So, how do endowments come into being? Let’s go over an example to show the reasons why endowments are created, how they operate, how they can grow, and some of their pitfalls.

Assume Barry graduates from State College and goes onto a very successful career as a real estate developer. Then, one day Barry wants to give back to his Alma matter, State College, where he learned some of his real estate skills. Barry could give back to his Alma matter in many ways. For example, he could offer to come and give the commencement speech for free, offer a lump sum donation to build a new business building in his name, or just write a large check to State College and call it a day. However, Barry’s wants to do something a little more, something that will last longer. So, Barry decides to set up an endowment, in his name of course.

With the help of his lawyers, Barry creates Barry’s Endowment Fund in honor of State College and to keep his name affiliated with the College. Barry grants State College a $5 million dollar endowment to pay for 4 professors to teach in the business school in his name – the same school that he attended. These professorships are generally called endowed chairs because they are funded by the endowment. Endowed chairs were originally created by the Romans and are usually viewed as prestigious positions. Famous individuals such as Isaac Newton, Stephen Hawking, and others have received endowed chair positions.

State College now has 4 less professors to pay for because of Barry’s Endowment. Let’s also assume that the professors’ salaries cost Barry’s Endowment around $350,000 per year (i.e. each professor makes $87,500/year). Keeping the math simple, what happens to the other $4.65 million dollars that were not used on the professors’ salaries? Well, Barry put the funds from the Endowment into investments like stocks, bonds, CDs, mutual funds, and other combinations of investments. Barry expects the Endowment to make about 8% per year on interest in the investments.

Doing the math, that means Barry’s Endowment will make $372,000 per year on the interest alone ($4,650,000 x .08 = $372,000). Pretty amazing! In fact, Barry’s Endowment is actually making $22,000 per year (after subtracting the professors’ salaries). Some of that $22,000 will merely keep up with inflation (which rises at about 3% per year), while the remaining portion will help the endowment grow above the rate of inflation.

Barry also decided to put a provision in the Endowment which says that if the Endowment reaches $6 million dollars then he wants it to fund another professor’s position. As long as the Endowment continues to make that 8% per year, and everything else remains constant the Endowment will eventually reach $6 million. However, if Barry’s Endowment makes less than 8%, or even loses money, or inflation rises higher than expected - well, that’s not a good day for Barry’s Endowment or State College. Depending on the other provisions in the endowment, State College may actually have to start paying for those professors’ positions again.

Now, assume there are thousands of other Alumni from State College that have set up endowments like Barry, but for different things like for maintenance of the College’s dormitories, parks, buildings, or athletic center, or for scholarships or fellowships for students in many different fields. Once you start adding up all the different endowments, especially if Alumni can set up large endowments like Barry, you can see how a college or university can generate a lot of funds through an endowment to use for its operations.

Endowments are generally great for universities, but they can be bad too – especially when the economy takes a nosedive and the universities are not prepared to cover the costs that the endowments were covering.

Next, we’ll briefly go over a little more of the math behind endowments to better understand how endowments can grow or decline over time.