What is Endowment Fund, Features and Restrictions on its Usage
An endowment fund is a pool where the money from donations is brought together and invested in securities. The fund’s primary purpose is to support a Nonprofit Organisation or any other social welfare activity taken up by a university.
The best aspect of an endowment fund is that an independent body manages the fund and uses the interest earned from the donations to finance its activities. Therefore, the fund’s principal usually remains invested, and a portion of the returns is used to meet the short and long-term objectives. Read on to know everything about an endowment fund.
What is an Endowment Fund?
An endowment fund is a portfolio that is created out of the money received as donations. The primary purpose of an endowment fund is to fund all kinds of charitable activities and charitable institutions like hospitals, churches, etc. You get several tax deductions on these funds as they serve a charitable purpose.
The fund earns money through interest and dividends based on where the money from the fund is invested. Additionally, capital appreciation plays a significant role in the growth of these funds. Most of these returns are used to finance the regular operating activities of the organisation. An endowment fund is a primary source of working capital for nonprofit organisations.
How Does an Endowment Fund Work?
An endowment fund works like a regular asset. It provides steady returns over a period based on several market factors. An endowment fund can be incorporated by a student body like a university to fund educational initiatives or to provide additional resources to the students and the staff.
The working of an endowment fund is relatively straightforward. Several donors come together and make contributions to an endowment fund. The money accumulated in the fund is invested in different financial instruments like bonds, equity, etc. The organisation managing the fund tries to protect the principal by keeping it invested for a very long duration. However, the organisation takes a small portion of the fund annually to fund all the operational expenses.
There are certain restrictions to the usage of the fund. For instance, donors who donate to an education endowment fund expect the funds to be used solely for financing and educational initiatives. In this case, the fund’s organisation is legally bound to use the funds for the donation. These donations cannot be used to fund any other secondary or tertiary activities of the organisation.
The primary source of income for a nonprofit organisation is an endowment fund. Therefore, these NPOS take a conservative investing approach to ensure that they keep getting steady returns in the long term without any risk. While every endowment fund has a different objective, they all want long-term growth for the fund. Also, they try to devise ways to limit the fund’s distribution.
Also Read: Sinking Funds: Definition, Types, Advantages & Disadvantages Explained
Features of Endowment Funds
Now that you are aware of the endowment fund meaning, let’s understand the different features of the fund:
- A nonprofit organisation can start an endowment fund to finance a project or its regular operations. These nonprofit organisations include schools, hospitals, etc.
- The entire contribution of the fund comes from donations. These donations can be generic or made for a specific cause, like cancer treatment, education for visually impaired students, etc.
- Several restrictions are placed on the distribution and the usage of the fund. Also, the investments made via the fund are subjected to a few restrictions.
- The fund constitutes the principal amount of the donations and the interest it earns over time.
The endowment fund in NPO should adhere to these restrictions to avoid any penalties. The above features set the fund apart from all the other funds.
Types of Endowment Funds
Different kinds of endowment funds work slightly differently than others. Some of the popular types include:
Restricted Endowment
The principal donation amount is held within these funds forever, and the organisation cannot distribute or spend the principal amount. While the principal earns interest, it can only be used for activities defined by the donor. Therefore, they called restricted endowments.
They are also called ‘true endowments’, and they work per the document that states the usage policy of the fund.
Unrestricted Endowment
As the name suggests, there are no restrictions on using money that comes in as a donation. Here, the organisation that manages the fund has complete discretion on the usage of the fund. Therefore, the money can fund charitable projects or meet the organisation’s regular expenses.
Term Endowment
Unlike a permanent endowment fund, a term endowment exists for a fixed period. It is usually created to fund a specific project or activity. After the activity’s completion, the fund’s principal amount can be used to finance the organisation’s regular operations.
Quasi-endowment
A quasi-endowment fund is created within the organisation, and the money that goes into the fund also comes from the organisation itself. Therefore, there are no restrictions on the usage of the principal and the interest income. The organisation’s stakeholders mutually decide all the policies governing the fund and can decide to place or remove restrictions as deemed fit.
Components of Endowment Fund
The components of an endowment fund are an important aspect of the fund and define how the fund will work. Let’s understand them in detail.
Investment Policy
The fund’s investment policy is usually decided by the donor, who makes the maximum contribution to the fund. These policies can be aggressive, passive, or a mix based on the donor’s donation objective. Generally, theH3 organisation managing the endowment fund exercises flexibility on how to use the fund ad where to invest the principal. However, it might be impacted by the clauses listed in the investment policy.
Withdrawal Policy
Endowment fund treatment in NPO involves a withdrawal policy. The policy defines the terms and clauses governing the withdrawal of principal and fund returns. The policy might chalk out limits on withdrawals, the gap between two consecutive withdrawals, etc. These restrictions are in place to ensure the organisation is not misusing the funds.
Usage Policy
As the name suggests, the usage policy states the terms of usage of the endowment fund. The usage policy can be decided by the donor if they are making a sizeable donation or if they are already in place by the organisation managing the fund. In most cases, the donor does not restrict the usage of the fund. Hence, the organisation must draft a usage policy for the fund.
Endowment Fund Policies and Guidelines
Every endowment fund works under the purview of a certain set of guidelines. These guidelines are in place to monitor the usage of the assets. Organisations that manage similar funds should adhere to these guidelines to avoid legalities. Some of these policies include:
1. The Investment Policy
The investment policy should state the purpose of the fund’s existence and the terms of the endowment fund management. It should also include the investment objective of the fund and how the portfolio should be balanced. Some policy documents also state a few criteria for selecting the manager who will oversee the fund. The policy also includes the metric that should be used to understand its performance.
2. Fund Agreement
The fund agreement is curated by a donor who wants their donations to be used for a specific purpose. For instance, if a donor invests in an education endowment fund to support the education of differently abled children, the fund agreement would state the purpose of the donation.
Therefore, the organisation becomes legally obligated to use the fund for that purpose only unless the donor changes the terms of the fund agreement.
3. Endowment Spending Policy
This policy puts a limit on the usage of the returns of the fund in a particular year. Most funds spend about 3% to 7% of the fund to finance projects and their regular expenses. However, most funds earn about 4.5% of their principal amount annually.
Let’s take an endowment fund example to understand this better. If the endowment fund has a principal amount of $100 million, the principal will generate about $4.5 million in returns yearly. These returns are considered the income for the organisation that is managing the fund.
Tax Treatment of Endowments
Before establishing a permanent endowment fund, you must understand the tax treatment of these funds. The best thing about an endowment fund is that they are tax-free as they are a part of a nonprofit organisation. However, if you start an education endowment fund within a college or a university, you will have to pay a 1.4% excise tax on the fund’s earnings. A college with $500,000 or more in an endowment fund must pay this tax.
The taxation was imposed to encourage colleges and universities to spend more on educational initiatives to help students. Also, taxation promotes initiatives that can help off-setting the huge amount of student loans. Also, the donor can exercise tax deduction on the donated sum.
Advantages of an Endowment Fund
Some advantages of an endowment fund include:
- The nonprofit organisation can finance its regular expenses without any hassle.
- These funds are managed by professional fund managers who ensure a steady flow of income.
- The fund provides stability to the organisation.
- These funds go into financing a range of charitable initiatives.
Also Read: 10 Best Dividend Yield Mutual Funds to Invest in India
Disadvantages of an Endowment Fund
Some disadvantages of having an endowment fund include:
- The donor might place some restrictions on the usage of the fund and thus hamper the organisation’s flexibility.
- If the organisation withdraws the principal, it might affect its financial health in the long run.
Final Word
An endowment fund is created by several donors who have philanthropic interests and want to serve the world. Organisations can establish a usage policy to ensure that the funds are used within limits and are put to valid use. Before you open it, you must understand the policies governing an endowment fund.
FAQs on Endowment Fund
Ans: A nonprofit organisation usually creates an endowment fund. Also, several schools and universities have endowment funds to provide students and staff with better resources.
Ans: A restricted endowment fund works under the restrictions placed by the donor. These restrictions could be on the purpose of fund usage and the number of withdrawals.
Ans: The usage policy enlists the purposes for which the money from the endowment fund can be used.
Ans: Churches, charities, universities and even some hospitals are nonprofit organisations.
Ans: Most colleges, including Ivy League colleges, have an endowment fund. Institutes like Harvard have an endowment size of $41,894,380,000.
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
