A university endowment works by pooling donated money, investing it for the long haul, and paying out a small percentage each year to support the school’s operating budget. The principal is meant to last forever; the investment returns fund scholarships, faculty salaries, research, and buildings. Understanding how university endowments work means looking at four moving parts: where the money comes from and who controls it, how it gets invested, how much can be spent each year, and the state and federal rules that govern all of it.
What Counts as an Endowment
Not every dollar in a university’s investment pool is the same kind of dollar. Endowment assets divide into two broad categories based on who set the terms.
True endowments, sometimes called permanent endowments, come from outside donors who require that the original gift remain intact forever. Only the income the investment generates can be spent. Quasi-endowments are created by the university’s own governing board out of surplus revenue or unrestricted gifts. They function like permanent funds, but the board keeps the power to spend the principal whenever it decides the money is needed elsewhere.
Cutting across both categories is the question of donor intent. A restricted gift might require the income to fund a named faculty chair, support scholarships in a specific department, or maintain a particular building. Those terms are typically written into a gift agreement, and administrators are legally bound to follow them. Unrestricted endowment dollars give the institution room to cover emerging priorities or fill budget gaps. Most universities hold a mix of both.
Spending restricted dollars on something the donor didn’t authorize is a serious legal problem. The state attorney general has standing to investigate and pursue relief against directors who breach their fiduciary duties, and individual donors increasingly have grounds to enforce gift agreements themselves. Courts can order the university to restore the funds to their intended purpose, and if the misuse involved excessive compensation to insiders, the IRS can impose excise taxes on the individuals who received the excess benefit.
How the Money Gets Invested
Universities hire professional investment teams to build diversified portfolios that reach well beyond stocks and bonds. Large endowments put significant portions into alternative investments: private equity, venture capital, hedge funds, and direct real estate. The goal is to outpace inflation and preserve purchasing power across decades, which means accepting some illiquidity in exchange for higher expected returns.
That tilt toward alternatives has a real cost. Private equity and venture capital funds lock up capital for years and require universities to meet capital calls whenever the fund manager finds a deal. These unfunded commitments can strain a university’s cash position during market downturns. Analysis of Ivy League endowments has shown unfunded commitments averaging roughly a quarter of total private equity investments, creating liquidity constraints precisely when institutions most need flexibility.
The largest endowments run in-house investment offices with dedicated staff who can manage complex alternative portfolios directly. Smaller and mid-sized institutions often turn to an outsourced chief investment officer, where an external firm handles day-to-day decisions. Either way, the board keeps ultimate fiduciary responsibility. Outsourcing the technical work doesn’t outsource the legal obligation to oversee it, which means the board still has to review asset allocation, monitor performance, and confirm the investment policy is being followed.
How Much the University Can Spend Each Year
Endowments feed the operating budget through a defined spending rate. The average effective spending rate across U.S. higher education endowments was 4.8% in fiscal year 2024, and most institutions target somewhere between 4% and 5% of the endowment’s average market value. That percentage is calibrated to provide reliable annual revenue without slowly consuming the principal.
To keep budgets stable through volatile markets, universities apply smoothing formulas that average the endowment’s value over a rolling three-to-five-year window. Basing the payout on a multi-year average, rather than the current market value, prevents the school from slashing financial aid after a bad quarter or overspending after a bull run. Faculty salaries, scholarship packages, and research budgets all depend on that stability.
The underlying principle is intergenerational equity. Today’s students should benefit from the endowment, but not at the expense of students fifty years from now. Set the spending rate too high and the fund’s real value erodes; set it too low and current students don’t get the support donors intended. Getting that balance right is arguably the most important judgment call endowment managers make.
When a Fund Goes Underwater
An endowment fund is underwater when its current market value falls below the amount originally donated. That raises a hard question: can the university keep spending from a fund that has already lost money?
Before the Uniform Prudent Management of Institutional Funds Act (UPMIFA), many states enforced a rigid “historic dollar value” rule that prohibited any spending once a fund dipped below the original gift amount. UPMIFA eliminated that bright line. Institutions can continue spending from underwater funds so long as the decision is prudent, judged against the same factors used for any spending decision: the fund’s duration, the institution’s purposes, economic conditions, inflation, expected returns, other resources, and investment policy.
The flexibility has limits. Several states adopting UPMIFA included an optional provision creating a rebuttable presumption of imprudence when spending exceeds 7% of the fund’s value in a single year, calculated by averaging at least quarterly valuations over three years. It isn’t a hard cap, but spending above the threshold shifts the burden to the institution to justify the decision. Gift agreements can also impose their own limits that override UPMIFA entirely.
The Legal Rules Governing Endowment Managers
Nearly every state has adopted UPMIFA. Forty-nine states plus the District of Columbia use it as the baseline for how universities and other charities handle endowment assets. The core standard is that board members and investment committee members must act in good faith, with the care an ordinarily prudent person in a similar position would exercise under similar circumstances.
UPMIFA lists eight factors fiduciaries must weigh before making investment decisions: general economic conditions; the possible effect of inflation or deflation; expected tax consequences; the role each investment plays in the overall portfolio; expected total return; the institution’s other resources; the need to make distributions and preserve capital; and any special relationship an asset has to the institution’s mission. No single factor controls, and the law doesn’t assign fixed weights. But fiduciaries must at least consider all eight, and failing to do so can expose board members to personal liability.
UPMIFA’s duty of loyalty requires investment decisions to be made solely in the institution’s interest, not for the personal benefit of board members or their associates. In practice, universities maintain conflict of interest policies requiring annual disclosure of any financial relationship a board member has with investment firms, fund managers, or other entities doing business with the endowment. When a conflict exists, the affected member typically leaves the room during deliberations and abstains from voting.
State attorneys general are the primary public watchdog over charitable assets. Most states require charities to register and file annual financial reports with the AG’s office, and those filings can surface problems like excess compensation, self-dealing, or outright fraud. When violations turn up, the attorney general can investigate, negotiate settlement agreements requiring reforms, impose compliance monitoring, or in extreme cases seek dissolution of the nonprofit.
Changing a Donor’s Restrictions
Donor restrictions can outlive their usefulness. A scholarship restricted to a discipline the university no longer offers, or a fund tied to a demolished building, creates a legal problem that doesn’t solve itself. Two mechanisms exist for changing the terms.
The first is the cy pres doctrine, from the French for “as near as possible.” When a donor’s original purpose becomes impossible, impractical, unlawful, or wasteful to carry out, a court can redirect the funds to a purpose that reasonably approximates the donor’s original intent. The court doesn’t ask what would be most convenient for the university; it asks what the donor likely would have wanted given the changed circumstances. A prerequisite is showing that the donor had a general charitable intent, not just a narrow desire to fund one specific thing.
The second is a streamlined UPMIFA process for small, old funds. Under the uniform act’s default provision, an institution can release or modify a restriction without going to court if the fund is worth less than $25,000 and has existed for more than 20 years. The institution has to determine that the restriction has become unlawful, impractical, impossible, or wasteful, and must notify both the state attorney general and the donor if the donor can be found. Some states have adopted higher dollar thresholds.
Federal Taxes That Apply to Endowments
Universities generally operate as tax-exempt organizations, but several federal tax rules reach directly into endowment activity.
The 2025 Excise Tax on Large Endowments
The most significant change in endowment taxation takes effect for tax years beginning after December 31, 2025. The One Big Beautiful Bill Act of 2025 overhauled Section 4968 of the Internal Revenue Code, replacing the old flat 1.4% excise tax with a tiered structure that hits the wealthiest institutions much harder. The tax applies to private colleges and universities that had at least 3,000 tuition-paying students in the prior year, with more than half of those students located in the United States, and a student-adjusted endowment of at least $500,000 per student. State colleges and universities are exempt entirely.1Office of the Law Revision Counsel. 26 USC 4968 – Excise Tax Based on Investment Income of Private Colleges and Universities
The tiered rates are 1.4% of net investment income for institutions with a student-adjusted endowment between $500,000 and $750,000 per student, 4% for institutions between $750,001 and $2 million per student, and 8% for institutions above $2 million per student. The student-adjusted endowment equals the aggregate fair market value of the institution’s assets (excluding those used directly for its exempt purpose) at the end of the preceding tax year, divided by the total number of students.1Office of the Law Revision Counsel. 26 USC 4968 – Excise Tax Based on Investment Income of Private Colleges and Universities
Net investment income is calculated using rules similar to those for private foundations, with two additions. Interest income from student loans made by the institution or a related organization counts as gross investment income, and so does royalty income from intellectual property created with federal funding, even if the underlying work was done by students or faculty. Assets and income of related organizations are attributed to the institution as well, blocking universities from sheltering endowment assets in affiliated entities to duck the tax.2Office of the Law Revision Counsel. 26 US Code 4968 – Excise Tax Based on Investment Income of Private Colleges and Universities
Unrelated Business Income Tax
Tax-exempt universities owe federal income tax on revenue from activities that are regularly conducted and not substantially related to their educational mission. For endowments, the most common trigger is debt-financed investment property. Dividends, interest, rents, and royalties are usually excluded from this tax, but when the underlying investment was acquired or improved with borrowed money, a proportional share of the income becomes taxable. The taxable percentage equals the ratio of the average debt on the property to the property’s average adjusted basis during the year.3Internal Revenue Service. Publication 598, Tax on Unrelated Business Income of Exempt Organizations
Partnership investments create a similar exposure. If an endowment holds a stake in a partnership operating an unrelated business, the university must include its proportional share of that partnership’s income in unrelated business taxable income, as if it had run the business directly. S corporation stock is treated even more broadly: all income flowing through from an S corporation counts as unrelated business income regardless of its nature.3Internal Revenue Service. Publication 598, Tax on Unrelated Business Income of Exempt Organizations A partial safe harbor lets qualifying educational institutions acquire real estate with debt without triggering unrelated business income, provided the partnership holding the property meets specific structural requirements, including that all partners are qualified organizations and allocations have substantial economic effect.4Office of the Law Revision Counsel. 26 USC 514 – Unrelated Debt-Financed Income
Public Disclosure Through Form 990
Every tax-exempt university files IRS Form 990 annually and must make it available to the public for three years after the filing deadline.5Internal Revenue Service. Public Disclosure and Availability of Exempt Organization Returns and Applications Schedule D reports the endowment across five fiscal years, including beginning and ending balances, new contributions, investment earnings, grants and scholarships paid, and administrative expenses, and breaks the current balance into board-designated, permanent, and term endowment percentages.6Internal Revenue Service. Schedule D (Form 990) Schedule J discloses compensation for officers, directors, key employees, and the highest-paid staff, including base pay, bonuses, deferred compensation, and benefits, along with perks like first-class travel, housing, and club memberships. For endowment-heavy institutions, this is where the public can see what the chief investment officer earns.7Internal Revenue Service. Schedule J (Form 990)