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Understanding Endowments Types and Policies That Govern Them

Understanding Endowments Types and Policies That Govern Them

Understanding Endowments: Types and Governing Policies

With over 20 years of experience in the financial services industry, Tim Smith is an expert in the field.

What Is an Endowment?

An endowment is a gift to a nonprofit organization for a specific purpose.

It also refers to the investable assets of a nonprofit institution, such as a university. These assets, also known as the institution’s "principal" or "corpus," fund operations or programs aligned with the donor’s wishes.

Most endowments aim to preserve the principal while utilizing the income to support the designated cause. Restricted endowments must be held indefinitely, with only the income available for expenditure.

Key Takeaways

  • Endowments are awarded by trusts, private foundations, or public charities.
  • They benefit nonprofit educational, cultural, and service-oriented institutions.
  • Most endowments restrict the use to investment income, not the principal.

Understanding Endowments

Endowments are typically organized as trusts, private foundations, or public charities. They benefit various institutions, including educational, cultural, and service-oriented organizations.

In some cases, the amount withdrawn from an endowment is a combination of interest income and principal, with the ratio varying based on market rates.

Governing Policies of Endowments

Endowment funds are governed by three components: an investment policy, a withdrawal policy, and a usage policy.

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Investment Policy

The investment policy outlines permitted investment types and the level of risk to achieve the target return. It ensures long-term sustainability.

Larger university endowments have multiple funds investing in various securities or asset classes, each with long-term goals and specific asset allocation.

Withdrawal Policy

The withdrawal policy determines the amount an organization can draw from the fund, usually based on its needs and the fund’s size. Most endowments have annual spending limits.

Usage Policy

The usage policy defines the purposes for which the fund can be used. Endowments can support departmental financial health, scholarships, fellowships, or other forms of student assistance.

Endowments may also establish prestigious positions or programs within institutions.

Types of Endowments

There are four types of endowments:

  • Unrestricted Endowment – Assets that can be spent, saved, invested, or distributed at the institution’s discretion.
  • Term Endowment – Principal available for expenditure after a certain period or event.
  • Quasi Endowment – A specific-purpose donation where the principal is retained while earnings are spent according to the donor’s specifications. Institutions often start these endowments using unrestricted funds.
  • Restricted Endowment – Principal held indefinitely while earnings are spent per the donor’s specifications.

Violating the terms of an endowment is rare, but exceptions may occur under exceptional circumstances, subject to court approval.

Requirements for Endowments

Endowment managers navigate competing interests to sustainably grow assets while contributing to their institutions’ goals.

Philanthropies are legally required to pay out a portion of their investment assets annually for charitable purposes. Private operating foundations must distribute most of their investment income, while community foundations have no requirement.

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Under the Tax Cuts and Jobs Act of 2017, large university endowments are subject to a 1.4% tax on net investment income.

Endowments and Higher Education

Endowments play a vital role in funding operating costs and providing financial stability to colleges and universities.

Older institutions, like Ivy League schools, tend to have robust endowments due to continued donations from wealthy alumni and effective fund management.

Endowments have a long history, with the first recorded endowment established by Marcus Aurelius in 176 AD for schools of philosophy in Athens, Greece.

Criticism of Endowments

Harvard and other prestigious universities have faced criticism for the size of their endowments, with concerns raised about hoarding wealth.

During the Great Recession, many endowments reduced their payouts, leading to scrutiny regarding prioritizing endowment health over institutional well-being.

Investment Controversies

Students often scrutinize their institutions’ endowment investments. In the past, divestment movements protested investments related to apartheid.

More recently, some universities declined federal aid meant for higher education to avoid controversy and demonstrate financial stability.

Real-World Examples of Endowments

The oldest active endowments were established by King Henry VIII and his relatives, supporting divinity chairs and professorships.

As of 2023, the ten largest U.S. university endowments, according to the National Center for Education Statistics, were:

  1. Harvard University – $49.5 billion
  2. University of Texas – $45.0 billion
  3. Yale University – $40.7 billion
  4. Stanford University – $36.5 billion
  5. Princeton University – $34.0 billion
  6. Massachusetts Institute of Technology – $23.4 billion
  7. University of Pennsylvania – $21.0 billion
  8. Texas A&M University – $19.2 billion
  9. University of Michigan – $17.8 billion
  10. University of California – $17.7 billion
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Harvard University Endowment

Contrary to expectations, Harvard’s endowment grew during the pandemic, returning 7.3% in 2020 and 33.6% in 2021 due to favorable market conditions.

The endowment’s asset allocation includes stocks, hedge funds, private equity, real estate, bonds, and cash.

Harvard’s endowment contributes significantly to the institution’s financial stability and long-term growth.

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