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Endowments – An Overview

Introduction

You may have heard about Harvard’s or Yale’s multi-billion dollar endowments. But how do universities like Harvard, Yale, or other institutions have such large endowments? And how are these endowments created? And what exactly is an endowment?

Well, the term "endowment" can have multiple meanings depending on what industry you’re referring to (e.g. mortgages, policies, etc.), but in this article we’re going to focus on endowments as the money donated to institutions. So, an endowment at its core can be defined as a monetary donation made by a person or entity to an institution.

Endowments can be set up by the donor, i.e. the person or entity making the donation, or by the donee, the institution receiving the donation. Some of the biggest endowments have been around for a long time. This is because endowments generally tend to grow over time. Why? We’ll explore this question and the others in the pages that follow.

In this article, we’ll take a look at how endowments are created, how they grow and decline, what universities have some of the biggest endowments, and how to donate to or set up an endowment.

Next, we’ll go over a hypothetical situation to show how an endowment can be created.

The Hypothetical Endowment

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.

Barry’s Endowment Fund (hypothetical situation)

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.

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.

Top 10 University Endowments

Some of the largest endowments are set up for universities and colleges (like our hypothetical with Barry’s Endowment Fund). In fact, according to the 2008 study by the National Association of Collage and Business Officers (NACUBO), out of 791 American universities the average endowment was over ½ billion dollars. That’s quite large – but almost "chump change" compared to the largest university endowments.

According to NACUBO’s 2008 stats, the top 10 university endowments by funds include:

Harvard University, MA - 36.5 billion
Yale University, CT - 22.8 billion
Stanford University, CA - 17.2 billion
Princeton University, NJ - 16.3 billion
University of Texas, TX - 16.1 billion
Massachusetts Institute of Technology (MIT), MA - 10 billion
University of Michigan, MI - 7.5 billion
Northwestern University, IL - 7.2 billion
Columbia University, NY - 7.1 billion
Texas A&M University - 6.6 billion

With those 2008 stats, it should also be noted that many universities’ endowments have taken some hard hits from the recent financial crisis. According to the New York Times, Harvard’s endowment took a 22% hit from 2008 and lost over $8 billion (that right, billion) in just 4 months (so many of the above numbers have changed). In fact, for the very first time in Harvard’s history of about 375 years – which is older than the United States itself – it faces some difficult financial problems.

As you can see, endowments can be a great source of funds for universities and colleges, as long as they are making money (and not losing it). It’s likely that Harvard will take a much stronger look at its financial endowments, and learn to finance more operations through areas other than endowments.

Next, we’ll take a look at how to donate or set up your own endowment.

Donating To or Setting Up an Endowment

There are basically 2 ways to get involved with endowments: (i) by donating to or (ii) setting up your own endowment.

Donating to an Endowment

Because there are currently so many endowments out there right now (and institutions are always looking for new donors) most people choose to donate to an endowment. Donating to an endowment is also the easiest and quickest way to give back. You simply have to find an institution that you would like to contribute to and add your funds to its endowment. You may even be able to add some restrictions to the endowment depending on its nature and the size of your contribution. The key to contributing to an endowment is that you really believe in its purpose.

Setting Up an Endowment

If you have the financial resources, you may elect to actually set up your own endowment for a university or other institution. There are both advantages and disadvantages to setting up endowments. One obvious advantage is that you can create the endowment to do just about anything you want (within reason) with the consent of the institution you’re donating to. For example, you could set up an endowment to pay for all painting required on campus each year. Many people also choose to set up an endowment upon their deaths in a written will, trust, or other legal document. Endowments are a great way to carry on a legacy.

Generally, there are 5 different things you would want to do if you set up an endowment:

Name the endowment
Restrict the endowment’s use for a particular purpose(s)
Set guidelines for how much of the interest can be used on a yearly basis
Create exceptions for when the endowment principal can be used under special circumstances; and
Set forth how the principal in the endowment should be invested (this is obviously an important step in which financial experts can help you)

You’ll also want to make sure that the endowment complies with the state laws (and other applicable laws) in which it will operate. So, you’ll likely want to find an accountant and/or attorney to set up and/or review the endowment for you.

Finally, let’s wrap up this article with the main points.

Conclusion

In this article, we talked about how endowments can be created, how they grow and decline, the top university endowments, and how to donate to or set up your own endowment. We also explored how poor economic times can lead to trouble for endowments.

While endowments will continue to be a source of revenue for universities and other organizations (like non-profit organizations), the financial crisis should teach us that endowments should not be the only source of revenue for certain aspects of an institution. And the next time you receive a letter from your Alma Mater or other organization to pledge a donation to an endowment, you’ll have a better idea about how that money will be used.