Endowment Funds

Q1: What is an endowment fund?

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This is part of "What Every Grantmaker Should Know & Frequently Asked Legal Questions."

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An endowment fund is a fund held by a charitable organization in which the donor has imposed a restriction that prohibits some or all of the fund from being spent currently. This would include, for example, a gift that is to be held "in perpetuity," or one that must be held for 25 years before it can be spent.

Q2: How is an endowment fund created?

An endowment fund may be created by virtually any means that indicates that the donor intended to create an endowment fund. Such means include a direct instruction from the donor, a donor's gift designated for an existing endowment fund, or an otherwise undesignated gift that is received in response to a request for an endowment gift.

Q3: How must an endowment fund be invested?

In general, the board members of a foundation must perform their duties, including their investment duties, with the care an ordinarily prudent person in a like position would exercise under similar circumstances.

Various laws governing the investment of charitable assets "” including the Uniform Prudent Management of Institutional Funds Act (UPMIFA), the Uniform Prudent Investor Act (UPIA), and the Third Restatement of Trusts "” all embrace the concept of modern portfolio theory. Under modern portfolio theory, prudent investment policy is based on diversification of assets, long-term performance benchmarks and the importance of a portfolio's total return on investment.

Q4: How much may be spent from an endowment?

Unless the donor specifies a particular percentage or dollar amount that is to be spent periodically from the endowment, the governing body of the foundation is responsible for determining the amount that may be spent currently from an endowment. In doing so, the board must act reasonably, and must take into account the duration and preservation of the endowment fund, the purposes of the institution and the endowment fund, general economic conditions, the possible effect of inflation or deflation, the expected total return from income and the appreciation of investments, other resources of the institution and the investment policy of the institution.

Q5: What happens if the current value of an endowment is below its original value?

Unless expressly provided for by the donor, there is no absolute requirement that the value of an endowment fund must never fall below its original value. The board is given considerable discretion in determining spending from an endowment, but it must always act prudently, taking into account the considerations listed in Q4 above. Over the long term, it is generally expected that a perpetual endowment fund should maintain its value, adjusted for inflation, but short-term deviations from this objective may sometimes be justified as "prudent," depending on the particular circumstances. It is important to keep in mind that private foundations must always comply with the 5-percent payout requirement imposed by federal tax law, even if distributions at that level would cause the endowment fund to fall below its target level.

Q6: How does the endowment spending policy relate to the 5-percent payout requirement for private foundations?

A private foundation must meet the 5-percent payout requirement that is imposed by federal tax law even if distributions at that level would cause the endowment fund to lose value or not meet its target value.

Note: The 5-percent payout requirement applies only to organizations that are private foundations.

Q7: How do "board-restricted" endowment funds differ from "donor-restricted" endowment funds?

If, at the time a contribution is made to a foundation, the donor restricts the type or manner of investing the assets of the gift, or restricts the time or manner of making distributions of earnings from the gift, such restrictions normally can be modified or eliminated only with the written consent of a living donor or pursuant to a court proceeding. This includes restrictions establishing the contribution as part of the permanent endowment funds of the foundation. Restrictions placed on assets of the foundation by its governing board, however, such as designating a portion of the foundation's assets as permanent or endowment funds, may usually be released or modified by resolution of the board acting alone.

Q8: Can the amount available for spending be determined by looking at the "unrestricted funds" column on a foundation's financial statement?

Generally, no. In most cases, financial accounting standards treat as unrestricted assets any portion of an endowment fund that exceeds the fund's historic dollar value. For legal purposes, this entire amount may or may not be available for current expenditure, depending on the board's determination of what is prudent.

Q9: Can endowment principal be used as a last resort if the foundation becomes insolvent?

Generally, no. Insolvency does not excuse a foundation from its obligation to maintain an endowment fund as such. As a general rule, the portion of an endowment fund that is not available for current spending is not available to creditors unless a court authorizes the expenditure based on certain extraordinary circumstances.

Q11: What responsibilities does the board have with respect to the endowment?

The governing board of a foundation is ultimately responsible for all aspects of the administration of an endowment fund, including its investment and determination of how much can be spent from year to year. In making these decisions, each board member must act in a manner he or she reasonably believes to be in the best interests of the foundation, and with the care of an ordinarily prudent person in a similar position under similar circumstances.