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Surviving a Wild Ride

Riding out a bucking financial market, institutions are re-evaluating endowment spending rates and carefully scrutinizing budgets.

Catalyst for Change

By Kenneth E. Redd

Surviving a Wild RideUndoubtedly, business officers and endowment managers did not relish the unexpected jolt of a stock market in free fall for much of FY09. In the first nine months of the year—from July 2008 through March 2009—at the height of what some economists are now calling the Great Recession, the Standard and Poor's 500 index fell more than 46 percent. Then, in the final three months of FY09, as economic conditions appeared to stabilize, the S&P surged almost 37 percent. Despite the gain, the index was down roughly 26 percent for the full fiscal year.

The entire impact of these wild swings in market performance on college and university endowments won't be known until January 2010, when the results of the inaugural NACUBO-Commonfund Study of Endowments (NCSE) are available. However, it is already clear that deteriorating market conditions led to declining endowment values, upset plans for future endowment withdrawals, and contributed to steep budget cuts and other cost-cutting measures at many institutions. The effects of these uneven downdrafts and upswings in market conditions may be felt for years to come. In response, new patterns of operation could emerge as some colleges and universities explore what a more volatile marketplace means for longer-term institutional investment and spending decisions.

Riding Out a Midyear Plunge

Among the many casualties of the collapse of the equity markets were college and university endowments. In the first five months of FY09, endowments lost an average of 23 percent of their value, according to the 2008 NACUBO-Commonfund Endowment Study Follow-up Survey. Collectively, institutional endowments are estimated to have lost more than $94 billion in value during the period of July 1 to Nov. 30, 2008.

This rapid decline hit some independent colleges and universities particularly hard because of their concerns about liquidity. At Spelman College in Atlanta, for instance, preliminary data suggest the endowment, valued at about $351 million at the start of FY09, had a –20 percent investment return in the first nine months of the fiscal year. “Public market holdings are down, and the asset allocation weights have shifted, putting more weight on private equity, venture capital, and other illiquid assets; and liquidity issues are becoming more prevalent at Spelman and other institutions,” explains Robert D. “Danny” Flanigan, Spelman's vice president for business and financial affairs and treasurer.

Even independent institutions that did not experience immediate liquidity issues had to adopt more conservative investment policies during the year. “We are certainly more defensive now,” says Karen Goldstein, vice president for business and finance at Davidson College, Davidson, North Carolina. Davidson's $500 million endowment had an unofficial investment return of –25 percent in FY09. Despite this loss, Goldstein adds, “We believe that we have made the changes to our portfolio that should protect us more as we move forward in this environment. We are lucky that we do not have any particular difficulties with liquidity, though we are watching it carefully.”

For four-year public institutions, the drop-off in endowment value came at the same time many state appropriations for higher education were dramatically cut. At the University of Virginia (UVA) in Charlottesville, early estimates show the $4.6 billion endowment suffered a –20 percent investment return in FY09, according to Vice President and Chief Financial Officer Yoke San Reynolds. In addition to endowment losses, the university learned that its state appropriation could be reduced by up to $19 million, on top of the $32 million permanent reduction in state funds since October 2007.

Community colleges also saw investment declines. The $186 million endowment of Florida's Miami Dade College did perform 8 to 12 percentage points better than the S&P 500, according to E.H. Levering, senior vice provost for business affairs and chief financial officer. Still, this equates to an investment return of approximately –18 percent in FY09.

Equalizing Withdrawal and Budget Decisions

In addition to steep losses in endowment values, a second—and probably longer-lasting—impact of the recession and related market declines has been the swaying effects on annual endowment withdrawals and institutional budgets. On average, institutions that participated in the 2008 NACUBO Endowment Study withdrew about 4.6 percent of their endowment's market value to support spending on financial aid and other programs. In FY08, the average endowment dollar withdrawal generated more than $15 million for colleges and universities, which equates to about 11 percent of their annual total operating revenue.

New This Year: NACUBO-Commonfund Study of Endowments

In 2009, NACUBO began a new partnership with Commonfund Institute to conduct the NACUBO-Commonfund Study of Endowments (NCSE). This new survey project combines the traditional NACUBO Endowment Study with the Commonfund Benchmarks Study of Educational Endowments. The 2009 survey, conducted from August through October, examined endowment performance and other issues during FY09. The data were collected through an online survey and representative telephone interviews.

In addition to endowment investment performance, asset allocation, and market values, the NCSE will include new sections on endowment and institutional finance data, such as portfolio rebalancing, debt load, policies and responses to the current economic and investing environment, and responses to new American Institute of Certified Public Accountants guidelines. Data from the new study will be released at the 2010 NACUBO Endowment Management Forum (see sidebar for details). As in past years, all institutions and foundations that participate in the study will receive complimentary access to the final report.

For some institutions, the decline in endowment value had an immediate impact on their planned endowment withdrawals and spending rates. Results from the NACUBO-Commonfund Follow-up Survey suggest that 27 percent of institutions planned to reduce their endowment withdrawals in FY09 to compensate for the unexpectedly sharp drop in market values.

At most institutions, however, endowment withdrawal amounts and spending rates for FY09 were less volatile than the wild changes in the market might otherwise have suggested. For instance, in spring 2008, UVA raised its endowment spending rate from the prior year's 4.5 percent of market value to 5 percent in order to begin funding priorities that had been identified in the recently completed strategic academic plan. This action increased the university's dependence on the endowment distribution from 7 percent of operating revenue in FY08 to 8 percent in FY09.

When the drastic decline in market value became apparent in the fall of 2008, UVA reviewed that decision. “We looked at the changes in circumstances very carefully and recommended to our board that we not change the dollar distribution for FY09, even though this decision would lead to an increase in the percentage of spending relative to a lower market value,” says Reynolds. “Given the extraordinary budget cuts in state appropriations and the accumulated capital appreciation in our endowment, we did not want to cut endowment distributions immediately as well. We tried to avoid disrupting programs funded by our endowment, but we did provide notice that we expected a lower distribution for FY10.”

Davidson College kept its endowment spending rate stable despite FY09 losses. “Our endowment payout normally covers approximately 22 percent of our operating revenue, and it did the same in FY09,” says Goldstein.

Spelman's Flanigan points out that for his and many other institutions the discipline of spending rules and other “smoothing” policies would negate the need to make immediate changes to endowment withdrawal rates. Spelman College typically draws about 18 percent of its operating revenue from its endowment, a percentage that remained unchanged in FY09, notes Flanigan.

Rebalancing Expectations

While endowment spending rates for FY09 were essentially unchanged at most institutions, planned spending rates and withdrawal amounts for FY10 are another story. Carleton College, Northfield, Minnesota, will see lower overall payout from its endowment during the current fiscal year. Income from Carleton's endowment, valued at $648 million at the start of FY09, typically funds 26 percent of institutional operations. However, due in part to the endowment's estimated –16 percent investment return in FY09, projected endowment withdrawals for FY10 and beyond have been reduced.

As Frederick Rogers, Carleton's vice president and treasurer, explains: “The normal spending policy would allow for an increase in spending for FY10, but due to our longer-term forecasts, the FY10 budgeted draw is lower than what was drawn for FY09.”

Spelman College will also have a reduced endowment draw in 2010, and Flanigan anticipates that leadership will re-examine the college's endowment spending rule.

Lower endowment draws and other reductions in revenue have caused some independent institutions to take drastic measures to keep their budgets in balance. For Carleton College, the measures are particularly painful for faculty and staff. Wages have been frozen for FY10, says Rogers. “All faculty and staff may be required to take a one-week unpaid furlough during the fiscal year, and the college's contribution to retirement accounts for all faculty and staff may be reduced by 2 percent,” he adds.

Plan Now to Attend the 2010 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 27–29, 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, risk management, and dynamic effects of the economy and financial markets.

Speakers include campus experts and financial and investment authorities on the major markets. Findings of the 2009 NACUBO-Commonfund Study of Endowments will be presented. The forum provides time for participating in discussion, asking questions, meeting the experts, and networking with colleagues from around the country.

The program provides a balanced perspective on the investment management world. Learn about operational issues, market direction, and 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. Register or find more information here about this and other programs, or call 800.462.4916.

Budget cuts at Spelman College were also difficult. In addition to lost revenue from its endowment, Spelman saw declines in contributions from private foundations and other donors, losses in revenue from other sources, and lower student enrollments. “We have reduced programs and restructured some personnel work schedules,” including converting some 12-month employees to 10-month employees, says Flanigan.

While Davidson will draw the same proportion (5 percent averaged over five years) from its endowment in FY10 as it did for FY09, budgeted expenses will be reduced by 3 percent, since the 5 percent draw will represent fewer dollars, notes Goldstein. The budget situation at Davidson is not as grim as at other independent institutions, however. “While we cut our budgets for FY09 by 2.5 percent and instituted a hiring freeze in November 2008, our fundraising has surpassed our original goal,” says Goldstein. “We did not lay off any employees or cut any benefits, and most of the staff who left the college were eventually replaced.”

Like many large public institutions, Reynolds notes, UVA will continue to try to use its endowment draw to enhance academic quality in ways that cannot otherwise be achieved during this time of declining state appropriations. However, UVA still plans to adhere to its current spending policy, which calls for an increase in endowment draw to cover inflation as long as the end result falls within a range of 4–6 percent of market value.

“I believe that by limiting our FY10 draw to, at most, 6 percent of market value, we can provide a draw that would be lower than the FY09 distribution but still higher than our FY08 draw-and not create severe hardship for our units,” says Reynolds. “Units will have had the higher FY09 draw for only one year, and have been advised to plan on the FY10 draw being about 85 percent of the FY09 draw.” Still, Reynolds notes that the FY10 draw would be the second-highest endowment dollar distribution in UVA's history.

Seeking a Steady State for Financial Aid

Institutionally funded student financial aid is one budget item that endowment managers and other college and university officials have vowed to protect from the budget ax. As Goldstein explains, “Because of the financial crisis, we have seen greater financial need on the part of Davidson students, and thus we will face larger financial aid bills than in the past.” Despite this higher expense for student aid, Davidson intends to fully fund the Davidson Trust, a program established in 2007 that covers all eligible students' financial needs with grants and work study and no loans, says Goldstein. “We have the funds to cover those extra expenses, but we will need to keep raising funds for future financial aid costs.”

UVA and Carleton College likewise share a firm goal to meet the financial needs of their students. “We are committed to our need-based AccessUVa program,” says Reynolds. AccessUVa offers loan-free financial aid packages for low-income students, caps on need-based loans for all other students, and a commitment to meet the full financial need of every student at UVA eligible for financial aid. “We will use cost savings in other areas to make up for the decreased draws of approximately $1.3 million from endowments that provide need-based grants,” notes Reynolds.

Rogers claims that financial aid will not be affected by Carleton's planned budget reductions. However, the college has made specific changes to reduce ongoing operating costs and has delayed a planned decrease in enrollment to get its student population down to normal levels after having admitted a larger-than-expected freshman class in 2005.

Like all other high-priority budget items, the continuing ability of university officials to fund further increases in financial aid programs will depend in large measure on a turnaround in endowment performance. The concern from some managers is that the recent recovery has thus far not been large enough to generate sufficient income to cover the needs of more students. As Goldstein explains, “Our concern is not for FY10, but rather, for three to five years out, since we believe that the endowment will not recover quickly and financial aid costs will continue to rise.”

Even community colleges could have trouble funding financial aid programs weakened by the economic slowdown and endowment losses. “At Miami Dade College,” says Levering, “the lack of state matching funds for scholarship donations will impact institutional financial aid in two to three years if not funded within that time frame.”

Riding the Upswing

Goldstein and others are concerned that, despite their recent rise, stock prices and college and university endowment values still have a long way to go to reach prerecession levels. In addition, most economists anticipate that the economic recovery will be quite slow, as many expect unemployment to continue to rise and income growth to remain low.

Public institutions in particular may be hard-pressed to preserve their state appropriations. At press time, a monthly update by the Center on Budget and Policy Priorities reported that in at least a dozen states, FY10 budgets that went into effect on July 1, 2009, had already gone into the red. In addition, more than 30 states were already projecting deficits for FY11.

Nonetheless, several endowment managers have begun to position their portfolios for a hopeful continuation of the upward trend that the stock market provided in the latter part of FY09. “Whatever economic conditions we may experience, the contraction in private capital markets has created a more attractive investment environment,” says Rogers. “We have not materially altered our long-term investment strategy in response to the crisis, but we have taken the opportunity to invest with managers we believe are well positioned to exploit the values created by scarcity of capital.”

Like many other institutions, Davidson College has used the economic crisis to rethink budget-setting strategies and priorities going forward. “The financial crisis has allowed us the opportunity to look at all our budgets more thoroughly and will lead, I believe, to some permanent changes, but more in our planning and budgeting processes than in permanent cuts in any particular area,” says Goldstein. “We will be establishing processes that allow closer reviews of many budgets to make sure that we are being as efficient and effective as possible.”

While the Great Recession shows signs of abating, it is likely that the stock market and the broader economy will continue to buck college and university endowment managers in an uneven, unpredictable series of ups and downs. The message for all is to hold the reins firm to keep from being thrown from the saddle.

KENNETH E. REDD is director, research and policy analysis, for NACUBO.