What's the Skinny on Endowments?
Exploring Investment Vehicles: Classification and Regulations Governing Them
Endowments are gifts given to non-profit organizations for specific purposes. The term 'endowment' may also refer to the total assets of a non-profit institution, like a university. These assets, known as the institution's "kitty" or "nest egg," are typically used for operations or programs that align with the donor's wishes.
Most endowments have restrictions on spending, ensuring the principal remains intact while the income is used for its intended purpose. A restricted endowment must be held in perpetuity, with only the income available for spending.
The Nitty-Gritty of Endowments
Endowments are commonly organized as a trust, private foundation, or public charity. They often benefit educational institutions, cultural centers, and service-oriented organizations. In some cases, a percentage of an endowment's assets can be used each year, combining interest income and part of the principal.
Endowment funds are governed by three main policies – an investment policy, a withdrawal policy, and a usage policy.
The investment policy outlines the types of investments a manager can make and dictates the risk they can take. Many endowment funds have specific investment policies integrated into their legal structure for long-term sustainability. University endowment funds can have various smaller funds that invest in different securities or asset classes. These funds usually have long-term goals, like a specific rate of return or yield.
The withdrawal policy establishes an amount the organization can take from the fund at each period or installment based on prevailing market rates. Most endowments have an annual spending limit to ensure they last for eternity.
The usage policy determines the purposes for which the fund can be used. These endowments might be used to ensure financial health within specific departments, provide scholarships or financial aid for students, or establish endowed faculty positions.
Flavors of Endowments
There are four categories of endowments: the unrestricted endowment, term endowment, quasi endowment, and restricted endowment. An unrestricted endowment can be spent, saved, invested, or distributed at the discretion of the institution. A term endowment allows the principal to be expended after a specific time or event. A quasi endowment is a donation made to achieve a particular purpose, with the principal typically retained. A restricted endowment holds the principal in perpetuity while the earnings from the invested assets are spent according to the donor's specifications.
The terms of endowments can be altered only in rare situations, such as when an institution is facing bankruptcy but still possesses endowment assets. In such cases, a court can issue a cy pres doctrine, allowing the institution to use the assets to improve its financial health while honoring the donor's wishes as closely as possible.
The Ins-and-Outs of Managing Endowments
Managers of endowments face the challenge of striking a balance between using assets to advance their causes and sustainably growing their institutions. The goal is to both sustainably grow the funds through reinvestment of earnings and aid the institution.
In the United States, philanthropies are required by federal law to pay out 5% of their investment assets from their endowments every year for charitable purposes, risking losing their tax-exempt status. Private operating foundations must pay out substantially more - 85% or more - of their investment income. Community foundations have no requirement.
Under the Tax Cuts and Jobs Act of 2017, large university endowments may be subject to a 1.4% tax on net investment income.
The Role of Endowments in Higher Education
Endowments play a crucial part in U.S. academia, acting as a source of funding for both operational costs and emergency funds. Older institutions, such as Ivy League schools, are particularly successful in amassing robust endowment funds with the help of ongoing donations from wealthy graduates and sound fund management.
A Brief History of Endowments
Marcus Aurelius established the first recorded endowment, circa 176 AD, for major schools of philosophy in Athens, Greece. Endowments have since been integral to higher education institutions worldwide.
Fast Fact:
Harvard and other elite universities have faced criticism for their large endowments amid mounting tuition fees. During the Great Recession, many endowments provided relief by cutting payouts instead of mobilizing funds to benefit students.
Real-World Examples of Endowments
Harvard University's endowment, worth over $50 billion, is an example of a large university endowment. Its returns vary year by year depending on changing financial conditions and market fluctuations. In 2020, despite the impact of the pandemic, Harvard's endowment surprisingly grew by 7.3%, returning to about $53.2 billion in 2021.
The management of Harvard's endowment fund invests in multiple asset classes, including stocks, hedge funds, private equity, real estate, bonds, and "other" investments. The annual payout rate is capped, reaching $2.2 billion in 2023.
Where Does the Money Come From?
The endowment of a university or other non-profit institution consists of numerous individual donations, each called an endowment. These gifts may contribute to specific departments, research efforts, or fellowships. In most cases, only the investment income, not the principal of the endowments, is spent each year.
Who Runs Endowments?
An institution that manages an endowment may have an internal financial manager or hire an outside firm. The institution's Board of Trustees sets the rules for investing and spending money.
Who Can Receive Endowments?
In principle, any educational, charitable, religious, or scientific institution can receive an endowment. The creators of an endowment are generally high-net-worth individuals or groups who wish to contribute to a particular cause.
The Bottom Line
In the United States, some prestigious universities boast remarkable endowments. Although this may cause frustration among students burdened by tuition costs, endowments can't be used for broad cost reduction or to cover essential expenses. Instead, they are used for specified purposes, ensuring their longevity for future generations.
In the realm of finance and business, defi and ico projects sometimes allocate a portion of their funds towards education-and-self-development programs and scholarships, demonstrating a blend of traditional finance and progressive, decentralized models. Additionally, some successful universities, like Harvard, have expansive endowments that support specific areas of research, departments, or scholarships, serving as a testament to the integration of philanthropy and higher education.
