Philanthropy 101: Endowments – A Key to Sustainability

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Posted: September 25, 2020
Category: SDSCF Blog

The term Endowment has various meanings. This article will focus on the power of endowments in contributing to long-term sustainable revenue, so we will define an endowment as follows:

A contribution where:

  1. The original gift amount is permanently restricted by the donor, and as such cannot be expended for operational support, programs, or grant awards

    and

  2. Investment earnings from the endowment may be either added to the endowment to grow the principal balance or expended for the intended charitable purpose

Endowment funds are required by law to be managed in a prudent manner, ensuring that investment assets are well-diversified and professionally managed. Endowment investments are designed to produce sufficient income to grow the endowment corpus (principal) against inflation and also provide a targeted annualized income that funds the designated programs or operations. The income allocated for expenditures is typically referred to as a spending policy.

For example, endowment assets may be invested to achieve a long-term total return of 7%, with the goal of allocating 2% per year to the endowment to hedge against inflation, and 5% per year to a spending policy that funds the intended programs or operational expenses. The following provides a simple visual, for illustration. Assume the non-profit organization needs income of $200,000 per year to help meet operational expenses:

In this example, for every $1,000,000 of endowment principal, $50,000 per year is generated for operational expenses. And, allocation of a portion of earnings to endowment principal means that the spending policy amount will gradually increase over the years as the endowment corpus grows.

To achieve these investment objectives, most nonprofit organizations retain an outside professional investment consultant and utilize one or more investment firms with the requisite expertise to manage various classes of investment assets. The mix of specific investments is designed to achieve the desired long-term total return, and may consist of domestic and international equities, fixed income instruments, and alternative investments. A qualified outside investment advisor should be retained to help ensure that investment assets are diversified with an acceptable level of market risk and return.

It is important to observe that actual earnings will fluctuate each year depending upon the investment market. Some years may have large investment gains, and other years will experience losses. This can create challenges in achieving a stable budgeting process and reliable annual income available for spending. To compensate for these fluctuations, many nonprofit organizations adopt a policy whereby the spending policy calculation is “smoothed” by utilizing a multi-year rolling average of the endowment principal balance.

An example of a method that is often used by nonprofits with substantial endowment assets is to employ a 36-month rolling average calculation. This is done by averaging the monthly endowment principal balance over 36 months, and then calculating 5% of that amount for the annualized spending policy. In essence this means that when annual investment earnings are high, most of those earnings are set aside for years when investment earnings decline or are negative (losses). This smoothing technique provides a measure of stability and dependability of spending policy amounts, contributing to a more effective budgeting process.

The challenges of raising enough endowment principal to achieve significant spending policy amounts may at first appear intimidating. However, a permanent endowment is exactly the type of leveraged philanthropic investment that some donors are interested in funding. Sophisticated donors know that the stability and sustainability of a nonprofit organization can be assured through the instrument of a permanent and well-managed endowment. Often the donor’s name(s) will be associated with the endowment, giving them a named legacy that lives beyond their lifetime. Such gifts may be given during the donor’s lifetime, but more often are included in a donor’s estate plans, reinforcing the role of planned giving as an essential component of a nonprofit organization’s overall fundraising strategy.

Endowments may be held by the beneficiary nonprofit organization, or they may be donated to a community foundation for safeguarding. There are at least two benefits of placing an endowment at a community foundation:

  • A community foundation has specific and extensive experience in managing the investment assets of multiple endowment funds, with well-diversified pools of professionally managed investments overseen by an independent investment committee.
  • The nonprofit agency remains the permanent beneficiary of spending policy distributions, but the endowment itself is not included in the asset base of the nonprofit agency, ensuring that the endowment principal cannot be accessed by creditors, and is protected in perpetuity even if the beneficiary nonprofit experiences any future financial difficulty or even insolvency.

Directors of 501c3 nonprofit organizations should actively engage in cultivating and building a donor pipeline, designed both to raise current gifts and to develop a long-term planned giving strategy for cultivating larger endowment gifts that build operational capacity. The San Diego Seniors Community Foundation is available to assist nonprofit organizations with endowments that benefit older adults and to receive and manage those endowments for the benefit of the nonprofit agency.

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