What Is an Endowment?

What Is an Endowment?

Let me explain what an endowment really is. It's a financial gift you make to a nonprofit organization, intended for a specific purpose. You might hear the term used for the total investable assets of an institution like a university, which they call the 'principal' or 'corpus.' This money supports operations or programs that align with what the donor wanted.

In most cases, I see endowments set up to keep the principal untouched, while the income from investments goes toward the cause. If it's a restricted endowment, you have to hold it forever, spending only the income.

Key Takeaways

You should know that endowments often come from trusts, private foundations, or public charities. They support nonprofit educational institutions, cultural spots like museums, and service organizations such as hospitals. Remember, most have restrictions limiting use to the investment income, not the principal.

Understanding Endowments

Endowments are usually structured as a trust, private foundation, or public charity. Many go to educational institutions, but others benefit cultural institutions like museums, libraries, religious groups, private schools, or service places like retirement homes or hospitals.

In some setups, only a certain percentage of the assets can be used each year, so what you withdraw might mix interest income and principal. That ratio can shift based on market rates.

Policies of Endowments

Endowment funds follow guidelines from three main components: investment policy, withdrawal policy, and usage policy.

Investment Policy

The investment policy tells you what types of investments the manager can make and how much risk they're allowed to take for the target return. Many endowment funds have these policies baked into their legal structure to ensure the money lasts long-term.

For larger universities, their endowment funds might include hundreds or thousands of smaller funds investing in various securities or asset classes. They aim for long-term goals like a specific return or yield, with asset allocation designed to meet those objectives.

Withdrawal Policy

The withdrawal policy sets how much the organization can take out from the fund each period. It's often based on the organization's needs and the fund's size, but most have an annual limit.

For example, an endowment might cap withdrawals at 5% of the total fund. University endowments are built to last forever, so they stick to annual spending limits.

Usage Policy

The usage policy defines what the fund can be used for. Endowments, whether set up by the institution or donated, can serve multiple purposes like securing department finances, awarding scholarships, or assisting students.

You could use revenue from an endowment to pay for university chair positions or endowed professorships, which frees up other capital for hiring faculty. These positions are prestigious and go to senior faculty.

Endowments can target specific disciplines, departments, or programs. Take Smith College with its endowment for botanical gardens, or Harvard with over 14,600 separate funds.

Endowment Types

There are four types of endowments you should be aware of.

Additional Notes on Endowment Terms

You can only violate endowment terms in exceptional cases. If an institution faces bankruptcy but has endowment assets, a court might apply the cy pres doctrine to use those assets for financial health while honoring the donor's wishes as closely as possible.

Drawing down the principal for debts or expenses is called 'invading' the endowment, and it often needs court approval.

Requirements for Endowments

Managers of endowments balance using assets for causes and growing the institution sustainably. The goal for university endowment managers is to reinvest earnings for growth while contributing to the school.

Philanthropies must pay out 5% of their investment assets annually for charitable purposes to keep tax-exempt status. Private operating foundations need to pay 85% or more of investment income. Community foundations have no such rule.

Large university endowments face a 1.4% tax on net investment income under the Tax Cuts and Jobs Act of 2017, applying to private colleges with at least 500 students and $500,000 in net assets per student.

Endowments and Higher Education

Endowments are key to U.S. academia; the size of a school's endowment measures its well-being. They fund operating costs beyond tuition and act as rainy-day funds.

Older institutions like Ivy League schools build robust endowments through donations from wealthy alumni and solid management.

Fast Fact

Marcus Aurelius set up the first recorded endowment in 176 AD for philosophy schools in Athens, Greece.

Criticism of Endowments

Harvard and other elite colleges get criticized for their massive endowments, with some calling it hoarding.

Large endowments were seen as rainy-day funds, but many cut payouts during the Great Recession. A 2014 study found overemphasis on endowment health over the institution's overall well-being.

Student activists often scrutinize endowment investments. In 1977, Hampshire College divested from South Africa over apartheid, inspiring others.

Harvard, Princeton, and Stanford declined CARES Act funds, and Harvard turned down $25.5 million from the American Rescue Plan.

Real-World Examples of Endowments

The oldest active endowments come from King Henry VIII and relatives. His grandmother established divinity chairs at Oxford and Cambridge, and he set up professorships there.

According to the National Center for Education Statistics, the top 10 U.S. universities by endowment size in 2023 include Harvard at $49.5 billion, University of Texas at $45.0 billion, Yale at $40.7 billion, Stanford at $36.5 billion, Princeton at $34.0 billion, MIT at $23.4 billion, University of Pennsylvania at $21.0 billion, Texas A&M at $19.2 billion, University of Michigan at $17.8 billion, and University of California at $17.7 billion.

Harvard University Endowment

Harvard officials thought the endowment would shrink in 2020 due to the pandemic, but it returned 7.3% and grew slightly. In 2021, it surged 33.6%, growing by $11.3 billion to $53.2 billion. It returned -1.8% in 2022 and 2.9% in 2023.

Harvard's endowment has thousands of specific funds, allocated to stocks (11%), hedge funds (31%), private equity (39%), real estate (5%), bonds (6%), and other/cash (7%). The annual payout is capped; in 2023, it was $2.2 billion.

Over the long term, it produces strong returns, boosted by new endowments.

Where Do Endowments Get Their Money?

A university or nonprofit's endowment consists of many individual donations, each an endowment. Harvard's over $50 billion comes from gifts with specific rules. A donor might fund anthropology research, for instance.

Administrators typically spend only investment income, not the principal, as per common stipulations.

Who Manages Endowments?

An institution might have an internal manager or hire an outside firm. The Board of Trustees sets rules for investing and spending.

Who Is Eligible for an Endowment?

Endowments go to nonprofit institutions in education, charity, religion, or science. Creators are usually high-net-worth individuals or groups targeting specific causes, allowing precise use of their money.

The Bottom Line

Prestigious U.S. universities have huge endowments, which might frustrate students paying high tuition, but these can't just reduce fees or cover basics. They're made of specific gifts for research, scholarships, or chairs.

Endowments are designed to last forever, spending only investment returns each year, not the assets themselves.