What Is an Endowment Fund?

Endowment Funds Explained

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An endowment fund is a type of investment fund that’s set up to receive gifts and donations from donors. What makes an endowment fund unique is that the organization overseeing the fund typically uses the interest earned from donations to finance its activities—the donations themselves never get spent.

Unlike many types of investments, which typically benefit individual investors, the beneficiary of an endowment fund is a nonprofit organization. Here’s how an endowment fund works and how organizations use these funds to further their missions.

Definition and Examples of an Endowment Fund

An endowment fund is an investment portfolio held by a nonprofit organization—such as a university, hospital, or museum—for the purpose of generating a permanent stream of capital. The fund’s portfolio can be made up of cash, publicly traded securities, real estate, life insurance, retirement accounts, and other assets. 

Endowment funds are usually permanent because the principal balance, or “corpus,” stays invested forever. The organization can only spend the investment income generated by the fund—and that income must be used according to donors’ wishes.

For example, the San Diego Foundation is a community-focused and run organization that distributes the funds’ investment earnings to “impactful organizations for social impact” on its donors’ behalf. It manages 1,330 individual endowment funds, totaling more than $682 million. Collectively, these funds make up its endowment fund investment portfolio.

How Does an Endowment Fund Work?

Imagine you inherit a trust fund from your parents. The trust has $1 million in it, but there’s a catch: Your parents have explicitly stated that the principal balance is off-limits. You can only spend the interest the trust’s assets produce each year—and you can’t blow it on frivolous purchases like a trip to Tahiti or a McMansion. The money has to be used specifically for continuing education, health care costs, and other necessities.

That’s essentially how an endowment fund works. A donor (or several donors) provides substantial assets to a nonprofit institution. Those assets are invested, usually in stocks, bonds, or other types of investment vehicles, so they grow over time due to the income earned on the interest generated by the underlying assets. A set of guiding documents often outlines how the organization can spend the income that those assets produce.

If the nonprofit is a university, the donor may say their endowment fund can only be used to fund scholarships, professorships, or research programs. If it’s an animal shelter, a donor might specify the fund is to be used to finance pet supplies and vet bills.

Generally speaking, nonprofits use endowment funds because they provide a predictable stream of income and signal to the community that the organization is stable and plans to be around long term. Some donors like endowment funds because they get a tax deduction. It also gives donors the opportunity to immortalize their charitable legacies by naming the fund after themselves or their families.

Some organizations manage endowment funds themselves, while others may hire an outside investment firm to help maximize the fund’s performance.

Three Types of Endowment Funds

There are three main types of endowment funds:

True or Restricted Endowments

A true endowment is designed to exist forever; therefore, the principal balance is usually permanently “restricted” by the donor, which means it can’t be spent. In other words, only the income generated by the investment interest can be used to finance the fund’s charitable activities. Many donors create true endowments to fund college or university scholarships, or to provide financial support for specific academic programs.

Term or Temporarily Restricted Endowments

Term endowments are typically temporarily restricted by the donor until a certain event or “defined term” takes place—such as a specific time period passes or an event happens. For example, a donor may allow an organization to dip into the principal balance to launch a new research program after the initial endowment term has expired.

Quasi or Unrestricted Endowments

Quasi-endowments aren’t restricted. They’re typically set up and funded by the foundation itself and can be used as the organization sees fit—to cover operating costs, fund payroll, or for any other purpose.

Endowment Fund Policies and Guidelines

Endowment funds are governed by a set of guiding documents that outlines how their assets can be used. If the organization violates the terms in these documents, it could face legal trouble.

Investment Policy

The fund’s investment policy dives into the nitty-gritty of why it exists and how it should be managed. It typically includes information on:

  • The fund’s investment objectives
  • Guidelines for allocating and rebalancing the assets in the fund’s investment portfolio
  • Recommendations for fund-manager selection and portfolio monitoring
  • Benchmarks for evaluating performance

Fund Agreement

The fund agreement is a signed document—typically created by the donor—that clearly states how the organization can spend the fund’s budget. The organization can’t use the fund for any other purpose unless the donor makes an amended agreement.

Endowment Spending Policy

The spending policy outlines how much of an endowment’s investment returns can be spent each year. Most endowment funds have spending rates of 3% to 7%, with 4.5% being the average rate for endowment funds of at least $100 million. This means that on average, an endowment fund with a $100 million balance may generate $4.5 million in yearly investment income for an organization.

Endowment Fund Fees and Costs

Endowment funds can be expensive to manage and maintain. The exact cost depends on the size of the fund, how it’s invested, and the number of people in charge of managing it.

For example, the Clemson University Foundation has an annual administrative management fee of 1.25% for its endowment funds. This fee is assessed on the value of the endowment’s accounts each quarter. It covers the costs of raising, investing, and administering funds in the endowment as outlined in the foundation’s policies and procedures.

Key Takeaways

  • Endowment funds are a type of investment fund held by nonprofit organizations such as universities, hospitals, churches, museums, and other charities.
  • The donations inside the fund usually stay invested forever, and only the earned interest is available to finance the endowment’s activities each year.
  • Generally, investment income generated by the endowment must be spent according to the donor’s wishes, as outlined in the fund’s guiding documents.
  • There are three primary types of endowment funds: true endowments, term endowments, and quasi-endowments.