How to know if your nonprofit is ready for an endowment

Nonprofit organizations pursue financial stability to sustain and grow their mission over the long term. To accomplish this goal, many nonprofits consider creating an endowment—a pool of funds invested to generate income in perpetuity. Beyond generating long-term income, it is important to recognize that an endowment is legally restricted for a specific purpose agreed upon by the donor and the organization.

Here are some key considerations before establishing an endowment:

• Assess the overall financial health of the organization and confirm It has reliable and diverse sources of funding.
• Consider the organization's long-term strategy, including if the organization is intended to exist in perpetuity. Ensure that a robust succession plan is in place and identify any significant funding needs in the future.
• Ensure the organization has sufficient liquidity or dedicated cash reserves to cover at least 6 to 12 months of operating expenses because endowment funds are restricted for specific purposes. The corpus of the endowment is generally meant to exist in perpetuity, and an endowment should not be treated as a "rainy day" fund. A best practice is to use cash reserves—not the endowment—for emergency funding needs.

So, if your organization has a variety of funding sources, a solid plan for the future, and healthy cash reserves, creating an endowment might be a good next step. Below are some advantages and disadvantages to consider before moving forward.

Pros

Financial Stability

Assets in an endowment are invested with the goal to achieve a level of capital appreciation that aligns with the endowment's annual spending (plus the rate of inflation), as this will allow the endowment to preserve real wealth over time. Professional investment managers like Fidelity can work with you to design an endowment portfolio structure that aligns with your organization's investment policy and mission-specific spending goals.

Once the endowment is established, we suggest building a corpus that is two to three times the organization's annual operating budget to create a meaningful and sustainable revenue stream.

Legacy

An endowment is meant to generate sufficient returns to meet the organization's annual spending goals, net of inflation. It is often a great way for nonprofits to attract legacy gifts like bequests, benefits from life insurance policies, and other sources. Many donors like the idea of leaving a lasting legacy, and a gift to an endowment allows them to support an organization well beyond their lifetime.

Credibility

The existence of an endowment can signal that an organization is fiscally responsible and intentional about its future, which can boost donors' confidence and potentially attract more donations.

Cons

High funding requirement

While there technically is no minimum to create an endowment, endowment investment management is subject to fiduciary standards. Smaller endowments are often self-managed by nonprofit staff or investment committees. In these situations, organizations must ensure they are managing the endowments' assets in a way that fulfills the organization's fiduciary standards of care, which may be taxing to internal or volunteer resources.

Alternatively, endowments may look to outsource daily fiduciary responsibility to an asset management firm or community foundation. Notably, asset managers that oversee endowment funds have minimums for investable assets. Endowments held at community foundations or similar institutions may have a minimum of $25,000; many investment managers require a minimum of $1 million or more.

Restrictions

An endowment is typically governed by three key policies: an investment policy, a withdrawal or spending policy, and a usage policy. The investment policy articulates the types of investments, risk tolerance, and long term objectives. The withdrawal policy stipulates the amount and timing of funds that can be taken from the endowment each year. And the usage policy dictates how the funds can be used. These policies safeguard the endowment for the future but limit the flexibility of the fund and how it can be utilized.

Perception

Some potential donors might be uncomfortable with the idea that large sums are tied up in endowments instead of being used right away. If your organization serves communities with significant, urgent needs, the tension between putting funds to use now and ensuring funding is available in the future might be even more pronounced.

Conclusion

An endowment can be a powerful tool for a nonprofit to ensure a level of financial and programmatic stability over the long term. However, nonprofits should be aware of the advantages, challenges, and requirements of creating and maintaining an endowment before committing to establishing one.