Raising money only the beginning of managing nonprofit endowment

Published in the January 26, 2007 edition of Columbus Business First

One of my most spirited workshops discusses the uses and abuses of endowments in sustaining a nonprofit’s mission. It is easy to be seduced by the potential benefits of endowment: It provides a supplement to current income and it can contribute to greater stability in a nonprofit’s overall financial health. 

Unfortunately, I find too many nonprofit trustees and executives approach endowment as a goal rather than as a tool that must be used carefully and knowledgeably. Tools can be misused and be a cause of volatility rather than sustainability in a nonprofit’s mission.

Denison University is an example of endowment causing volatility. Denison shuns traditional investment in stocks and bonds in favor of venture capital and hedge funds. It also follows the unusual policy of distributing a sizable portion of current investment income rather than following the conventional three-year-moving-average approach.

When the markets peaked in 2001, volatility followed and Denison faced double-digit declines in its endowment and the income distributed to operations. Denison continues its aggressive approach, but as of June 2005 its consolidated endowment pool had just reached $478 million compared with its peak of $527 million in fall 2000.

Borrowers beware

More recently, the Milwaukee Public Museum got into trouble by “borrowing” money from its endowment to sustain spending and cover operating deficits. This practice led to criminal charges that may put the museum’s chief financial officer in prison for 24 years if convicted, even though the criminal complaint notes “he did not profit personally from his actions.” By the way, half the staff lost their jobs and two-thirds of the board members have been replaced.

Far from horror stories ,these examples reflect two, albeit extreme, approaches to the dilemmas of how to invest and spend endowments. No one wants to be labeled a rube for failing to follow high-flying stock markets or hedge funds. And few have the courage to cut spending when operating budgets are tight and everyone can see the endowment just sitting there. Rather, everyone hopes financial crises are short-lived so temporary “borrowing” from the endowment seems prudent. 

Verne Sedlacek, my former colleague at Harvard Management Co. and now CEO at Commonfund, recently wrote a thoughtful essay on the dilemmas of how to invest and spend from endowments. He reminds us there are three goals that guide modern endowment management:

• Maintaining intergenerational equity by assuring the inflation-adjusted value of the endowment does not decrease.

• Maintaining real spending power in the short term by adjusting spending rates (the percent of endowment withdrawn each year to support operations) for annual inflation.

• Maintaining stability year to year in the level of endowment spending.

No one has yet figured out how to achieve all three. As this column discussed last month, the last two goals usually lose out to the intergenerational goal.

Sedlacek offers three ways to reduce this conflict.

First is asset allocation. This familiar tool requires little discussion. Identifying a mix of assets that provide adequate growth within a tolerable range of year-to-year volatility can support all three goals. 

Interestingly, extensive simulation work at Commonfund suggests most nonprofits have at best a 50-50 chance of maintaining intergenerational equity using the common mixes of stocks and bonds and the conventional 5 percent annual withdrawal of endowment to support operations.

Different approaches

Second and most surprising is the continuing need for annual fundraising for the endowment. Sedlacek notes “gifts are a highly positive factor that increase the likelihood of achieving intergenerational equity, enable a nonprofit to spend more for present operations, and reduce the volatility of spending.” He goes on to report Commonfund research has found “one-half the dollar increase in the average market value of endowment funds came from gifts and one-half from retained investment return.” 

He quickly notes the gifts must be current and unrestricted; restricted and deferred gifts do not deliver the same benefit. This finding is ironic and runs counter to much of the current emphasis in philanthropy on restricted and deferred giving. 

Furthermore, it highlights that once a nonprofit diverts some of its annual fundraising toward endowment, it must continue to do so in perpetuity if it is to address the three goals above. 

Third, Sedlacek finds the conventional three-year moving average approach to calculating the annual withdrawal from the endowment is an inferior way to achieve our three goals. He advocates two other approaches, which he calls banded inflation and hybrid spending. 

Banded inflation increases the annual dollar amount withdrawn from the endowment by the rate of annual inflation; however, in no case can the withdrawal go above or below a specific percentage (or band) of the endowment’s value.

The hybrid method combines annual inflation and annual investment return by calculating the annual increase or decrease in endowment withdrawal as 0.7 times the inflation rate and 0.3 times the change in the value of the endowment.

Getting stability and sustainability from an endowment is complicated and hard to achieve. A superficial approach to raising and managing an endowment can make the three goals of endowment elusive and mislead trustees that the effort is supporting the nonprofit as a reliable provider to an important community need. 

If your nonprofit is ready to consider raising an endowment, start doing your homework now. 

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 2007. Reprinted with permission, Business First of Columbus Inc.