Updated July 17, 2023
What is the Endowment Fund?
The term “endowment fund” refers to the pool of money accumulated through gifts and donations. The principal of an endowment fund is usually perpetually invested, and the beneficiary uses only a particular portion of the fund’s return to accomplish its pre-determined long-term objectives.
The remaining part of the return is plowed back to the principal to support fund growth. In this way, endowment funds aid short-term liquidity as well as long-term financial objectives of the organization.
It is essential to understand that the primary objective of an endowment fund is to ensure the achievement of long-term goals and maintain the financial health of the beneficiary organization. In other words, the beneficiaries hold these funds to meet their everyday operational expenses and specific needs. In this way, the fund supports their financial needs. However, endowment funds are typically guided by strict rules and contractual obligations, and the beneficiaries should follow them to remain entitled to the fund’s benefits. Some of the most common examples of beneficiaries of endowment funds include non-profit organizations such as universities, hospitals, churches, etc.
How Does Endowment Fund Work?
The endowment funds are formed based on the contributions extended by philanthropic organizations and individuals in the form of donations and gifts. These funds are then invested, and the income generated from these funds in the form of interest and dividends is used for covering the day-to-day operational expenses of the beneficiaries. The guidelines in the different policies govern the principal withdrawal of these funds. While some funds allow the withdrawal of the principal after a certain period, others may not allow the beneficiaries to withdraw the principal at all.
Example of Endowment Fund
Let us take the example of a fund with a principal fund balance of $100,000,000, which has been invested by the fund manager in a stable investment portfolio that generates interest and dividends of 5% of the fund balance. The guidelines of the endowment fund strictly prohibit the beneficiary from using the principal to fund operations. Determine how much of the endowment fund the beneficiary can use to meet its operational expenses.
The beneficiary can use the investment’s earnings (interest and dividends) to pay for the operational expenses. The earnings from the investment will be $5,000,000 (= 5% * $100,000,000).
Types of Endowment Fund
Let us now look at some of the most common types of endowment funds:
- Term Endowment: In this type of fund, the return on the investment should be used for a pre-determined specific purpose during a particular period. Post-expiry of the term, the beneficiary can use the principal and its return as per their wish. The terms and conditions of the fund are mutually agreed upon between the donor and the beneficiary.
- Quasi-Endowment: In this type of fund, the beneficiary can either avail of the fund’s annual return or use some portion of the principal per their requirements. These funds are overseen by the governing board of the beneficiary, who acts on behalf of the donors.
- Unrestricted Endowment: In this type of fund, the donor doesn’t restrict the beneficiary’s use of the funds. In other words, the beneficiary can use the return on the investment for any purpose it deems fit for use.
- Restricted Endowment: In this type of fund, the donor guarantees the investment return for some particular purpose.
Components of Endowment Fund
A typical endowment fund can be broken down into three major components, which are discussed below:
- Investment Policy: Usually, the recipient organization or beneficiary in an endowment fund has the flexibility to invest the principal amount. However, the donor decides the type of investment policy (aggressive, passive, or otherwise) for the fund.
- Withdrawal Policy: In this section, the withdrawal guidelines of the fund are described, which include the withdrawal limit per instance, the period between two consecutive withdrawals, etc. These guidelines are usually unique to the needs of the beneficiary and the restrictions put forward by the donor.
- Usage Policy: This section defines the endowment fund’s usage guidelines per the donor’s desires or a pre-determined objective. However, there are instances where the donor doesn’t restrict the usage of the funds, and in such cases, the beneficiary defines the usage policy.
Some of the significant benefits of an endowment fund are as follows:
- It helps the beneficiary achieve its objectives by providing financial support.
- Fund managers professionally manage these funds, ensuring that the principal grows and generates adequate cash flow.
- It is a stable source of income that covers the beneficiary’s expenses.
- The recipient uses the fund proceeds for different programs.
Some of the significant disadvantages of the endowment fund are as follows:
- In some cases, the day-to-day usage of the funds is limited due to the restrictions advised by the donor.
- The restrictions on withdrawal of the principal may, at times, hamper the recipient’s operations.
So, it can be seen that the money in an endowment fund is formed through the contributions of philanthropic donors, and the return on investment of these funds are then used to meet the long-term objectives of other non-profit organization. However, the welfare of the beneficiaries depends on the restrictions governing the fund, which vary from one to another.
This is a guide to Endowment Fund. Here we also discuss the introduction and how endowment funds work with benefits and disadvantages. You may also have a look at the following articles to learn more –