An endowment may be something your nonprofit cannot yet afford

Published in the December 8, 2006 edition of Columbus Business First

Nonprofits are caught in the crossfire of a weak economy and rising costs. This has created budget pressures that some think can be relieved by building an endowment.

At the extreme, endowment is held out as a silver bullet that will ensure the financial stability of a nonprofit. This is a dangerous misconception. If not approached carefully, shifting fundraising efforts toward accumulation of endowment has the potential to seriously weaken and destabilize a nonprofit.

An endowment is a concept that is unique to nonprofits and foundations. Endowment is a sizable pool of money that is set aside in perpetuity. Only the investment income of the endowment, but never the original principal, can be used to support the operations of the nonprofit. The idea is for a nonprofit to save for the future by making part of its assets unavailable, regardless of current need.

But this unavailability, and its consequences on current financial health, place nonprofits in stark contrast to for-profit businesses, which have complete access to all their assets to grow and support operations in good times and in bad.

Prior to considering shifting fundraising efforts toward building an endowment, it is important that nonprofit executives and trustees understand these facts:

• Endowment practice requires the future be provided for before the present. It is a misconception to believe newly raised endowment will be a source of near-term operating support.

The underlying principle of modern endowment management is that the primary fiduciary responsibility of the board of trustees is to preserve the future buying power of every endowment gift.

This obligation means the first dollar of investment income must be reinvested to cover future anticipated inflation so that the inflation-adjusted buying power of the endowment principal is never reduced. Only after this future inflation is financed can one take money out to support current operations. As a result, endowments must grow before one can use any money to support current services.

• One can guarantee to future generations stable annual endowment spending or a stable value of the endowment, but not both. It is a misconception to believe both goals can be achieved – and stable spending is usually the loser.

Overall, when endowments plunged along with the stock market early in this decade, endowment spending was reduced. Even nonprofits with sizable endowments made this choice, a result of the tension between operating needs and fiduciary obligations.

In a poor investment year, for example, one cannot spend and reinvest the same amounts as in the previous year. If one is to remain at the same amount, the other must decrease.

Though the nonprofit’s operating staff wants inflation-adjusted spending to remain the same, the board, as trustees of the endowment and its donors, prefer the inflation-adjusted value of the endowment stay the same. It was no surprise, therefore, that many nonprofits’ spending rates were reduced to preserve the endowment’s value, weakening rather than stabilizing their current operations.

• Raising endowment shifts resources from the present to the future. Can your organization afford this shift?

The decision to raise an endowment is a decision to focus some current fundraising on building a nest egg – albeit a very restricted one – that is highly unlikely to support or stabilize service delivery in the next five years. The previous points have already made it clear the impact of the year-to-year volatility of the investment markets falls most harshly on current operations.

This greater exposure to investment volatility, combined with a shift of resources toward the future, creates a potential vulnerability that a nonprofit must carefully consider.

It’s true that it is easier to set aside a nest egg for the future if you are wealthy than if you are poor. A nonprofit must first ask itself, therefore, whether its financial health for the next five years is secure enough to be able to shift some of today’s resources toward providing for service delivery 50 years from now. Nonprofits that are blessed with strong support from endowment are benefiting from a choice made decades ago – and are lucky that choice did not fatally destabilize them in the intervening years.

Your primary obligation as a nonprofit manager is to be a reliable provider of a service that fulfills a useful need in the community. Because of this, your first duty is to ensure your reliability for the next five years before you begin to worry about being reliable 50 years from now.

Do you have sufficient current revenue to produce operating surpluses or repay your debt? Do you have sufficient cash reserves to stabilize your spending from year to year? Do you have money set aside for predictable major replacement expenses, such as computers, roofs, vehicles and building systems?

Only if you have answered yes to all three questions may raising an endowment be the right next step in your financial plan.

Allen J. Proctor was chief financial officer of Harvard University and is the author of “Linking Mission to Money, Finance for Nonprofit Board Members.”  www.proctorconsulting.org

Copyright 2006. Reprinted with permission, Business First of Columbus Inc.