Why We Recommend a Board-Designated Reserve over an Endowment as a Tool for Nonprofit Sustainability
In the nonprofit world, we often hear about endowments as being the gold standard for nonprofit sustainability. And in a world where funding is rarely guaranteed and often capricious, sustainability is usually an ongoing concern. If we have an endowment, we think, then our organization is sure to be here forever.
But the truth is much more complex than that. At Nonprofit Finance Fund, we generally recommend that, where possible, organizations move away from donor-restricted endowments and towards board-designated reserves. Both support nonprofit sustainability, but a reserve provides near-term and mid-term flexibility and control as well. This blog post outlines in more detail some of the benefits of reserves and the drawbacks of endowments.
Reserves: Board-designated funds
Reserves are savings that mitigate risk for the organization – whether that be the risk inherent in your funding streams, the risk of trying something new, or the risk that something may go wrong with your building or equipment. All nonprofits need easily accessible reserves, but how much you need and what you use them for is different for every organization. There is no one-size-fits-all amount or type of reserve.
Reserves offer several advantages for nonprofits. First, they are fully under the organization’s control, meaning they are not restricted by a donor. If a reserve is “board-designated,” that means the board, in partnership with organizational leadership, determines the purpose, type, and use of the reserve via a written policy. The board can decide when management needs board approval to access the funds, as well as when to release and repurpose funds in times of need or emergency. This makes board-designated reserves more flexible than funds that are donor-restricted. In addition, reserves can reduce an organization’s reliance on working capital, lines of credit, and other loans from banks, which can be difficult to acquire and expensive to pay back.
Common types of reserves:
- Operating reserve: To protect the organization from short-term risk (e.g. lost funding, unexpected expense, leadership transition) or pursue opportunity. This is often a good first priority for organizations building reserves.
- Facilities reserve: To maintain fixed assets and pay for repairs and/or replacement (e.g. building, equipment, etc.)
- Strategic Opportunity or Innovation reserve: To take advantage of opportunities; to allow for experimentation, risk-taking, trial and error; to investigate a new program or approach
- Investment reserve: To generate revenue through investment vehicles like stocks. This type of reserve is most similar in purpose to an endowment, where the principal isn’t meant to be touched but the organization uses the interest earned.
Your board and leadership can name and define reserves for your organization in a way that best supports your mission and vision. In addition, it is possible to have a single reserve that can serve multiple purposes. For example, you could have an operating reserve that can also be used for research and development of new programs.
However, you should carefully define the criteria of the reserve and the amounts needed for different purposes. One aggregated reserve can give a false impression that your reserves are big enough to meet the full scope of your organization’s needs.
Reserves may be held as cash in a bank account, in savings, or in short-term investments that can be liquidated in a reasonable timeframe. This allows management to access the funds without penalty when the need arises. Typically, only an investment reserve is tied up in longer-term investments. Most reserves are intended to be replenished once they have been used. Information on where the reserve is held and how it should be replenished is typically included in the reserve policy set by leadership.
Endowment: Donor-restricted funds
A traditional endowment is composed of permanently restricted resources – intended by the donor to be kept in perpetuity. The goal of an endowment is typically to generate long-term investment income for an organization, because while the principal is restricted, the investment income usually is not. However, in order to generate a substantial amount of income, the endowment principal must be quite large. For example, a million-dollar endowment with an interest rate of 5% will only generate a yearly income of $50,000. If that organization needs more than $50,000, then they must look elsewhere.
Also, endowment funds are subject to laws designed to both maintain the principal balance and protect the original donor intent. Strict spending policies usually stipulate how the funding can be spent, or drawn down, over time. This greatly limits the fund’s ability to support the organization in times of need – or times of opportunity. If the organization runs low on cash to pay the bills, these funds cannot typically be used; to spend them anyway without the donor's consent is a violation that can be investigated or punished by the state Attorney General. Organizations with endowments but without other resources may appear wealthy on paper, but actually may be missing key flexible liquid resources.
In addition, endowments can be difficult to build and require ongoing investment management and expertise once built. Building and managing endowments can cannibalize other fundraising efforts or take energy away from mission and programs. And like all investments, many endowments are susceptible to market risk. During tough economic times and recessions, the principal of many endowments loses value and earnings are reduced, precisely when more funding might be needed by the organization to weather the storm.
It is possible to talk to the endowment donors to see if the funds can be released for other purposes. However, this is usually much more difficult than simply talking to one’s board, as one does with board-designated funds.
Some funders might believe that organizations with endowments are more stable and "mature" than counterparts without endowments. This might be true if the organization raises an endowment when it is truly ready – that is, when it has excess fundraising capacity and its short-term needs are already covered. But the mere act of undertaking an endowment campaign does not prove or guarantee financial health. And having board designated reserve can be an equally strong sign of maturity and stability while providing the added benefits of flexible and adaptable support.
In sum: the advantages of a board-designated reserve
Every nonprofit’s situation is different. However, in most cases, we recommend that nonprofits invest in sustainability through a board-designated reserve instead of an endowment for the following reasons.
- Board-designated reserves give the organization greater control over their money than endowments do. It is almost always simpler for a nonprofit to speak with their board about releasing money from a reserve than for a nonprofit to ask their donors to change the terms of an endowment.
- Board-designated reserves give nonprofits more liquid money than endowments do. While nonprofits with endowments can typically only spend the interest earned on the principal of the endowment, nonprofits can usually access the full amount of their board-designated reserves.
- Board-designated reserves can reduce nonprofits’ reliance on loans from banks. These loans can be difficult for nonprofits to find, especially in today’s uncertain economic climate. Instead of seeking a loan or line of credit with a high interest rate from a bank, nonprofits can use their reserves as an “internal line of credit” that’s more reliable and less expensive.
- Board-designated reserves allow nonprofits to respond quickly to needs and opportunities. Whether it’s responding to a crisis like the COVID-19 pandemic or investing in an opportunity like a new program or facility, reserves that are more easily accessible allow nonprofits to be flexible and responsive.
Reserves are just one of the types of capital that organizations need to thrive. Learn more about the different types of capital in our Full Cost video series.