Managing an Endowment: Three Key Principles

Managing an endowment means balancing competing needs and goals. How to do that effectively is the topic of an article by Bob Moser, LNWM CEO, and Gino Perrina, LNWM CIO, published in the Puget Sound Business Journal this week. Here is what Bob and Gino advised:

“Many nonprofits rely on endowments as a critical component of their financial strategies. Distributions from endowments can be counted on for general operating expenses or for specific uses, such as capital spending, program expansion or, in the case of colleges and universities, devoting funds to provide scholarships.

But in times of financial uncertainty, the stability of an endowment can seem to slip away. For finance committee members of nonprofits, now is the time to evaluate if you’re using your endowment effectively, and adjust if needed.

In principle, endowments are long-term pools of capital that shouldn’t be negatively impacted when investment returns are expected to decline in the near term. The reality, however, can paint a different picture, especially when an organization sets its distribution level — or draw — too high.

Unlike a private foundation, which is legally required to distribute at least 5 percent of its earnings annually, an endowment’s draw can be set at the discretion of an endowment committee. Many set their draw at levels below 5 percent. This is often the case with large, well-established institutions, like universities.

These large endowments make heavy use of private equity, hard assets and other illiquid investments in their portfolios and have a reliable base of donors from which they can expect significant donations. Their stability allows them to keep the vast majority of their investments set aside for growth, as their sheer size alone can make even a small draw highly lucrative.

Endowments that are comparatively smaller have a much different profile. They are more likely to set their draw rates higher to fund more immediate needs and invest a higher percentage of their portfolios in listed securities, stocks and bonds to generate liquidity.

But when these organizations become too dependent on a high draw from their endowment, they can face significant financial problems, especially when short-term investment returns decline or inflation rises. When this happens, it could be the beginning of a downward spiral. When draws remain too high relative to returns, continued distributions may chip away at the principal. This reduces the financial performance of the endowment itself, which can lead to a myriad of problems. Donors may have less confidence in the organization, critical programs may be curtailed or capital projects put on hold.

Three Key Principles for Managing an Endowment

If your organization currently draws against its endowment, take the time now to consider the following three principles.

#1. First, determine the delta between what you can reasonably expect to generate from returns and what you need from the endowment for expenses to help define the maximum draw the organization can stand. This may seem obvious, but it’s often an overlooked step. Using basic business principles will help tell you how much liquidity you need for expenses and will drive risk, allocation and other investment decisions in the portfolio itself.

#2. Second, compare financial value to organizational values. Many endowments want to — or feel pressured to — invest in socially responsible endeavors or divest themselves from things that don’t align with their institutional goals. While socially responsible investing is both an intelligent approach and one that can generate strong financial returns, it’s a long-term investment strategy that may come with increased short-term volatility. If the draw on the endowment is relatively conservative, short-term swings in volatility should have little effect on long-term value. However, if the draw on the endowment matches or exceeds the current earnings rate, short-term volatility can have unwelcome negative impact on the endowment’s sustainability.

#3. Third, remember that yesterday isn’t the best predictor of tomorrow. An organization that sets a 7 percent draw on its endowment because the previous year saw a total market return of 8 percent will be in for a rude awakening when next year’s return clocks in at 6 percent. Work with investment professionals to assess the entire landscape of economic indicators, asset classes and historical trends to establish an endowment’s investment portfolio that matches today’s reality with tomorrow’s needs, not last year’s yields.

Endowments are powerful financial tools that can help nonprofits serve their important missions long into the future. But without rigorous planning and diligent management, their value can become a liability.

If your organization makes use of an endowment, take the time now to make sure you’re using it to its greatest potential.”