It's every charity's dream to have enough money to pursue its mission without the need for constant fundraising activity. Given how hard it is to solicit donations, win grants, and collect money from activities like bake sales and car washes, it's easy to understand how those who work for charities might wish they could dispense with fundraising and turn their full attention toward fulfilling their charitable purposes.

For charities that are starting out, just collecting enough money to cover ongoing expenses is a big challenge. However, once they get past their growing pains and have a solid base of regular contributors and volunteers, many charities turn their attention to the future by creating a permanent endowment fund. Setting up an endowment allows a charity to put aside money for long-range planning and ensures ongoing support for the charity's operations.

How permanent endowment funds work
In contrast to a charity's general fund, which finances the typical day-to-day operational expenses of the charity, a permanent endowment fund is intended to provide the charity with an ongoing source of support in the future. Donations to the endowment are accounted for separately from regular charitable donations, and the endowment fund is sometimes established as a separate legal entity from the charity itself. While a charity often uses donations it receives for whatever immediate needs it may have, funds that are donated to an endowment must remain within the endowment, subject to its terms and conditions.

In order to establish a permanent endowment fund, a charity's board of directors must prepare and adopt a board resolution. The board must come up with policies and procedures for soliciting and accepting donations to the endowment, as well as guidelines for investing the endowment assets in an appropriate manner. Depending on the size of the charity, the board may consult its own members who happen to be financial professionals or may seek outside guidance for doing what is necessary to develop these initial policies and to put them into action. For the most part, endowment funds can accept any type of gift, including cash, appreciated stock, and more complicated planned gifts. So if potential donors want to give low-basis shares of long-term holdings like DuPont (NYSE:DD) or AT&T (NYSE:T) in order to avoid large capital gains taxes, the endowment should be able to accept them.

Most endowments provide for regular distributions to their associated charity. However, these distributions are usually limited either to the amount of income generated by the endowment fund or to a small percentage of the fund's assets. By restricting the flow of money out of the endowment, the charity and its donors can be certain that the bulk of the endowment's principal will remain intact and continue to generate income for the charity far into the future. In addition, because the distribution limitations mean that most of the endowment's assets will be held for the long term, the endowment can invest the bulk of its funds in investments with longer time horizons, which can potentially increase return and lead to a more prosperous future for the charity.

All sizes and shapes
Within the universe of endowment funds, you can find small funds and gargantuan funds. According to a study by the National Association of College and University Business Officers, the top 20 universities in the United States had combined endowments exceeding $140 billion as of the middle of 2005. Harvard headed the list with over $25 billion in assets. Even with just modest returns, it's clear that many major educational institutions earn millions of dollars just from investment income on these huge principal balances.

On the other hand, an endowment doesn't have to be large in order to be effective. Just having an endowment fund established helps charities think more ambitiously, as the fund draws attention away from the everyday challenges of keeping the charity going and instead makes people think about the future and strategic opportunities that may lie ahead. In the same way that a personal retirement fund builds over time through new contributions and investment income, a charity's endowment fund can grow as well.

Attractive to donors
Not only can endowment funds help charities expand their horizons, but they also may be attractive to donors. Increasingly, donors are more careful about monitoring and overseeing how charitable gifts are actually used. Some donors are interested not just in helping the immediate needs of their community but also in building a legacy for themselves and their families that will last well into the future. For these donors, gifts to an endowment fund fit their goals more closely and ensure that the charity thinks in the same manner as the donor.

Furthermore, having an endowment facilitates certain types of planned gifts that many wealthy donors prefer. For instance, the successful use of charitable gift annuities, which involve making an immediate gift to charity in exchange for a stream of payments back to the donor or another beneficiary, depends on whether the charity has enough funds in the future to make the required annuity payments. If donors make such gifts into an endowment fund, they can be more comfortable that the ongoing existence of the endowment will provide enough money to cover the annuity payments. Similarly, gifts that the charity won't receive until some later time, such as will bequests or payments from charitable remainder trusts, may be better suited for endowment funds, as large one-time lump-sum payments from such arrangements may overwhelm a charity's regular budget and mislead board members and other interested people into developing unrealistic expectations of the charity's donation revenue in the future.

In the same way that opening an investment account or buying your first mutual fund may signify your arrival at a new stage in your financial development, establishing a permanent endowment fund can be a major milestone in the history of a charitable organization. By putting aside money to grow and generate income for ongoing needs, charities demonstrate their ability to think beyond today's demands and desires and instead focus on the good work they can do for decades and generations to come.

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Fool contributor Dan Caplinger enjoys his work with charities and their endowments. He doesn't own shares of any of the companies mentioned in this article. AT&T is a former Stock Advisor pick. The Fool's disclosure policy is here for the long-term.