An endowment is one of the most misunderstood assets of non-profit organizations. The press often quotes funders, clients, employee groups, and patrons that rationalize their non-assistance of struggling non-profits because “the organization has an endowment”. It’s worth considering what an endowment can and cannot do.
Non-profits often receive gifts that are “restricted”, meaning the donor requires the funds to be spent for a specific purpose or at a specific time or both. An endowment is a very particular type of restricted donation, where the original gift (corpus) is required to remain untouched, unspent, in perpetuity. If an endowment is created, a non-profit benefits solely from the net earnings (after expenses) of that endowment. Again, the corpus is never available for distribution, a concept upheld by courts, monitored annually by auditors and overseen by the non-profit’s governing body. An entire section of law entitled the Uniform Prudent Management of Institutional Funds Act with the clunky acronym “UPMIFA” is dedicated to endowment practices. Specific state laws may also apply.
In a simplified example, a donor gives $1M to a non-profit and the funds are invested to earn an average of 7.5% per year or $75,000. Expenses like investment management and administration fees are deducted from the $75,000, leaving $70,000 per year or 7%. These earnings – this $70,000 – is all that a nonprofit may receive in a year. The original $1M remains intact and, indeed, spending it might subject the non-profit to legal action.
Consistent with UPMIFA, non-profits adopt an endowment distribution or spending policy that selects a prudent level of annual payout that avoids diminishment of the corpus. In the previous example, a 10% spending policy would be imprudent since it exceeds average market returns and would eventually result in the diminishment of the original gift (“invading the corpus”). Conversely, a spending policy of 2% would deprive the non-profit of maximum benefit of the endowment’s earnings. Most spending policies with assets invested in the capital markets select a distribution rate of between 5 and 7%, the range of which reflects the types of asset classes selected for investment, the risk appetite of the governing body and inflation.
Endowments are often mistaken as something akin to a savings account – something to be accessed in troubled times. This is a serious misunderstanding. Only a legal process such as bankruptcy can release endowment assets from restriction. Since “donor intent” is a guiding principle in legal actions, an endowment’s nature as perpetual gift supersedes the distress of the non-profit. Therefore, a likely result of a severely distressed non-profit is that it would dissolve with its endowment being assigned to another healthy non-profit with a similar purpose. Stated another way, it is very unlikely that a severely distressed non-profit would receive permission via a legal process to convert endowed assets to unrestricted aid.
The great irony is that a severely distressed non-profit with a substantial endowment can dissolve and, thus, “die with money in the bank”.