How Do University Endowments Work? (2024)

University endowments are comprised of money or other financial assets that are donated to academic institutions. They have a specific legal structure that is intended to indefinitely perpetuate a pool of investments for a specific purpose. University endowments work by act as a self-sustaining source of funding by intentionally not paying out the entire fund balance.

Understanding University Endowments

Charitable donations are the primary source of funds for endowments. Endowment funds support the teaching, research, and public service missions of colleges and universities.

Typically, endowment funds follow a fairly strictset of long-term guidelines that dictate the asset allocation that will yield the targeted returnwithout taking on too much risk.

In the case of endowment funds for academic institutions, the income generated is intended to finance a portion of the operating or capital requirements of the institution. In addition to a general university endowment fund, institutions may also maintain a number of restricted endowments that are intended to fund specific areas within the institution, including professorships, scholarships, and fellowships.

Sometimes, colleges and universities pool together many individual endowments into a single investment fund which allows for a consistent investment approach. In this way, a university endowment may resemble a mutual fund.

Some endowment funds have guidelines statinghow much of each year's investment income can be spent. For many universities, this amount is approximately 5% of the endowment's total asset value. Some elite institutions, such as Harvard, have endowments that are worth billions of dollars, so this 5% amount can end up equaling a large sum of money. In the context of the U.S. higher educational system, the presence of endowment funds are often integral to the financial health of educational institutions.

History of University Endowments

In general, an endowment is a donation of money or property to a non-profit organization, which uses the resulting investment income for a specific purpose. An endowment can also refer to the total of a non-profit institution's investable assets which is meant to be used for operations or programs that are consistent with the wishes of the donor. Most endowments are designed to keep the principal amount intact while using the investment income for charitable efforts.

The Roman emperor and Stoic philosopher Marcus Aurelius established thefirst recorded endowed professorships in Athens in A.D. 176. He created one endowed professorship for each of the major schools of philosophy at that time. Later, more educational endowments were created at different schools throughout the Roman empire.

The practice of endowing professorships officially began in the modernEuropean university systemin England in approximately 1502. The Countess of Richmond (and grandmother to the future King Henry VIII, Lady Margaret Beaufort, created the first endowed professorships in divinity at Oxford and Cambridge University. Then later, in approximately 1550,King HenryVIII also established endowed professorships at both universities in five different subjects: divinity, civil law, Hebrew, Greek, and physic.

University Endowments Today

In the modern era, endowment donors can sometimes restrict how the schools spend this money with an investment policy statement (ISP). For example, donors can decide to use a portion of an endowment's scheduled income on a merit-based or need-based scholarship. Another standard restrictive use of an endowment's income is to provide funding for endowed professorships.

Other than these restrictions, universities can use the rest of the allotted spending amount as standard income. Decisions about whether it should be spent on hiring professors, upgrading/repairing facilities, or funding more scholarships are typically left up to school administrators. An endowment's investment income can also significantly lowertuition costs for students.

For example, if a university's endowment yields a total of $150 million and has a 5% spending limit, this would provide $7.5 million of available income. If the university had originally budgeted $5.5 million in endowment funds, this would mean that the excess $2 million could be used to pay other debts/expenses; ultimately, the savings could be passed on to institution's enrolled students.

However, because universities depend on investment returns for supplementary income, there could be trouble if the investments do not yield a suitable amount of returns. Therefore, most endowments are run by professionals to ensure the investments made are in line with the aforementioned policy allocation.

Types of Endowments

There are four different types of endowments: unrestricted, term, quasiand restricted.

1. Term endowments usually stipulate that only after a period of time or a certain event can the principal be expended.
2. Unrestricted endowments are assets that can be spent, saved, invested, and distributed at the discretion of the institution receiving the gift.
3. A quasi-endowment is a donation by an individual or institution,givenwith the intent of having that fund serve a specific purpose. The principal is typically retained while the earnings are expended or distributed per specifications of the donor. These endowments are usually started by the institutions that benefit from them via internal transfers or by using unrestricted endowments already given to the institution.
4. Restricted endowments have their principal held in perpetuity, while the earnings from the invested assets are expended per the donor’s specification.

Except in a few circ*mstances, the terms of these endowments cannot be violated. Drawing down the corpus of the endowment to pay debts or operating expenses is known as "invading" or "endowment invasion." However, there are some instances where it may be legally allowed. If an institution is near bankruptcyor has declared bankruptcy–butstill has assets in endowments–a court can issue adoctrine of cy-prèsthat allows the institution to use those assets towardbetter financial health (permitting they are still honoring the wishes of the donor as closely as possible).

Criticisms of Endowments

Harvard University and other elite higher educational institutions have, at times, come under criticism for the size of their endowments. Critics have questioned the utility of large, multi-billion-dollar endowments, likening it to hoarding, especially as tuition costs began rising at the end of the 20th century.

Large endowments had been thought of as rainy-day funds for educational institutions, but during the 2008 recession, many endowments cut their payouts. Researchers have looked closely at the incentives behind this behavior and found that there has been a trend toward an overemphasis on the health of an endowment rather than the institution as a whole.

It’s not unusual for student activists to look with a critical eye at where their colleges and universities invest their endowments. In 1977, Hampshire College divested from South African investments in protest of apartheid, a move that a large number of educational institutions in the United States followed.

Advocating for divestment from industries and countries that students find morally compromising is still commonamong student activists; more recently, the act of divestment has evolvedand become a more efficient and effective practice.

Limitations of University Endowments

The criticism of endowments do bring light to some of the limitations of university endowments. For example, the way university endowments work is to accumulate funds based on donor restrictions. These restrictions limit the flexibility of institutions in responding to evolving needs or unforeseen emergencies, as the funds are earmarked for designated purposes. There are legal and accounting implications to following these rules.

Endowments are susceptible to market volatility since the funds are invested. Therefore, they can go up and down in value. Though endowments are expected to not necessarily decrease in value, they can if investments go awry. Universities must also be mindful of excessive spending, as it is possible (and allowable) to spend down an endowment. You'll note this in some figures below related to Harvard's 2022 and 2023 endowment values.

On a related note, endowment spending faces the risk of erosion due to inflation if investment returns do not outpace inflation rates over time. A core premise in finance is that a dollar today is worth more than a dollar in the future because you can generate income and growth from the dollar today. With an endowment, universities simply sit on much of the cash, meaning they lose purchasing power when investment growth does not keep up with inflation.

The Bottom Line

Endowments are funds or assets donated to universities (or other institutions) to provide ongoing financial support. These assets are typically invested, and the returns are used to fulfill the organization's mission or support specific programs in perpetuity. However, there's usually limitations to endowments, and they may be a little controversial.