, their assets. Nonprofits with large endowments may have a Chief Investment Officer (CIO) on staff who serves as investment manager. But most Investment Committees work with an investment advisor or an investment manager. The former offers professional guidance and can facilitate the selection of investment managers or investment vehicles; the latter is given direct responsibility for making investment decisions usually subject to the approval of the nonprofit each time a transaction is made. Smaller nonprofits might entrust their endowments or quasi endowments to a “fiduciary” who is given responsibility to act on behalf of the organization or institution. Sometimes called an Outsourced Chief Investment Officer (OCIO), the fiduciary is empowered to act on behalf of the organization or institution just as an in-house CIO would.

Pay for quality advice. Fee structures vary among investment advisors and managers, and there may be opportunity for negotiation. But like a developer selecting an architect, an Investment Committee may be willing to accept a higher fee structure because of the quality of advice, attention, analysis or investment opportunity they gain in return. An Investment Committee should interview several prospective advisors or managers before making a selection.