An excerpt from Linking Mission to Money

Chapter 15 pp. 66-67 "A Cautionary Note about Endowments"

The actual performance and value of endowments is widely misunderstood. Endowments are usually seen as the ultimate protection for a nonprofit. While endowments are certainly valuable, I believe they are overemphasized as a source of stability. Endowments have ups and downs related to the ups and downs in the investment markets. Most organizations seek to limit these year to year changes by basing their endowment draws on a percentage of the three-year moving average of the market value of the endowment, which will change more slowly from year to year. This policy is very helpful; however, it cannot completely eliminate substantial year to year changes in the value of the annual endowment draw.

The presumption that endowments provide stability is based on the assumptions that the endowment will remain strong when the nonprofit's other revenue sources may decline and that the three-year moving average draw policy will eliminate volatility. The experience of the 2001-2002 recession demonstrated the fallacy of these assumptions. Just as revenues, government support, and private donations were falling, nonprofits saw their endowments plummet sharply enough to cause major changes in the three-year moving average. The result was that the endowment draw dropped sharply and became yet another leg slipping out from under the nonprofits. Similarly, during the latter half of the 1990s, endowments were showing stunning growth at the same time that the other sources of nonprofit support were also growing. Many nonprofits responded by increasing their spending rate, expanding their programs, or presuming that endowments would be able to reliably support a larger portion of their services.

Stability is supported by having resources that move in opposite directions, especially with respect to the economy. The economy moves in up and down cycles, which are often called recessions and recoveries. Activities that move up when the economy moves up and which move down when the economy declines are called "procyclical." In contrast, activities that move up when the economy slows or move down when the economy expands are called "countercyclical." Stability is provided when a nonprofit has a mix of revenues that are distributed among procyclical and countercyclical sources so that declining revenue sources are offset by rising revenue sources regardless of where one is in the economic cycle. Ideally, the nonprofits' expenses will show a similar blend of procyclical and countercyclical expenses.

Unfortunately, especially for nonprofits in higher education and social services, their expenses tend to be countercyclical and their revenues procyclical, meaning that expenses rise and revenues fall when the economy sours. That makes it even more important for the nonprofit to have countercyclical revenues that can increase by enough to support these rising expenses and offset falling revenues during economic downturns. Without that balance, nonprofits get a double whammy: their expenses and demand for their services rise during a recession at the same time that many of their revenues dry up.

Endowment policy can increase or reduce the inherent cyclicality of endowment income and the board should pay careful attention to its investment policy and its effect on the cyclicality of its endowment. Key elements of policy include rules on the "draw" of income each year, the "asset allocation" of how the endowment is invested across different types of investments, the "target rate of return" for the investment portfolio, and the "investment risk" the nonprofit is willing to take to earn that rate of return. When the economy is strong and the investment markets are rising, there can be a temptation to amend the endowment policy to allow higher draws, to permit more aggressive asset allocations, to seek higher rates of return, and to permit higher levels of risk. These amendments can undermine the very stability the endowment is intended to provide. Remember, stability means not just to minimize declines, it also means to rein in the horse when it begins to race ahead!

The endowment is always a very tempting pot of money to tap to expand services. That temptation is strongest when the endowment doesn't appear so necessary, most often during economic expansions. How can one deny a needed expense when millions of dollars are sitting in an endowment fund? When economic expansions occur, the board needs to remind itself that its fiduciary duty is to sustain services during recessions. That duty may require actually reducing the draw, moving to a more conservative asset allocation, reducing the target rate of return, and reducing the amount of investment risk. Remember, long term sustainability requires surpluses during economic expansion that are set aside to internally finance deficits during economic contractions. Make sure your endowment sets aside more, not less, during those expansions.