0.13 Chapter ten: the complexities of nonprofit financing  (Page 7/10)

Endowment management

The importance of endowment to the Society's long-term financial viability makes the events of the past twenty-five years especially tragic. In 1969, the market value of the Society's unrestricted endowment was $15.7 million, a figure 21.5 times larger than that year's total operating expenditures. Investment proceeds from the endowment exceeded the Society's total operating expenditures. Even if the Society had not generated a single dollar of contributed or earned income, it would have had an operating surplus.

By 1989, the Society's endowment base had been almost totally eradicated. Nominal endowment had fallen to just $5.5 million, $1 million less than that year's annual total expenditures. Whereas investment income accounted for 91 percent of total revenues in 1969, it represented just 13 percent of the total in 1989. Obvi­ously, the magnitude of this decline has the most profound implications for the Society. Documenting the causes of that decline offers a classic illustration of the complex and sometimes confusing issues that endowed institutions face as they strive to balance the need for current income with the desire to protect the real value of their endowments over time.

The growth of an endowment depends on three primary elements: invest­ment performance, the addition of capital gifts, and the amount of investment income spent on operations or otherwise drawn down. Before addressing the Society's experience in each of these categories, it is helpful first to summarize briefly some basic principles of endowment management.

Total return

The return on a capital investment has two fundamental components. The first component, the current return or yield, usually comes in the form of dividends and interest and can be spent without affecting the nominal value of the capital base that generated it. The second component, capital appreciation, is not fun­gible unless some part of the underlying capital asset is liquidated. Selling units of capital generates realized gains or losses, which are the difference between the sell­ing price and the price at which each unit of the capital in question was purchased (or if a gift, the market value at the time it was received).

In the 1960s, most institutions, including the Society, operated under the as­sumption that it was inappropriate to "invade" the principal of the endowment by spending realized capital gains. Only dividends and interest generated by the port­folio could be spent. As operating costs rose, so did pressure to generate more current spendable income. For many institutions, maximizing current yield became their investment managers' primary objective. This emphasis on current returns led many managers to sacrifice the long-term growth of their investment capital.

In 1967, the Society adopted a "total return" investment policy for its en­dowment. The primary objective of this policy is to maximize the total return on the portfolio, independent of whether that return comes in the form of interest, dividends, or gains from capital appreciation. A total return approach is based on the premise that the decision regarding how much of the total return should be spent in a given year can and should be separated from the decision about what assets the portfolio should be invested in.