The Surprisingly Complex ABCs of Endowment Funds

Perhaps no area of philanthropy is more misunderstood than the permanently restricted gift. There is so much lore surrounding this type of charitable gift that many people believe they understand it and act with complete confidence. In practice, however, the activities of various organizations surrounding permanently restricted gifts are so diverse that states finally got together and passed a series of laws governing these donations.

Let’s first talk about the lore and then get into the details of the law.

When a donor gave funds to a charity with instructions to use the annual income generated from those funds, this is called an endowment gift. If you look up the definition of an “endowment,” you will find something along these lines: A financial endowment is a donation of money or property to a not-for-profit organization for the ongoing support of that organization. Everyone involved with philanthropy believes they have a good understanding of endowment gifts. Reality may be quite different.

Here is the general understanding (the lore) of endowments. The amount donated (the principal) is invested and the annual income (interest and/or dividends) is available for spending. If the principal was invested in a stock that increased in value and then was sold (resulting in a capital gain), the sales proceeds were re-invested in a new stock and that became the new principal. The capital gains were re-invested into investment principal. Therefore, the principal grew over timesort of nature’s way of keeping pace with inflation.

If the income was available to the charity to spend on any portion of its charitable mission, then that was called an unrestricted endowment. If the donor had specified a specific purpose for which the endowment income was to be spent, that was called a restricted endowment. The use of the words “unrestricted” and “restricted” was always a source of some confusion, because the endowment itself was permanently restricted. The charity could never spend the principalonly the income that it generated. And if the donor had specified a use of the annual income, that income was restricted to that specific use.

For example: A donor gives a charity $5,000 for its endowment without stipulating how the income is to be used. The charity invests in a stock paying an annual dividend of $250. The charity may use the $250 dividend money in any manner they wish within the charity. A second donor gives a charity $5,000 for its endowment and specifies that the annual income is to be used for staff training. The charity invests in a stock paying an annual dividend of $250. The charity may use the $250 dividend money each year only for paying the expenses of staff training. Any unspent money must be carried forward and saved for future staff training expenditures.

Sometimes charities created their own endowment-type funds from money accumulated over time. The charity may want to set aside surplus money for the long term and have it function like true endowment funds gifted to them by donors. Since these “endowment” funds were not, however, received as gifts from donors, everyone recognizes that they are not true endowments and therefore refer to these funds either as “quasi-endowments” or “funds functioning as endowments”.  

The importance of drawing a distinction between a true endowment and a fund functioning as an endowment is that while the board can remove funds functioning as endowments and spend them at any time, true endowment funds, permanently restricted by the donor, can never be spent.

Investment of the Principal

Investment theory created the need to put more structure into endowment lore and led to the development of endowment law. Some charities had a policy of making investments that produced income but did not necessarily accumulate much in the way of capital gains. Some charities had a policy of purchasing investments that produced little in the way of interest or dividend income but accumulated much in the capital gain area. And, of course, many charities changed their investment policies from time to time, depending on whether they needed or wanted annual income or simply wanted capital gain appreciation.

Let’s go back to the examples above. If the charity took the $5,000 donation that was restricted to produce income for staff training and purchased an investment that produced little or no annual income, there would be little available for staff training. This was probably not what the donor intended at the time of donation. True, the $5,000 would likely grow more quickly and someday there would be $10,000 available to invest to generate income for staff training. But isn’t it likely that the donor intended some funds to be made available for immediate staff training? (If a donor makes a gift to a charity that they do not expect the charity to use for years into the future, they should specify that in the gift instrumentthe letter that accompanies the donation check.)

Conversely, suppose the charity purchased an investment that paid immediate interest but had no chance of generating a capital gainsuch as investing in a bank certificate of deposit paying 6 percent interest. The institution would receive $300 of interest per year for as long as the charity held the bank CD. However, with the effects of inflation, the $300 of annual income would purchase less and less staff training each year.

Obviously, the best investment decision is somewhere in the middle of these two options. The charity should invest with an objective of maximizing the total return from the investmentthe highest total of both interest/dividends and capital gains. And the charity should commit to spend only a portion of that total return (by creating a spending policy), leaving some of the total return for reinvestment into endowment principal so that the endowment keeps pace with inflation.

Let’s stop here and summarize. You now understand the basic concept behind endowment funds. You realize that some endowment funds are permanently restricted by the donor and the principal can never be spent. You understand that some endowment funds are created by the charity and these are not permanently restricted even though at the present time, it may be the charity’s intention to keep the funds permanently invested and producing annual income. You also understand that there are issues related to how endowment funds are invested and produce income for spending.

In the next blog I will delve into endowment law by discussing the Uniform Management of Institutional Funds Act, or UMIFA, and the Uniform Prudent Management of Institutional Funds Act, or UPMIFA.