Charitable Endowments: Creation, Management, & Reporting

A charitable endowment is a fund established by a nonprofit to provide a long-term source of income. The principle is to invest a donated sum of money (the principal) and use only the investment earnings to support the organization’s mission. This preserves the original gift, allowing it to generate funding indefinitely. An endowment provides a predictable stream of revenue that supplements other income sources, ensuring the organization’s financial stability for the future.

Establishing a Charitable Endowment

The creation of a charitable endowment begins with a gift from a donor. Endowments can be funded with cash or non-cash assets such as publicly traded stocks, bonds, mutual funds, and real estate. Some donors may also use life insurance policies, naming the nonprofit as the beneficiary.

A legal document, known as a gift instrument or endowment agreement, formalizes the endowment. This binding agreement between the donor and the nonprofit defines the purpose of the endowment and how annual distributions are to be used. The agreement also details any restrictions, such as holding the principal in perpetuity, and establishes guidelines for management.

Donors can establish an endowment directly with a large nonprofit like a university or hospital, which integrates the fund into its existing investment pool. An alternative is to establish a fund at a community foundation. The community foundation handles all investment and administrative responsibilities, distributing funds to the designated charity per the donor’s agreement.

The endowment agreement also sets expectations for communication. Donors often want regular updates on the fund’s performance and impact. The agreement should specify the frequency and content of these reports, which can include investment returns and a narrative on how distributed funds were used. This stewardship helps maintain a strong relationship between the donor and the organization.

Endowment Fund Classifications

Endowment funds are categorized based on the donor’s intent, which dictates how the nonprofit can use the assets. These classifications have legal and accounting implications that determine the fund’s permanence and the organization’s flexibility. The distinctions ensure compliance with donor wishes and proper financial reporting.

The most restrictive category is a true endowment, also called a permanent endowment. The terms of the gift instrument state that the original principal must be preserved in perpetuity. The nonprofit is legally prohibited from spending this principal and may only use the income and appreciation generated from its investment.

A term endowment requires the principal to remain intact for a designated period or until a specific event occurs. Once the term expires or the condition is met, the restrictions on the principal are lifted. The nonprofit may then have the authority to spend the principal as directed in the original gift agreement.

A quasi-endowment is created by the nonprofit’s governing board, not a donor. The board can set aside unrestricted funds to be managed like an endowment, investing the principal and spending the earnings. Because there are no donor-imposed restrictions, the board retains the authority to spend the principal if it deems necessary.

Managing Endowment Fund Assets

Investment Management

The management of endowment assets is guided by an Investment Policy Statement (IPS). This document outlines the fund’s risk tolerance, time horizon, and investment objectives. A primary goal is to achieve a total return that funds the annual spending distribution while growing the principal at a rate that outpaces inflation, preserving the fund’s purchasing power.

A component of the IPS is the asset allocation strategy, which diversifies the portfolio across asset classes like equities, fixed-income securities, and alternative investments. The IPS establishes target ranges for each asset class, allowing flexibility to respond to market conditions. An investment committee is responsible for overseeing the IPS, reviewing performance, and making adjustments.

Spending Policy

An endowment’s spending policy determines the amount withdrawn from the fund each year to support the organization. This policy is designed to create a predictable stream of funding while protecting the endowment’s long-term value. State laws, such as the Uniform Prudent Management of Institutional Funds Act (UPMIFA), provide a framework for these decisions.

A common method for calculating the annual distribution is the percentage-of-market-value approach. The organization establishes a spending rate, between 4% and 5%, which is applied to the endowment’s average market value over a period like the preceding 12 quarters. Using a rolling average helps smooth out the effects of market volatility and provides a stable flow of funds for budgeting.

When determining its spending policy, the board must consider several factors outlined by UPMIFA. These include the duration and preservation of the fund, the purposes of the organization, economic conditions, inflation, the expected total return from investments, and the organization’s other available resources. This approach ensures that spending decisions balance the immediate needs of the charity with the long-term goal of preserving the endowment.

Financial Reporting and Compliance

The management and reporting of endowments are governed by state law and accounting standards. The primary legal framework is the Uniform Prudent Management of Institutional Funds Act (UPMIFA), adopted by most states. UPMIFA provides guidelines for managing and investing institutional funds, requiring fiduciaries to act in good faith and with the care of a prudent person while using a total return investment strategy.

Under Generally Accepted Accounting Principles (GAAP), nonprofits must provide specific disclosures about their endowments in their financial statements. The statements must classify the endowment’s net assets based on donor-imposed restrictions. True and term endowments are classified as “Net Assets with Donor Restrictions,” while quasi-endowments are “Net Assets without Donor Restrictions.”

The footnotes to the financial statements must describe the nonprofit’s endowment, including its investment and spending policies. The organization must disclose its policies for appropriating funds for expenditure and how its investment objectives support those policies. A reconciliation of the beginning and ending balance of the endowment is also required, showing all contributions, investment returns, and amounts spent.