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Business Officer Magazine

Perpetual Notion

Endowment managers look for spending rates that can ensure support for their institutions forever. Funding “for today” versus “in perpetuity” requires a fine balance, something the public wants to help determine.

By Matt Hamill

In fact, such scrutiny began by necessity when the first endowment gifts were made to institutions of higher education more than three centuries ago. While the earliest managers of endowments faced a significantly different investment landscape, they still had to wrestle with some of the same fundamental spending questions that institutions grapple with today—namely, how best to balance current and future demands for endowment resources.

The Strategies of Spending

Don’t Miss the 2009 Endowment Management Forum

Learn about investment management issues and trends in higher education endowment management from top industry experts at NACUBO’s Endowment Management Forum, January 28–30, in New York City. Developed and presented by veterans in the field of college and university endowment management, the forum focuses on asset allocation, diversification of investments, and risk management, as well as the dynamic effects of the economy and financial markets on institutional endowments.

Speakers include campus experts and financial and investment authorities on the major markets. Findings of the 2008 NACUBO Endowment Study will be presented. The forum provides time for participating in discussion, asking questions, meeting the experts, and networking with colleagues from around the country.

This program provides a balanced perspective on the investment management world. Learn about operational issues, market direction, and the impact of regulatory and legislative actions. Discuss current issues, including working with investment committees and investment consultants and managers.

The forum is designed for chief financial officers, treasurers, senior investment officers, trustees, foundation officers, and professional endowment fund managers. To register, or for more information on this and other programs, go to or call 800.462.4916.

Of course, the management of endowment spending is inextricably linked to understanding the purpose of endowments: to financially support the institution, or some specific aspect of it, in perpetuity. Managing assets in perpetuity places colleges and universities in a relatively unique position. Virtually no other category of institutional investor has a similar investment horizon, and there are similarly few other organizations that must design and manage a spending policy that supports this objective.

Managing both for perpetuity and for the short term holds inherent tension and complications. To help guide these decisions, colleges and universities have generally adopted the theory of intergenerational equity as a framework.

Intergenerational equity refers to the concept that tomorrow’s students (as well as faculty and programs supported by the endowment) should benefit from the endowment to the same degree that today’s students do. In essence, this means that an endowment’s value to today’s generation is the same as the inflation-adjusted value for future generations. It is this concept that led Nobel Prize–winning economist James Tobin to observe that “the trustees of endowed institutions are the guardians of the future against the claims of the present.”

Posing the fundamental question of whether current endowment spending rates were consistent with the notion of intergenerational equity, public scrutiny of endowments ramped up in 2007 and has not subsided since. Members of Congress, media representatives, and others have taken a higher level of interest in spending policies and rates. After several years of strong endowment investment returns and the seemingly inevitable upward movement of posted tuition prices, questions about the role of endowments, how they support institutions (with a particular focus on student aid), and whether colleges and universities were spending quickly enough reshaped
the public debate.

The Public’s Opinion

An early hearing before the Senate Finance Committee on September 26, 2007, offered several skeptics an opportunity to make their case. Jane Gravelle, an economist with the Congressional Research Service, a division of the Library of Congress, observed that the amount of foregone revenue from not taxing endowment income “is larger than the total tax expenditure for charitable giving to education.”

Lynne Munson with the Center for College Affordability and Productivity said: “Our colleges and universities are sitting on some of the largest fortunes amassed by any institutions in the history of our nation … but this wealth is being hoarded instead of shared.”

News and editorial coverage have raised similar concerns. One commentary that appeared in the Daily Iowan earlier this year suggested that “university officials should dip into the cookie jar and offer its cash-strapped students a much needed Oreo.”

Concepts such as intergenerational equity and managing assets in perpetuity are somewhat foreign in the U.S. political system. Yet, policymakers are responsible for the policies that guide many endowment management decisions and allow endowments to be created and strengthened. These policies fall into two broad categories: (1) those that shape the oversight and public understanding of endowments through the establishment of fiduciary duties, reporting requirements, and public disclosure; and (2) those that provide financial benefits to endowments and the donors who support them.

Setting aside any real or perceived relationship between endowments and tuition levels, the increasing number of institutions with endowments and the large volume of assets held in those endowments have led some policymakers to conclude that new or more rigorous policy positions are warranted. The focus of this scrutiny primarily has been on the level of endowment spending, but it has also manifested itself in discussions about endowment investment decisions and whether, and to what extent, speculative investing has contributed to price spikes in certain commodities, particularly oil.

This newfound willingness to rethink the policy framework that has guided the development of college and university endowments for many years has led to a broader and more sustained dialogue between college and university leaders and their elected and appointed representatives. The public scrutiny of endowments and the increased dialogue about college and university endowments is here to stay.

Within this context, how might institutional leaders think about the multiple factors influencing institutional budgeting and adopt endowment-spending policies that incorporate both long-term endowment goals and institutional needs? To what extent should the role of long-term investment returns guide spending practices? Similarly, with the unique blend of expenses that drive institutional budgets, what about the effects of higher education inflation?

The Backdrop for Spending Decisions

The demand for higher education has continued to increase. Almost 4.5 million more students are taking classes on college and university campuses today than there were two decades ago. Yet, colleges and universities routinely face a variety of financial challenges. Among these challenges are increasing operating costs, growing expectations from students for additional services, legislative pressures on public institutions, and the ebb and flow of public resources to support student and research activities.

For most colleges and universities, the primary source of new revenues is tuition. During the past decade, revenue from tuition has increased faster than other revenue sources at most institutions, except at private research universities. At public institutions, tuition revenue has grown faster than state and local appropriations, which have not kept pace with enrollment growth and inflation.

The challenge of securing stable revenue inflows and balancing competing financial demands for core academic programs and new services has never been greater. Revenue streams from an endowment can stabilize a portion of institutional revenue, but for most institutions, endowment income is a relatively small fraction of total revenue, limiting their ability to smooth out revenue peaks and valleys.

Investment policies, endowment spending rates, and reinvestment decisions must all be made in a holistic fashion. In today’s legal and investment environment, investment officers at institutions of higher education manage their endowments with a keen eye on total return. In the long history of endowment management, this is a relatively recent phenomenon. The legal framework guiding endowment management for several centuries essentially limited spending to interest and dividend income, and endowments increased through the combination of appreciation and new gifts.

In a total-return environment, managing the connection between investment and spending policies requires a more sophisticated and nuanced understanding of capital markets and institutional needs. Actively managing institutional investing and spending policies side by side allows institutional leaders to maximize opportunities for stable spending growth to support critical academic programs and student services while also increasing endowment market value sufficiently to keep pace with rising costs. This side-by-side strategy can also facilitate an institutional focus on the uncertainties of both future investment returns and future demands on endowment resources.

The Evolution of Spending Rules and Rates

Like its predecessors, the 2007 NACUBO Endowment Study compared institutional spending rules. Largely gone are the rules that frame annual spending in the context of current income. The most common rule continues to call for spending a prespecified percentage of the moving average of endowment market value. This rule “smoothes out” annual spending from the endowment, which is a desirable goal.

It also results in relatively lower spending rates when strong investment returns drive endowment values up, and conversely, higher spending rates when investment returns are weak and endowment values decline. In other words, the most common spending rule yields a more predictable and reliable dollar contribution from the endowment year after year at the same time that it generates a more volatile annual spending rate.

According to the study, endowment spending policies, expressed as a percent of market value at the beginning of the year, generated a median spending rate for FY07 of 4.6 percent. The table summarizes spending rates from FY98 through FY07. The data show that endowment spending rates varied within a band of approximately one-half of one percent during this time period. The data suggest that the desired smoothing effect of institutional spending rules is working more or less as intended.

Spending rates in the decade prior to 1998 are not directly comparable to this table due to different data collection and reporting protocols in earlier endowment studies. However, as a general matter, the prior 10 years were marked by slightly lower average spending rates and a slightly wider range of average rates. For independent institutions during this period (1997–1988), spending rates generally fell within a range of 4.2 to 4.9 percent, while public institutions reported spending rates ranging from 3.4 to 4.7 percent.

The Adjustment for Inflation

To effectively gauge whether an institution is appropriately balancing the contribution that an endowment makes today and well into the future, institutional leaders must keep a sharp eye on the changes in the purchasing power of endowment resources. While the Consumer Price Index was developed to track such changes across the broad economy, the goods and services used to calculate changes to the CPI do not always correlate to those purchased by colleges and universities.

Since 1961, an alternative measure has been used that is designed specifically for institutions of higher education. Now maintained by the Commonfund Institute, the Higher Education Price Index (HEPI) is calculated using an array of goods and services commonly purchased by colleges and universities, including a substantial weighting to reflect changes in labor costs. As a result, HEPI is generally viewed to be a more accurate measure of price movements in higher education.

Higher education leaders must understand their institutional inflation factors and cost drivers and how they shape what investment income should be reinvested in the endowment to preserve future purchasing power. All other things being equal, higher rates of educational inflation make it increasingly difficult to maintain a spending policy that protects the endowment against erosion of real value.

Of course, high rates of spending can have the same effect. Using the theory of intergenerational equity, strong weight would be given to developing a reinvestment policy—akin to an institutional spending policy—to track the effects of higher education inflation and ensure that the proper amounts of investment income are reinvested in the endowment to better offset long-term erosion of endowment value.

No Single Spending Solution

Experiences across institutions suggest that there is no single correct approach to managing endowment investment and spending policies. Institutional policies must accommodate differing market conditions and institutional spending requirements, including those imposed by donors when making endowment gifts. Some institutions have had success relying on relatively fixed rules and practices to determine their spending policies. However, active management during periods of strong and weak endowment performance is likely to result in a more carefully balanced outcome between meeting current needs and ensuring the capacity to adequately respond to anticipated future requirements.

Active management of these key components of endowments also supports a greater understanding of the role of the endowment within the institution as a whole and an enhanced ability to engage in broader public debate about endowment policies and practices. Endowments have rather rapidly emerged in both the public consciousness and policy debates in Washington and state capitols across the country. It is incumbent on higher education to better explain how these resources are appropriately used to support the educational, research, and service missions of our institutions, as well as the perpetual role that endowments play in institutional finance.

MATT HAMILL is senior vice president, advocacy and issue analysis, at NACUBO