How Endowments Grow & Decline
In the previous hypothetical, we talked a little bit about how Barry’s Endowment could grow. As long as Barry’s Endowment continued to make 8% interest per year, and all the other variables remained constant, his Endowment would continue to grow. But if variables changed (which they do in the real world), the Endowment could grow or decline depending on what happens.
Well, let’s talk a little bit more about the math behind endowments to develop a clearer picture about how they can grow or decline in value.
In every endowment, there are basically 2 monetary parts which include (i) the principal and (ii) the interest. The principal is the actual money invested in the endowment. With Barry’s Endowment Fund, the remaining $4.65 million represents the principal, while the $372,000 that it earned in 1 year represents the interest.
The goal of every endowment is to make as much money on the principal as possible while also covering the costs of what the endowment was set up to do. However, in the real world, endowments often lose money when their investments do poorly. If the endowment loses a lot of money, it won’t be able to pay for its original purpose (e.g. the 4 professors’ salaries with Barry’s Endowment).
At some point, if the endowment loses too much money, there may not be enough principal to make much interest at all. At that point, the endowment will often be set up to pay out the rest of the principal. And once the principal is gone, the endowment ceases to exist because there’s no more money left in it.
So, in order to keep making money, i.e. interest, on the endowment, the endowment must maintain as much principal as possible. That’s why most endowments are set up to only spend about 4-10% of the total amount in the endowment to allow it to continue to make interest.
Ok…so that covers the basics of the math behind endowments.
Next, let’s take a look at some of the top American university endowments.