What is the Endowment Fund?
The term “endowment fund” refers to the pool of money that has been accumulated through gifts and donations. The principal of an endowment fund is usually perpetually invested and only a certain portion of the fund’s return is being used by the beneficiary to accomplish its pre-determined long-term objectives. The remaining portion of the return is ploughed back to the principal to support fund growth. In this way, an endowment fund aids short-term liquidity as well as long-term financial objectives of the organization.
It is important to understand that the primary objective of an endowment fund is to ensure the achievement of the long-term objectives and maintain the financial health of the beneficiary organization. In other words, these funds are maintained by the beneficiaries in order to meet their mundane operational expenses as well as any specific need, and 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 be remain entitled for 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 on the basis of 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 are used for covering the day-to-day operational expenses of the beneficiaries. The principal withdrawal of these funds is governed by the guidelines in the different policies. While some funds allow withdrawal of the principal after a certain period of time, others may not allow the beneficiaries to withdraw the principal at all.
Example of Endowment Fund
Example 1: 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 can the beneficiary use to meet its operational expenses?
The beneficiary can use the earnings (interest and dividends) from the investment 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 of time. 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 annual return of the fund or use some portion of the principal as per their requirements. These funds are overseen by the governing board of the beneficiary who act on behalf of the donors.
- Unrestricted Endowment: In this type of fund the donor doesn’t put any restrictions on the beneficiary on the use of the funds. In other words, the beneficiary has the flexibility to use the return on the investment for any purpose it deems fit for use.
- Restricted Endowment: In this type of fund, the donor ring-fences the return on the investment 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 have the flexibility to invest the principal amount. However, the type of investment policy (aggressive, passive, or otherwise) for the fund is decided by the donor.
- Withdrawal Policy: In this section, the withdrawal guidelines of the fund are described, which include withdrawal limit per instance, the time period between two consecutive withdrawals, etc. These guidelines are usually unique to the needs of the beneficiary as well as the restrictions put forward by the donor.
- Usage Policy: This section defines the usage guidelines of the endowment fund as per the desires of the donor or a pre-determined objective. However, there are instances where the donor doesn’t provide any restriction on the usage of the funds, and in such cases, the beneficiary defines the usage policy.
Some of the major benefits of an endowment fund are as follows:
- It helps the beneficiary in the achievement of its objectives by providing financial support.
- These funds are professionally managed by fund managers, which ensures that the principal grows and generates adequate cash flow.
- It is a stable source of income that covers the expenses of the beneficiary.
- The fund proceeds are used by the recipient for different programs.
Some of the major 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 with the contributions of the 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 varies from one to another.
This is a guide to Endowment Fund. Here we also discuss the introduction and how does endowment funds work along with benefits and disadvantages. You may also have a look at the following articles to learn more –