What is an endowment fund & how does it work?

In the world of nonprofits, strategically managing financial resources is key to making the impact you want and having sustainable growth. An endowment fund is a tool many successful organizations use to support and maintain their long-term initiatives. Understanding what they are and how they can help reach specific charitable goals is crucial for nonprofit financial managers.

In this article, we'll cover how endowment funds work, their main features and the different types you can explore for your organization.

An endowment fund is a pool of assets established by a nonprofit, such as a charity, church, hospital, service group, educational institution or cultural facility. It's a way for monetary donations to develop into long-term financial support for mission-related activities. Ideally, the fund's principal is preserved over time while only a small percentage of the endowment's assets support the nonprofit's operations, programs, scholarships, research or other designated purposes. When used correctly, it's a model for sustainable ongoing funding.

Organizations use endowment funds to pool financial resources given to them—gifts, bequests and other donations—and invest them. To create the fund, the organization sets up a formal structure, such as a trust or operational account, to hold and manage the contributions. The donations typically form the principal investment balance, with the nonprofit then using a small portion of that to pay for its initiatives.

Anyone can donate to an endowment fund: individuals, groups, trusts, corporations, other foundations, etc. Donors may specify how they want their contributions to be used, or they may leave it up to the organization's governing board to decide how best to use it.

Endowment funds are just one tool nonprofits have to help manage their finances. And while they offer several potential advantages, they also can come with restrictive rules and administrative complications.

• Endurance. Can provide long-term financial support for mission-critical activities.
• Stability. May reduce reliance on unpredictable funding sources, such as goodwill donations and government grants.
• Reputation. Can boost credibility and attract supporters by showing a commitment to financial sustainability.

• Restricted use of funds. Can come with donor-imposed requirements for how to use the contributions, potentially limiting the flexibility of funding for changing needs or emergencies.
• Subject to market fluctuations. Can gain investment growth, but also are exposed to losses subject to asset performance and economic conditions.
• Inflation risk. May not produce a rate of return that keeps pace with inflation, which can diminish the real value of the endowment.

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Endowment funds are created with guidelines set by the organization's leadership—typically a board of directors. They aim to ensure the money is spent responsibly and invested in alignment with the nonprofit's objectives. These rules might outline general policies or provide specific permissions and restrictions, such as:

Most endowments are designed so that the donated amount must, at least initially, become investment principal rather than being spent directly. This may depend on the type of fund created: restricted, unrestricted, quasi or term. Nonprofit leadership should also spell out guidance on what the fund's distributions can be used for, such as facility maintenance, support for programs, research in a particular field, and so on. In addition, donors can earmark their gift for a specific purpose within the fund's objectives.

The organization's leadership can use the endowment fund's guidelines to define an investment strategy that must be followed. For example, you may want to detail the fund's ideal asset allocation—the percentage of holdings in different asset categories such as stocks, bonds or cash—or set rules for or against investing in certain industries or companies.

Many organizations choose to cap how much can be taken out of the fund over a given period. This percentage is based on the fund's balance, as well as the institution's needs.

For example, the organization may choose to never withdraw more than 5% of the total amount in the fund annually. This, in turn, helps ensure the endowment's longevity.

Every endowment fund has the potential to be unique in its setup, but there are four general types. They differ mainly in how nonprofits access and manage the money to best help them fulfill their objectives.

Restricted endowment funds are created with specific guidelines on how the fund's distributions can be used. With this type of setup, fund spending may be limited to projects, programs or initiatives aligned with an expressly stated objective.

Unrestricted endowment funds can support an organization without limitations on how the distributions must be used. This type of fund gives the nonprofit the flexibility to allocate funds based on its current operational needs and priorities.

Also known as "board-designated funds" or "funds functioning as an endowment," quasi-endowment funds are used like an endowment even if the fund doesn't fully meet the legal definition. These accounts ultimately can be managed at the nonprofit leadership's discretion, but they typically continue to function and be treated like true endowment funds.

Term endowment funds are established for a specific period or until an event occurs, providing a means for temporary or short-term financial support for a designated purpose. After that, the principal and any investment returns are disbursed to the nonprofit or transferred to its general fund.

The tax treatment of an endowment fund can vary depending on several factors, including the type of organization, the purpose of the endowment fund and the governing jurisdiction where the nonprofit is located or registered to operate.

While many nonprofit organizations qualify for tax-exempt status under national and state laws, certain types of income generated by endowment funds may be subject to taxation. For example, unrelated business income generated by investments in businesses or partnerships that are not directly related to the organization's tax-exempt purpose may be subject to unrelated business income tax.

It's also important to remember that an organization can risk losing its tax-exempt status if it engages in activities or fiscal practices that are inconsistent with its tax-exempt purpose.

Endowment funds can be a means to provide nonprofits with ongoing financial stability and support. Donations build up the fund's investments, creating earnings potential for the organization to tap into for specified spending needs.

While endowment funds can offer financial sustainability, they also can have drawbacks, such as restricted fund use and investment risks. Organizations that establish endowment funds need to be prepared to manage them carefully. But they can be a powerful tool for helping nonprofits achieve their goals.

Learn more about support and resources for endowments through Thrivent Charitable Impact & Investing®. And consider partnering with a Thrivent financial advisor to craft a financial strategy that fits your organization's goals and needs.