Endowments represent money or other financial assets that are donated to universities or colleges and are meant to be invested to grow the principal and provide additional income for future investing and expenditures. Typically, endowment funds follow a fairly strict set of long-term guidelines dictating the asset allocation that will yield the targeted return without taking on too much risk.
Most endowments have guidelines stating how much of each year's investment income can be spent. For many universities, this amount is about 5% of the endowment's total asset value. Because some of the more coveted schools, such as Harvard, have endowments worth billions of dollars, this 5% can equal a large sum of money. (For related reading, see: Top 5 Largest University Endowments.)
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, which are used to attract world-class educators.
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 is left up to school administrators. An endowment's investment income can also significantly lower tuition 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 and the savings could be passed on to 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.
(For related reading, see: How to Invest Like an Endowment.)