Starting an endowment: what to consider

Starting an endowment is easiest when the economy’s strong, but it’s also a way to create a reliable source of income for lean times. Just as we personally save money for emergencies and retirement, nonprofits that can set aside money should. This week, we offer a few thoughts on the benefits and drawbacks of endowment funds, and next week we’ll share tips for getting them started.

An endowment is money set aside to invest in mutual funds or certificates of deposit. Endowments are permanent savings accounts, and nonprofits that intend to stick around use them to generate income for ongoing needs and capital for long-term growth.

To start an endowment, an organization puts aside money as principal and a small percentage of that principal (typically five percent) is used for annual needs. In years when the principal increases more than that percentage, the organization has more money it can use. When the principal doesn’t increase, the nonprofit can still take out five percent of the asset without affecting the principal too much.

During a market crash, even the principal may lose value, and there may be nothing to use for operating expenses. With a good mix of investments, an endowment can usually tolerate economic flux, but it should always be part of a nonprofit’s diversified income stream.

In addition to boosting annual income and long-term financial security, endowments are useful for several reasons. Most importantly for some organizations, endowments enable people to make larger gifts than they would through an annual fund. Donors who make large one-time gifts appreciate that their gift is an investment and will help support a nonprofit’s long-term growth.

Having an endowment is also very important if you expect your organization to be the recipient of bequests. For the most part, people who write nonprofits into their wills want their donations to go into a permanent fund.

One potential benefit of an endowment is that it can provide unrestricted income for operating or program needs. If donations to the endowment are no-strings attached, they help nonprofits be self-determining. Endowment income can be used to prioritize operating or program support, invest in capacity building, and respond to new opportunities. Sometimes principal from endowments can be used for capital purchases and loan collateral as well.

But not always. There have been notorious lawsuits when endowment gifts are linked to certain donor stipulations with which organizations have been accused of not complying. This can happen when a donor dies and no terms were developed for changing how the funds can be spent.

There are plenty of other reasons not to start an endowment. First, managing an endowment is more work for staff and Board. Investment policy can also be contentious, and leaders may not agree about controversial investments. Most importantly, like any investment, endowments represent a financial risk, and as we saw in the post-Madoff years, they can disappear in a flash.

Some critics point to millions of dollars sitting in the endowments of large institutions, suggesting that the practice disconnects nonprofits from their constituencies and compromises their missions. If a nonprofit has that much money, they say, it should be doing more.

More ideologically, endowments are perceived by some as contributing to the privatization of services that our tax dollars should be paying for. Endowment money is diverted from the tax stream but it isn’t used directly for tax-exempt activities.  Should nonprofits be building tax-free nest eggs to compensate for government spending cuts?

Nonprofit leaders considering starting an endowment should carefully consider the pros and cons. If they wish to forge ahead, they’ll also need to agree to how their endowment will be used—open a new office? Expand a program? Raise salaries or staff retirement benefits?

Next week, the logistics of starting an endowment. In the meantime, we’d love to hear from you. Experiences with endowments? Questions or opinions?

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