Viewpoints
Endowment Funds in the Not-for-Profit sector
Gerald Archibald
Originally Published In:
ROCHESTER BUSINESS JOURNAL
September 2007
Author: Gerald J. Archibald, CPA
“In the long run, we are all dead.” John Maynard Keynes
“Life is more than just living. It is about leaving a legacy.” I made this statement at the funeral wake of my long time friend and colleague, Ben Giambrone. Ben was a lifelong community volunteer. I met Ben when we both served on the Board of the Mary Cariola Children’s Center in the 1980’s. Prior to his passing, Ben was most recently the Executive Director for the Compeer organization. Another life cut short way too early – Ben was a good man who will be missed by our community and those he touched during his lifetime. He most certainly left a legacy.
I am not entirely certain what prompted the thought of leaving a legacy at that particular time. Ben and his life of service to our community are the inspiration for this column.
That is, everything you need to know about endowment funds in the non-profit sector.
What is an Endowment Fund?
Endowment funds can take many different forms as described further below. However, let’s use the Yale University endowment as an example. The endowment at Yale exceeds $15 billion and is generally regarded as one of the most prolific in terms of investment returns. From 1995 to 2005, the Yale endowment generated annual net investment returns of 17.4%! Yale administration attributes its superb long-term record (16% per annum over two decades) to a disciplined and diversified asset allocation policy, superior active management results and strong capital market returns.
At the basic level, donor restricted endowment funds are intended to include the principal value of the donor’s gift in perpetuity (permanently restricted) with the income generated to be used either for the donor’s specified intentions (temporarily restricted) or as unrestricted funds available for supporting the operating/capital needs of the organization.
For example, the restricted portion of the Yale endowment is intended for professorships, scholarships, books and maintenance costs as well as a variety of donor restricted special purpose funds. In fiscal year 2005, the Yale endowment generated 32% of the total operating revenue for the University. This is a staggering percentage in relation to the vast majority of non-profit organizations.
What are the Types of Endowment Funds?
As mentioned above, a “true endowment” is permanently restricted as to the original donation amount. However, terms such as quasi-endowment, funds functioning as endowment and Board designated or Board restricted endowments are examples of unrestricted endowment funds. That is, in order to be classified as permanently restricted for financial reporting purposes, the donor must restrict the donation in perpetuity. Donor restrictions indicating a time or use restriction are classified as temporarily restricted for financial reporting purposes.
The nature and purpose of donor restrictions are the key to proper financial reporting and donor restrictions. It is important to keep in mind that, without a donor imposed restriction, the funds received or designated by the Board must be reported as unrestricted revenue and net assets under current financial reporting requirements.
Why do we need an Endowment Fund?
In my opinion, the vast majority of non-profits with budgets in excess of $5 million should have an endowment fund. Why? Read on for the top five reasons for establishing an endowment fund.
1) Endowment funds provide an opportunity for one more reason to prompt donors to give.
2) The opportunity for naming opportunities for the donor can stimulate giving in the memory of a loved one or in establishing a bequest or legacy through the donor’s will.
3) Endowment funds provide the income necessary to support organizational growth in program operations and capital needs.
4) Permanently restricted endowment fund assets are protected from being spent to “cover operating deficits” when financial stress occurs in the organization. This will typically instill a spending discipline in the organization.
5) Finally and, perhaps most importantly, it is extremely rare in the non-profit sector to have all organizational expenses covered by operating revenues. This is particularly true in government funded programs where the organization receives funding of less than its full operating costs. Strategically, your organization should generally anticipate that government funding will cover 95-97% of your costs. This may leave a gap of between 3-5% to generate from other sources of revenue.
For example, let us assume that the organization has a deficit of $125,000 after recognizing all government funding, grants, unrestricted contributions, special events, etc. An endowment fund with unrestricted income of $125,000 can represent the difference between financial success and failure for your non-profit.
How much is enough?
Yale University has grown its endowment from $ 4 billion in 1985 to more than $15 billion today. In most university settings, there is no upper limit on endowment fund accumulation. The answer is, it is never enough for organizations addressing community needs and in a program growth mode.
But, what about a minimum target level?
In order to establish a minimum target level for your organization, you need to estimate your operating deficit after all traditional operating revenues are estimated. Next, you must estimate an “imputed income percentage”. Imputed income (also known as total return concept) is a concept of projecting income needs from endowment funds representing market value appreciation, realized gains and losses, interest and dividends from the investments held by the endowment fund investment manager. Generally, the imputed income percentage is estimated at 4-6% representing a conservative projection of the amount of income that can be expected from a managed investment portfolio.
In order to determine your minimum target level for the endowment fund, divide the estimated annual operating deficit ($125,000, the imputed income needed) by the estimated imputed income percentage (5%). $125,000 divided by 5% produces a target minimum for the endowment of $2.5 million. It is much easier to do the calculation than raise the money, I might add.
How to address potential issues?
Be sure to consult with legal counsel and your financial advisors with respect to the proper establishment of and accounting for endowment Not-For-Profit Corporation Law (NPCL). Section 513 provides guidance with respect to the issues related to preserving the principal value of your endowment in accordance with the original donor’s intentions. Significant market value declines, allocation of income versus principal as to investment income appreciation and maintaining the historic purchasing power of the permanently restricted endowment, are three specific areas that require careful attention.
Establishing and nurturing an endowment fund for your organization can represent the difference between financial stability and failure. Address the potential for your organization now rather than later.
Disclaimer: The Bonadio Group provides the information in Viewpoints for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation. Tax articles in Viewpoints are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided "as is," with no assurance or guarantee of completeness, accuracy, or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability, and fitness for a particular purpose.
