Starting an Endowment: Key Considerations and Pitfalls to Avoid

Establishing an Endowment Can Help Fund the Future of Your Organization

Every organization should work towards setting aside funds for a rainy day (or in the case of 2020, a pandemic!). Programs, contributions, and expenses are not always consistent, and the ability to smooth the ups and downs will help your organization continue to focus on its mission. However, how do you know when it’s time to take the organization’s operating reserves to the next level in the form of an endowment?

Understand what an endowment is and what it isn’t

Endowments are created by donor contributions that are specifically restricted for this purpose. Typically, these contributions are restricted into perpetuity, however any income from the investment of the gifts is unrestricted for general use or can be earmarked for a specific initiative. Funds cannot be permanently restricted by a board or management, therefore they cannot be endowed. The board may only designate funds to function as an endowment.

What does it mean to “function as an endowment”?

If a board designates funds for an endowment, the intention is to allow the original designated amount to grow and provide a stream of income into the future. Those funds, often referred to as “quasi-endowment” remain unrestricted, and the designation as an endowment can be removed at any time. They are typically subject to the policies applicable to other donor-restricted endowments, such as the timing and amount of withdrawals.

Know when you can spend from endowments

A common misperception is that an organization must stop spending from the endowment at the moment the fair value drops to the value of the original gift amount. However, all states (other than Pennsylvania) have adopted the Uniform Prudent Management of Institutional Funds Act (UPMIFA) which allows spending from funds that have a fair value below the original gift amount – commonly known as “underwater” endowments – if the board determines it is prudent to do so. This policy is driven by the concept that the market always recovers and capitalizes on perpetuation of the original purchasing power of the funds. Developing this spending policy is an iterative process, and the board should closely monitor whether spending from underwater endowments in such amounts remains appropriate.

What makes an endowment complicated?

When establishing an endowment or accepting permanently restricted funds, front-end policy development is crucial. The board must establish an investment policy and a spending policy to frame the ability for withdrawals from the endowment in all market scenarios. If endowments are accepted where earnings are restricted for certain purposes, the board must develop appropriate internal controls over spending and record-keeping. If endowments are pooled for investment purposes, the board must determine an allocation process and establish consistent processes for compliance. Organizations with large endowments require significant staff time to manage the funds and investments. Use of an investment professional can lessen the burden of the latter by providing increased access to investment options, diversification, and potentially higher returns. However, keep in mind that the nature of whether the funds are endowed or not does not dictate how you are permitted to invest.

So why not just grow our operating reserve?

An operating reserve should be treated more like a savings account. Taking a lump sum from an operating reserve at inconsistent times or in varying amounts is easier than withdrawing from an endowment. If the organization needs a sum of cash for a short period, borrowing from an operating reserve requires no consideration of the restrictions around the use of the funds.  A board could decide in the future to use the entire operating reserve for a new program or particular expansion. Operating reserve funds can be invested and the board can decide whether the earnings are maintained in the reserve or used for operations. This type of flexibility need suggests a robust operating reserve may be preferable. Think of an operating reserve as funding for “today.”

An endowment is funding for “the future.” It should be developed to help ensure the organization can continue its mission by providing a reliable stream of income into perpetuity.

How do I know the right time for an endowment?

Establishment of an endowment is a statement that the organization plans to be around for a very long time. It can be a powerful fundraising tool, exciting donors that their gift can support the organization for long after they are alive.  On the flip side – some donors may feel that an organization with a large nest egg doesn’t need their contribution. Consider your donor base and where you want the organization to go.

As a final point, there is no magic number that makes an endowment “worth it”. However, if endowment income withdrawals would only be sufficient to cover one utility bill each year, you may want to build up the reserve a bit further before launching into an endowment campaign. It may be helpful to identify a particular large annual program or expense category that you’d like to fund through an endowment. Use this as your guide as to when you’re ready to take the leap.

Every organization is different and there are many good reasons for and against starting an endowment. After educating your board, engage in discussion regarding the pros, cons, and needs of the organization. What is the end goal? The decision that is right for you today may not be the decision that is right for you tomorrow, so don’t be scared to revisit the conversation. Endowments can be daunting, but we are here to help. Contact your Opportunity Advisor or Email | Call: 804.747.0000

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