It takes only a few days or weeks for a successful company to experience hardship. Approximately 20% of small businesses fail within their first year, and this is often due to financial issues. Nonprofits often struggle to make ends meet.
Endowments are one of the best ways to help a nonprofit organization stay afloat, and they can be a great opportunity for donors. However, not everybody understands how this monetary donation works.
So, what is an endowment? Let’s explore the key information you should know.
What Is an Endowment?
An endowment is a donation of property or money to a nonprofit organization. The purpose of an endowment is to allow the organization to use the investment income for charitable efforts. More often than not, the principal amount of the investment is kept intact.
For example, let’s assume someone donated $500,000 as an endowment to a public charity. This money is then invested, and the income is used to help the charity achieve its goals. The charity never takes money from the initial $500,000.
The most common nonprofits that receive endowments are cultural institutions and educational institutions. However, this isn’t an exhaustive list. Any nonprofit organization can receive an endowment.
Endowment Policies
Certain policies control three different aspects of endowments. These include withdrawal, investment, and usage. Let’s explore them in detail below.
Withdrawal Policy
This declares the amount of money the organization can take from the fund during each period. Withdrawal policies are often based on the organization’s needs. This means they can differ between nonprofits.
Regardless, most endowments have annual withdrawal limits. This is typically expressed as a percentage. To clarify, an endowment policy might declare the non-profit can only withdraw 7% of the total amount each year.
The longer the endowment is supposed to last, the lower the limit will be. University endowments, in particular, are meant to last forever. These have notably low limits, sometimes as small as 2% or 3%.
Investment Policy
This determines what type of investments the nonprofit can use the endowment for. It also has guidelines for how aggressive the endowment manager can be when seeking returns.
Since this money must be managed over a long period, there are policies to preserve its longevity. Endowment funds sometimes have smaller pools of money that are put toward different investable asset classes or securities.
This diversifies the fund and reduces overall risk. The money is used to reach a specific yield or rate of return.
Usage Policy
As the name implies, usage policies dictate what nonprofits can use the money for. These policies also ensure the money is handled appropriately.
It’s not uncommon for endowments to have multiple uses. One of the most common is ensuring financial health across specific departments. Universities typically use endowments to provide scholarships to certain students.
Endowments are sometimes used to compensate people in chair or committee positions. This frees up funds and allows organizations to hire additional staff.
Types of Endowments
There are four types of endowments that nonprofits work with. Each has its pros and cons, and it’s essential to choose the right one when donating. Listed below is key information about each.
Quasi-Endowment
This is a donation intended to have a specific purpose. The principal is often retained, and earnings are spent or distributed based on the donor’s terms.
To elaborate, assume someone gave $100,000 to a local university as a quasi-endowment. Their terms could dictate that the investment returns be spent only on classroom furniture.
Unrestricted Endowment
The institution can spend the endowment at its discretion. Unrestricted endowments have the most freedom and are the easiest to work with.
However, unrestricted endowments are only given under certain circumstances. Donors typically don’t offer unrestricted endowments to nonprofits that aren’t well-established in their communities.
Restricted Endowment
In contrast to unrestricted endowments, restricted endowments can’t be spent freely. The organization must also leave the principal balance alone.
The earnings from the investment can only be spent in ways the donor approves. In some cases, the donor’s regulations could be fairly rigid.
Term Endowment
Organizations can only spend term endowment principal under certain circumstances. For example, the nonprofit might have to wait until a certain period has passed.
They might also have to wait until a specific event occurs. In cases like these, the nonprofit might not be able to touch the principal balance until it reaches a certain performance metric.
Getting Started
For those looking to provide endowments to organizations, it’s essential to research the nonprofit you’re interested in. This plays a large role in the experience you’ll have.
The last thing you want is to donate money to an organization with a shady reputation. Disreputable nonprofits will be less likely to adhere to your terms. It’s best to meet with a representative from the organization before giving, as well.
They’ll provide insight into how they plan to handle the money you donate. You can also work with a professional to help you get started. They have the tools and resources that allow you to make the right decision.
When searching for someone to work with, see what other people online have to say about them. You should only choose a professional with a large amount of positive feedback.
They should have also worked with plenty of people like you in the past. Are they easy to communicate with?
If you find it difficult to get in touch with them, this is a red flag you can’t ignore. With enough due diligence, you’ll find the best decision for your situation.
Don’t Overlook Endowments
Under the right circumstances, endowments can be an amazing way to increase your investment income. Keep the answer to “what is an endowment” in mind so you can make the best decision for your situation.
Joshua M. Peck has over 20 years of experience in emerging technology and applied mathematics. He currently serves as the Chief Investment Officer (CIO) of TrueCode Capital and helps families manage risk and increase their net worth. You can learn more about what he’s capable of when you book a consultation today.
