Endowment Funds: Nonprofits must consider several key factors before creating an endowment

Date November 23, 2022
Authors Darby L. Beaverson Teal Strammer

An endowment allows a nonprofit to manage a financial instrument that generates earnings it can use to forward its mission, helping to fund future operations and promote the organization’s long-term financial stability. Donations to an endowment tend to be larger than regular contributions—an endowment fund can be comprised of cash, securities, and other income-producing assets—due in part by the donor’s ability to create an enduring legacy by funding the organization long-term. But nonprofits must consider several key factors before creating an endowment, including the type of endowment, compliance with laws surrounding the endowment, and management of the endowment funds.

There are three different types of endowments – true, quasi, or term:

  • A true endowment occurs when a donor restricts the principal balance of a gift in perpetuity, and the organization can only use the investment earnings. It is not uncommon for donors to require that a portion of investment earnings be added to the gift and re-invested.
  • A quasi-endowment occurs when the board restricts funds and designates a portion of net assets without donor restrictions to be invested. In this scenario, the board can decide when the organization can expend the principal balance at any time.
  • A term endowment is similar to a true endowment, however, with a conditional restriction on the endowment funds. Once that condition is met, the organization may be able to expend a portion or the full amount of the endowment.
  • Regulation

    Endowments are created to support a nonprofit, and spending or distribution policies apply to the amount of annual support an organization can obtain from its endowment. The Uniform Prudent Management of Institutional Funds Act (UPMIFA), a uniform law governing donor-restricted endowment funds, guides organizations and stipulates the management and investment of endowment funds. The UPMIFA is designed to protect donors and organizations related to contributions and ensure the funds are managed efficiently.

    Organizations may disclose the adoption of UPMIFA in their financial statement footnotes. Suppose a nonprofit organization chooses not to adopt UPMIFA. In that case, it still must be aware that it is subject to disclosure requirements, regardless of whether it implements or is subject to UPMIFA. In their financial statements, organizations must provide detailed information on the following:

    1. Return objectives and risk paraments that include the organization’s endowment composition and accounting policies

    2. Strategies employed for achieving objectives that disclose the organization’s investment policies

    3. Spending policy and investment objectives

    4. Summary and changes in endowment

    5. Interpretations of the relevant law

    6. Underwater endowments, if applicable

    An underwater endowment occurs when the fair value of the endowment fund is either less than the principal balance of the original gift or less than the amount that is required to be maintained as required by the donor or by law. In the event the endowment is underwater, the financial statements must disclose:

    1. The value of the original gift

    2. The fair value of the original gift

    3. The number of underwater funds

    4. The organization’s spending policy for underwater endowments

    Underwater endowments are required to be classified within net assets with donor restrictions. They may be included in the aggregate amount of the net assets with donor restrictions on the face of the financial statements or shown separately within the net asset classification.

    Before establishing an endowment fund

    Nonprofits should consider whether establishing an endowment fund is an activity they can take on in addition to running and maintaining their programs. Managing endowments can take significant time, which could otherwise be spent on the organization’s mission. Organizations should ensure they have the appropriate personnel managing their endowments to relieve the unforeseen administrative burden.

    Organizations must clearly understand what is involved in building and maintaining an endowment fund. Making an endowment fund large enough to where investment earnings are enough to sufficiently support an organization should also be a consideration.

    Community foundations

    Nonprofits may maintain their own endowment funds if they have the expertise, or they can place the funds with a community foundation that can provide financial expertise, access to planned giving, and access to financial resources they don’t have. Additionally, maintaining an endowment with a community foundation can help the organization focus on its mission, while the community foundation helps them stay compliant with the investment and spending policies.

    Endowments that are transferred to a community foundation have special accounting considerations. The nonprofit will have access to future distributions from the transferred funds, and therefore the funds remain an asset of the nonprofit.

    When the endowment gift is received by the organization, the entry recorded to show the receipt of the donation, and the applicable restriction would be such as:

    Dr. Cash

    Cr. Restricted Contributions

    The initial entry for the transfer and creation of an endowment fund at the community foundation would then be:

    Dr. Beneficial interest in assets held by the community foundation

    Cr. Cash

    As the community foundation distributes funds from the endowment to the organization— understanding that the distributions are in compliance with the spending policy—the organization receives cash and investment income. When changes in the endowment fund occur, the organization records any unrealized gains or losses, realized gains or losses, and interest and dividend income. When recording this activity, the organization would adjust the beneficial interest in assets held at the community foundation and other applicable income accounts.

    Community and donor perceptions

    If an endowment is very large, the organization could face scrutiny and have difficulty attracting donors and raising annual gifts; they could be perceived as not having a need. But an endowment does not address current needs. There are also administrative considerations. For example, each endowment should have separate accounting, even when they are pooled for investment purposes. Another consideration is the annual audit. The auditors will likely want to obtain copies of any applicable grant engagements related to the endowment, the organization’s spending, and its investment policy. Audit procedures performed can include:

    1. Reviewing the organization’s investment roll forward for the year under audit

    2. Sampling investments in the endowment fund portfolio and calculating fair market values subsequent to year-end

    3. Testing compliance with the spending and investment policy for the endowment

    4. Determining if there are any underwater endowment funds to disclose in the footnotes

    5. Reviewing board minutes for board discussions about the endowment fund

    6. Confirming investment balances

    7. Considerations on how the endowment affects the liquidity and availability of resources

    After all these factors have been considered, the board of directors will play an important role in determining if the organization moves forward with an endowment. If it accepts or sets up the endowment, it will require educating management, the board, and future donors on an ongoing basis.

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