The Importance of Endowments to Nonprofit Longevity

The Importance of Endowments to Nonprofit Longevity

As nonprofits grow and improve their fundraising capacity, they may enter into the stage of considering endowments. While investments may seem intimidating for new organizations, experienced nonprofits know that their longevity depends on them.

The importance of endowments is becoming widely recognized. As smaller nonprofits adapt this structure of handling donations, they are beginning to set themselves up for permanence in the sector. And there are a variety of endowment types — meaning there is a way for nearly all nonprofits to step into the world of investing.

So why are endowments so important, and why should you consider one for your charity? Let’s start with the basics first.

What Is an Endowment?

An endowment is a fund composed of monetary donations made to a nonprofit organization.

The principle investment is (almost) never used — only the interest earned on the investment. Nonprofits utilize the fund to secure their financial future by protecting the bulk of their monetary assets.

Some nonprofits invest the entirety of the organization’s donations in an endowment, using only the investment return to fund initiatives and pay for operating expenses. Others split their donations — using a portion to keep the lights on and fund initiatives, and investing the rest in an endowment and building on that investment by reinvesting the returns.

The importance of endowments lies in protecting the bulk of the organization’s funds to be in a healthy financial position for the long term. Endowments are a way to establish financial stability to ensure that they can continue their mission well into the future.

Debra Ashton, author of “The Complete Guide to Planned Giving,” compares endowment donations to a quantum leap for a nonprofit. The ability to protect the organization’s assets and use the windfall for operational costs is significant and life-giving to a young nonprofit.

In 2017, nearly 35,000 nonprofits in the United States had an endowment fund. These funds held close to $800 billion in assets.

Universities hold the bulk of endowment assets, with 69% of universities having an established endowment. In contrast, only 6.9% of religious organizations have an established fund. This trends toward larger nonprofits understanding the importance of endowments, as well as significant donor funding.

Where Do Endowments Come From?

Major donors often understand the importance of endowments, and they sometimes leave them as part of their legacy. They understand that the benefit of an endowment is that it is a long-term asset to the organization and can help support their mission for many years to come.

Although universities recognize the importance of endowments, you can see them in other nonprofit areas as well. Since an endowment is a financial structure, technically, any financially savvy organization can utilize one. Still, they are sometimes slow to build a return without the backing of a major donor.

The importance of endowments cannot be understated. They are vital to providing a financial safety net that helps the nonprofit survive periods of low fundraising or unexpected costs.

How Do Endowments Work?

A nonprofit, either with a donor or board agreement, can set up an endowment fund. Due to the management required of a fund such as this, it is a complex process involving investment managers. Once it is legally established, donor money can be contributed to the principal.

Since major donors often back investments, there are often terms or restrictions placed on the funds, so the organization cannot access them immediately. There is usually a written agreement in place, and the donor dictates the way in which the money can be used.

The investment manager then invests the principal, and the organization uses the acquired investment revenue as an annual fund. This money is used to pay for any expenses encountered throughout the year.

As with any investment, the importance of endowments continues to grow every year as the fund matures, placing the organization in a safe financial position.

How Are Endowments Structured?

There are several endowment types, and each organization must decide which one is appropriate for their particular circumstances.

First, there is a true endowment, in which the donor states that the organization must utilize the funds only through an endowment. This is usually stipulated in a written contract and is often organized as part of a planned giving initiative.

Next, there is a term endowment. A term agreement states that the organization must invest the funds for an agreed-upon period of time. For example, the donor may say that after 10 years, the nonprofit can access the funds, but before that must use only the acquired return.

In recent years, some nonprofits have begun using a quasi-endowment, which is quite beneficial for organizations still establishing their financial footing.

Once a board of directors understands the importance of an endowment, they must put policies in place so future members and executive directors know how to manage the fund. There are different types of policies that should be considered — including rules on investment, withdrawal of funds, and use of funds.

Quasi-Endowments — a Middle Ground

Quasi-endowments are set up with an agreement by the board of directors. The board recognizes the importance of endowments and wants to take advantage of the benefits these funds provide. However, as they establish themselves financially, they may be unable to manage for several years without access to the bulk of their funds.

A quasi-endowment allows the board to place all of their donations into the fund and leverage the investment income, but also withdraw from the fund if necessary. The board makes decisions on how and when to dip into the principal in order to fund necessary purchases or expenses.

For example, perhaps a younger organization understands the importance of endowments, but its leaders know they will have to purchase property in the upcoming years. The board can decide to tap into these funds for that specific purpose, because it will benefit the organization. If the benefit of withdrawing funds from the principal outweighs the safety net of the investment,  the executive director can act on this with agreement from the board.

Quasi-endowments are a wise choice for organizations that are relatively stable, but are unsure of their long-term future. They ensure financial stability and protect the nonprofit’s funds, but still offer flexibility and peace of mind to boards just dipping their toes into the investment waters.

Additional Endowment Benefits for Nonprofits

In addition to financial stability, endowments also help nonprofit organizations achieve legitimacy. Like a solid planned giving program, a nonprofit with an endowment(s) signals stability and authority to donors. An endowment shows that a nonprofit is not only serious about achieving its mission, but is also financially savvy and in it for the long haul.

Setting up an endowment also helps the nonprofit easily allocate donations. There are no lengthy discussions about what to do with a specific donation, because there is already an understanding that it will go straight into the fund, and be used toward achieving the nonprofit’s mission far into the future.As the organization receives annual donations, these can be transferred into the account as well. This raises the principal and encourages further growth of investment income. As with any investment portfolio, endowments are a future-facing strategy, and time is always on your side.

When contributing to a nonprofit with an endowment/investment portfolio, donors feel that they are donating to a fiscally responsible organization. They know their money will be spent in a way that fuels their own personal mission and values. They also understand the importance of endowments to long-term giving and may have peace of mind in knowing that their contributions will be felt for years to come.

The Importance of Endowments and Planned Giving

The importance of endowments is seen daily in planned giving. When presenting donation options, gift officers need to be able to fully explain the portfolio and how the donor’s contribution will increase the sustainability of the organization.

When funding the endowment, it is important to strike a balance between large donations and smaller annual gifts. While some donors are keen to donate large amounts in the form of investments and estate holdings, there is much benefit to contributing annually to the fund as well. Annual contributions will help grow the account, resulting in a greater time period for the donation to gain interest and work for the mission the donor supports.

Major gift officers can encourage annual gifts as well as planned major gifts by discussing tax rebates for charitable giving. Persistence on the part of fundraisers and the cultivation of donors can help grow contributions at both levels.

How To Grow An Endowment

Growing an endowment is key to securing a cash flow year after year. To ensure that an investment portfolio is a viable option for your organization, it is essential to understand how to leverage growth.

Investments grow by both accumulating donations to contribute to the portfolio and by the income earned on the investment. When considering the importance of endowments, especially a quasi-endowment, it is necessary to visualize the financial outcome.

Larger funds create more annual revenue for an organization than smaller amounts. Accounts with over $100 million have an average return rate of 7.6%, while smaller funds average 3.8%.

When establishing a quasi-endowment, there are several factors to consider. Bober Markey Fedorovich recommends that a nonprofit should be at least 10 years old, have an established board of directors, a history of meeting annual budgets, and savings of at least 25% of that budget before considering this type of investment.

Although the board of directors may decide to hire an investment manager, only 38% of organizations do so. Generally, until the account has grown to a sizeable amount, the decisions required to maintain and grow the portfolio are within the skill set of the board. Smaller organizations tend to pay a higher percentage on management fees, cutting into their annual spending allowance.

Many people wonder if endowments are taxed, and the answer is, generally they are not. But there are exceptions. This would be an article in itself.

Endowment Excellence — Private Universities

If there was ever an example of how to properly manage an endowment, it would be Harvard University. This massive portfolio is composed of 14,000 different sources that bankrolled nearly $2 billion of the university’s operating costs in 2020-2021.

While the majority of these finances are restricted due to donor demands, there is plenty of unrestricted investment revenue to continue permanently funding the school’s initiatives. Harvard self-manages its funds through a subsidiary nonprofit.

Due to the massive monetary size of the fund, Harvard University is not without its critics. Many people recognize the importance of endowments but believe that the school should use some of that money to reduce tuition and make education more accessible. Harvard explains on its website that due to the allocation of donations, it manages its reserve in order to secure financial viability for future generations.

Harvard is not the only university with a sky-high portfolio. It is closely followed by Yale, Stanford, and Princeton Universities. Although these schools have long-standing accounts and an even longer history of donations, the majority of these donations are restricted.

Endowments Are the Key to Financial Security

The importance — and effectiveness — of endowments is showcased by some of the largest nonprofits in the United States. Private universities have amassed billions of dollars to pay for the future of their programming and finance important research and initiatives with their annual revenue.

While smaller nonprofits may be nervous about restricting their access to money, investments are a fiscally responsible decision that will encourage long-term sustainability. Debra Ashton believes that donors are leaning toward investment donations as they see the success of larger nonprofits.

A properly managed, adequately funded endowment ensures the annual return on these investments will continue to provide money to cover operational and programming costs.

Since the concept is direct, and a board of directors has an agreed-upon policy, managing the investment should be fairly straightforward. This eliminates the need to pay high investment manager fees. There is a little bit of decision-making and discussion between the board and lawyers, but these steps are worthwhile for the financial payoff.

In the end, protecting your organization’s funding through an endowment will demonstrate your seriousness in the nonprofit sector, announce your desire to continue to serve your target population, and provide an established funnel for future major donations.

Category: Sustainability

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