May 01, 2012

The Truth About Endowments

Nonprofits and their donors often see endowments as the route to financial stability, but they aren’t the right solution for every organization. Here we debunk some of the longstanding myths about endowments.

Myth #1: A strong, sustainable nonprofit needs an endowment.

The one thing that sustainable nonprofits need is enough income to run their programs and pay for salaries, facilities, etc.  An endowment is one of many ways nonprofits can generate income. But for some groups, it is unnecessary or even a bad idea.

So before deciding to establish an endowment, nonprofits should decide if doing so addresses how income will be used to achieve the mission, when it will be needed, and how much will be needed. Organizations that are in financial crisis, that have limited capacity to attract more donors, or that have short-term missions should avoid establishing endowments.

Myth #2: An endowment must be continuously funded and can never be drawn down.

Nonprofits can choose when it’s most feasible to add to their endowments. For example, if it’s important to increase direct aid during a natural disaster, a relief organization might reduce or even forgo endowment funding for some period of time and redirect donors to an emergency appeal.  Alternatively, the board might continue to fund the endowment regardless of its current needs if, for example, it has a far-reaching goal, such as to eradicate hunger.

While most endowments have permanent restrictions on the use of their principal, others have only temporarily restrictions or even completely unrestricted components that allow the money to be spent. Endowments can also have end dates rather than existing in perpetuity.

Myth #3: An endowment is the same as a board-designated reserve account.

A designated reserve account is a pool of funds established by the board to provide certain types of capital to the organization. There are several kinds of designated reserve accounts: A working-capital reserve can provide funds during normal parts of the business cycle when cash is low--for example, when awaiting payment on a contract. A “rainy day” reserve is available for unexpected challenges or opportunities. Funds can also be reserved to help an organization recover from financial distress or to expand or acquire facilities. These pools are managed internally, though the board may place restrictions on their use.

Endowments, on the other hand, are not intended to fund routine operating activities and are often managed externally or held outside of the reach of the nonprofits’ general business managers.


Myth #4: There are limits on the amount of interest income that a nonprofit can take from its endowment

There are no such legal limits. The amount and timing of distributions is determined by the governing body of the endowment. Interest income is often used to fund board-designated reserves for future projects and to expand current programs and services. Nonprofits should, however, have realistic expectations about the yield on endowment investments. Only a large endowment that is professionally invested to maximize returns is likely to generate enough earnings to make a dent in the operating budget. Community foundations are well suited to manage smaller endowments.

When nonprofits recognize how fluid money can be, they can better assess the types of capital and cash flow they need to support both short- and long-term objectives and avoid making unnecessary trade-offs. They will also be able to tell a more compelling financial story to donors, clearly articulating their rationale and timing needs for a range of funding options including endowments, reserve accounts, grants, loans, and investments.