July 19, 2009
How Should Universities React to the Decline in Their Endowments?
How Should Universities React to the Decline in Their Endowments? Becker
The values of most university endowments have taken large hits during this financial crisis. The average decline since the real estate and stock market crashes began is probably over 20%, while the value of some endowments dropped by much more than that. Universities reacted to this severe shock with panic, and they often reduced their spending by too much. I say "by too much" not because of any confidence that stock markets and real estate will return any time soon to their peak values. This is highly unlikely for real estate, and dubious for stock markets. My reason for objecting to large cuts in university spending is that they have usually under spent relative to their endowments. The philosophy behind these spending rates is that universities should not live off of capital, so that they can pass their capital intact on to future students and faculty. In order to preserve endowment values for the future, universities have tried to spend from their endowments only the income yielded, including capital gains, adjusted for year-to-year fluctuations in returns, and for other risks. On average, they have spent between 4% and 6% of their endowments. This philosophy has not been implemented, if by not living off capital is meant that endowment values would be held rather constant in the long run. For endowments at all the major universities, and many other schools as well, have grown at very good rates during the past 40 years rather than being maintained intact. For example, Harvard's endowment increased many fold from 1960 to its peak at well over $30 billion in the fall of 2008. The University of Chicago was much less successful in its investment and gift-raising strategies than Harvard, but even the value of Chicago's endowment more than trebled from 1960 to its peak in 2008. University spending has been too little to maintain endowment values constant partly because the annual return on their endowments has been underestimated, and partly because of large annual gifts from alumni and foundations that raised endowments. These gifts were especially big during the past decade as stocks soared, and as financial executives and others received generous bonuses and stock options, but they have not been negligible even during more normal times. If we conservatively assume that gifts double endowments over 40 years, than in order to account for gifts and maintain endowment values, schools should spend 1 ¾ percent of their endowments in addition to the total incomes yielded by the endowment. Since incomes have averaged over long time periods at about 5-6% of endowments, the additional spending that would tend to keep endowments constant would raise endowment spending by more than one third. This means a very a large increase in total spending for schools like Harvard that get a big fraction of their annual revenue from endowment income. The percentage increase in spending would be significant but smaller for schools like Chicago that are less well endowed, and get a larger fraction of their revenue from tuition and grants. More fundamentally, the argument that universities should try to maintain a constant, or "sustainable", endowment value is flawed and not compelling for reasons similar to the criticisms of proposals to maintain an economy's capital over time to achieve "sustainable" economic development. Why should schools aim to maintain endowments constant when even aside from private gifts, endowment income provides only a fraction of their annual revenue? Moreover, technological improvements in the efficiency of spending, by schools, such as more effective use of internet learning, may allow smaller endowments in the future to achieve as much in educating students and conducting research as larger endowments do now. Another reason for spending more out of endowments than the income yielded is that effective spending on training of students and research, and often also spending on sports, are frequently productive in stimulating greater gifts and governmental grants. For example, schools that produce pioneering research, or that attract able and ambitious students who go on to achieve great success, tend to get larger amounts of foundation and other gifts through the favorable publicity they receive. In effect, spending is productive not only in raising student and faculty achievements, but also indirectly in inducing greater gifts that can lead to even greater accomplishments in the future. In recent years members of Congress have proposed forcing universities to spend a larger fraction of their endowments, so that endowments do not increase as rapidly as in the past. It would not be wise for Congress to get involved in university spending rates, but for the reasons I have given, it is in the self-interest of well-run universities to spend at much higher levels than they have been doing during the past several decades.
The Drop in University Endowments and What to Do about It--Posner
College and university endowments have taken a big hit from the drop in the stock market and other asset markets. A drop of 20 to 30 percent is common, and there is suspicion that endowments that contain a significant proportion of assets that are not traded on organized markets, such as real estate, have dropped even more, but without "marking to market" their nonfinancial assets.
The effect of a drop in the market value of endowment on a college's or university's finances depends on a variety of factors. I will give a hypothetical example that may help in understanding the issue. Suppose X College has an endowment that before the crash had a market value of $1 billion. In normal times X cashes 5 percent of the endowment each year to contribute to X's budget, 5 percent being a widely used estimate of the average real return of a typical university investment portfolio. Suppose X's total annual budget is $200 million, with a quarter contributed by the income on the endowment (5 percent of $1 billion = $50 million), a quarter by alumni gifts (apart from gifts intended to become part of the endowment), and a half by tuition. In the economic downturn, I'm assuming, the endowment has fallen by 30 percent, to $700 million; tuition net of financial aid has dropped by 5 percent (because of inability of parents to pay tuition, as a result of declines in their income and wealth); and alumni gifts have (for the same reason) fallen by 10 percent. Then College X's income will have declined by 12.5 percent, from $200 million to $175 million, assuming the college continues to treat 5 percent of the (shrunken) endowment as income.
What should X do (other than expelling its suddenly impecunious students and replacing them with affluent ones of less academic promise)? The typical response has been to cut spending by the amount of the drop in income: in my example, that would require X to reduce its spending by 12.5 percent, which it can do in various ways, the usual ones being laying off staff, freezing hiring of faculty and staff, delaying construction, deferring maintenance, reducing staff salaries, and curtailing extracurricular activities.
At first glance, this seems a puzzling response. Why all this dislocation, instead of either spending capital (that is, taking more than 5 percent out of the endowment) or borrowing? Take borrowing first. Unless a dollar is worth less to College X this year than it will be next year (or whenever its income returns to its normal level), why should it spend less when it can spend the same, with modest effect on future spending, by borrowing (in my example, $25 million)? Lending and borrowing are methods by which the marginal utility of income can be equalized across time when total income varies from year to year. Harvard is borrowing more than $2.5 billion, but it is still cutting its budget by 10 percent.
Similarly, although "spending capital" is a familiar example of improvidence, it can make perfectly good sense. In my example, College X is short only $25 million, and if it takes that out of the endowment, the endowment will fall only from $700 million to $675 million. A problem may be that donors of endowment money may have placed limitations on spending, fearing that a gift that they intended to be perpetual would be eaten up if X dipped into the principal of the gift. But not all endowment money is restricted in this way and trustees of trust funds usually have authority to dip into principal in the event of an emergency. However, X may fear that if it does that it will discourage future contributions to the endowment.
Given that last concern, borrowing seems the superior alternative to spending capital, and yet most colleges and universities seem reluctant to use borrowing to fill the entire gap between income and expenditure; otherwise they wouldn't be cutting spending. Granted, credit remains tight, but the elite universities, at least, are fiscally sound and have alumni in positions of influence in the credit industry.
Maybe the reason the colleges and universities are not borrowing more is that they do not expect their income to recover in the foreseeable future. Nonelite colleges depend heavily on state aid, which is likely to be meager for a number of years--state budgets are in terrible shape. And they draw students from the segment of the population that has been hardest hit by the economic downturn. Elite colleges and universities depend heavily on federal research grants, which may diminish as the government tries desperately to control the rapidly mounting national debt, and on donations by wealthy alumni. Many of those alumni have suffered a permanent reduction in their wealth, and many others are facing the increasingly likely prospect of having to pay higher income taxes, which will make it more difficult for them to pay their kids' tuition. Elite universities may have to limit tuition if they want to attract the best students.
A protracted economic crisis has different effects on different industries, because different industries have different vulnerabilities. The current crisis is speeding newspapers, and print media more broadly, to an early grave, and may yet destroy all three Detroit automobile manufacturers. It will not do in the colleges and universities, but it may have a lingering adverse effect on them that may explain and justify immediate measures to reduce expenditures.