In recent years, a number of factors have converged that make it more important than ever for many nonprofits to take steps to increase the size of their endowments and, in some cases, replace significant amounts that were lost during the Great Recession.
While many charities have substantially recovered the value of their endowments and now approach pre-crash levels, the Great Recession has had a sobering impact on those who manage endowments. In some cases, spending rates have also been lowered in the wake of recent investment experience.
For example, suppose the board of an institution with a $10 million endowment that was spending 5 percent, or $500,000, per year prior to 2008 decides to decrease the spending rate to 4 percent. To keep spending at $500,000, the endowment must increase to $12.25 million. If that endowment had lost $4 million in market downturns, then it must grow by over 100 percent to equal pre-Recession endowment spending. As a result of these realities, some charities were forced to encroach on unrestricted reserve funds during the past few years to balance budgets. This course of action isn’t sustainable, and for that reason and others, many charities are now embarking on campaigns designed to help rebuild their endowments.
The need to rebuild endowments isn’t unique in the history of non-profit funding. For example, there’s evidence that in the wake of the financial panic of 1908, charities shifted their fundraising focus to endowment development. The 1908 annual report of Texas Christian University states:
Endowment is the key word to the campaign. Resting awhile from brick and mortar, it is purposed to concentrate on obtaining an impregnable financial backing as the surest guarantee, not only for permanency, but for the highest grade of work as well.
Unfortunately, many donors now find themselves in the same financial position as their charitable interests. Many suffered numbing investment losses between 2008 and 2010, and, while they may have substantially recovered their asset values, many remain wary of future financial conditions when considering large charitable commitments.
Many wealthy individuals are, understandably, more reluctant than in the past to transfer large sums of cash and other assets during their lifetime to charitable interests to be held as part of their endowment/reserve funds. Exceptions to this trend may be those who are willing to fund scholarships, research, professorships and other restricted endowments.
In today’s environment, some older donors who, in the past, may have made significant endowment gifts during lifetime for unrestricted future needs are more reluctant to do so for the reasons outlined above. In other cases, donors may have significant amounts of capital tied up in closely held business interests, real estate, long-term speculative investments and investment portfolios that are professionally managed by their advisors.
These donors may only be willing to fund endowments through estate gifts because they believe their funds will grow more during their lifetime if they remain invested in a business they own or under more aggressive management of their investments by their fund managers. This reticence is understandable and often leads to a point in a relationship with a donor in which the charity must reluctantly accept a commitment to fund a bequest or other gift at death, while forgoing the economic benefit of a donor’s gift during lifetime.
To respond to such donors’ concerns, nonprofits have developed various methods of structuring endowment gifts that provide current benefits to the eventual charitable recipient. For example, during the recession of the early 1990s, some nonprofits developed what came to be termed as a “virtual endowment” or “flexible endowment.”
The idea of working with a donor to structure a gift that will take place in the future, while providing current benefits to the charity, isn’t altogether new. For example, when the University of Chicago was embarking on its initial funding campaign in 1890, gifts were accepted that could be paid off at any time during the 5-year term of the campaign, but for those pledges that weren’t paid before the end of the campaign, the unpaid amount bore annual interest at 6 percent.
A “Virtual” Solution
Borrowing from this historical precedent, under the terms of a virtual endowment, a donor makes an endowment commitment today, but agrees to make a specified amount of funds available for charitable use prior to completing their gift. I was privileged to work in the mid-1990s with the legendary fundraiser David Dunlop and others at Cornell University, during the creation of early prototypes of this type of gift vehicle.
For example, one donor was a relatively young individual who wanted to make a $5 million gift to a Cornell University capital campaign. At the time, nearly all of the donor’s net worth was tied up in a business that he’d founded and expected to take public within a few years.
The donor expressed a desire to make the gift commitment to endow a fund for a purpose he wished to support, but he didn’t foresee being able to fully fund his gift until he sold his business. The university worked closely with the donor and his advisors to find a way to accommodate both the needs of the institution and the donor’s financial situation.
It was decided to announce the funding of a $5 million endowment on the execution of a legally binding pledge for $5 million. The pledge would be paid at a future date of the donor’s choosing, but would be backed by a bequest commitment that would serve to fund any outstanding amount at the donor’s death if the pledge wasn’t fully paid at that time.
The initial commitment is termed the “applicable” amount. As a component of the pledge agreement, the donor agreed to make a payment each year equal to the university’s “spend rate” on its endowment. This amount, known as the “applicable percentage,” was the basis of an annual payment equal to the applicable percentage as applied to the applicable amount.
The term “virtual endowment” reflects the fact that the gift commitment over time mirrors the endowment in the same way as if it were already part of that endowment. For example, if the university endowment grew during the year, the original applicable amount would be adjusted by the growth factor. The new applicable amount would be the base against which the applicable percentage would be applied the following year.
For example, if the university endowment earned a total return of 8 percent and spent 4 percent, then the donor would make a payment of $200,000 for the current year, and the pledge amount would be indexed by the 4 percent growth factor to 5.2 million. This would be the applicable amount for the following year. If the spend rate (applicable percentage) remained at 4 percent, the donor would make a payment of $208,000 the following year. When the donor sells his business, he doesn’t make a payment of the original $5 million commitment, but rather the applicable amount, as adjusted for endowment performance between the time his pledge was made and the time it was fulfilled.
Any growth or income beyond that earned by the university endowment accrues to the benefit of the donor, in effect, substituting the donor’s risk tolerance for that of endowment managers who may be bound by fiduciary duty to take a less aggressive approach to managing investments, especially in light of lessons learned in recent years regarding the risk of more speculative and non-traditional endowment investments.
In addition to meeting the needs of donors with illiquid assets, the use of a virtual endowment can also help others who wish to keep control of their assets and invest them for what they believe, over time, will be higher returns.
Others may enjoy managing their assets in retirement years and not be ready to give up that pursuit. Instead of paying the applicable amount at the sale of a business or other liquidity event, they may instead only complete their gift in later years when they’re ready to relinquish control of the assets. If they’ve created more wealth at that point than the endowment they’re tracking, they may choose to give more than the required payoff amount.
This concept has also come to be applied to older donors making significant bequest commitments, who may wish to see an endowment commitment announced during their lifetime. In this case, a donor may make a commitment through an estate gift of a particular amount with the proviso that the donor will make payments to the charity each year equal to the spend rate of the university endowment, as applied to the future bequest commitment.
Take the case of an older donor who would like to create a $1 million endowment fund through a bequest. If the current endowment spend rate is 4 percent, he agrees to make a current gift of $40,000 using part of a mandatory retirement fund withdrawal and fund the balance from his retirement assets at death. In this way, the donor can start his endowment during lifetime with knowledge that he has access to underlying funds for the remainder of his life, if needed.
A donor could also make partial payments and, over time, “accelerate” all or a portion of the bequest, should that become feasible prior to his demise.
A flexible endowment is a variation on the underlying theme. In a flexible endowment, the payoff amounts may, for example, be indexed to a consumer price index or other cost-of-living indices or not indexed at all. In some cases, the payments may be revocable for a period of time, while the donor observes how the funds are used before deciding whether to make a permanent commitment. In the latter case, the gift may not be publicly announced until it’s no longer revocable.
A donor may also fund a charitable remainder trust or other split-interest trust that will fund the endowment at the end of her lifetime, while using all or a portion of the payments from the trust to satisfy the current gift portion of the commitment.
Wave of the Future?
In today’s environment, with many of the largest gifts coming from an aging 1 percent of the population, lower returns on investments and an uncertain future, the virtual endowment may be the ideal solution for some donors.
In February 2010, the Chronicle of Higher Education reported that Cornell University was one of a few leading universities that actually raised more money in the depths of the Great Recession in 2009 than it had in prior years. The concept of virtual endowments was credited as playing a major part in this success. As stated in the article:
. . . when donors were unable to give major endowment gifts, Cornell’s president asked them if they would be willing to make cash gifts equal to what their intended donations would have paid out from the endowment that year. Almost 200 donors ‘bridged’ their intended gifts in that way, a strategy that helped Cornell increase its annual fund in both dollars and numbers of donors.1
While most endowments will continue to grow through traditional gifts completed during lifetime and through estate gifts, the concepts of the virtual and flexible endowments may hold special appeal in today’s complex environment. For those working with clients considering significant gifts for endowment purposes, a virtual or flexible endowment may offer a way for them to make a gift that may not have otherwise been possible.
1. Kathryn Masterson, “Private Giving to Colleges Dropped Sharply in 2009,” http://chronicle.com/article/Private-Giving-to-Colleges/63879.