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Endowments: New Questions in the New Normal

What stakeholders really want to know
University Business, December 2012

The financial crisis is in the past, more or less, and campuses are looking ahead to a new era for their endowments. But what does this mean? Four years on, we’ve come to grips with the changes wrought by the September 2008 market crash. Finance departments are revising their theories and boards of trustees are revising their expectations under what has been called the “new normal”—a time of low stock market returns, low interest rates, and low growth in personal income.

The heart of the university may be the students and alumni, and the soul may be the faculty, but the bones are the funds that support them. It takes money to operate a university now and in the years to come. Permanent endowment capital helps keep the campus experience consistent through generations, supports growth, and serves as a source of funds should the institution become stressed.

These permanent funds have growing importance in the here-and-now. Cuts in state aid and difficulty in raising tuition mean that more institutions need to raise endowment funds.

The size of the endowment is a function of investment performance, spending, fundraising, and inflation, explains Ann Bennett Spence, managing director of Cambridge Associates in Boston. All these factors are influenced by choices on campus, except inflation. For the fiscal year ending June 2011, the mean annual rate of return on American college endowments was 19.2 percent, according to the NACUBO-Commonfund Study of Endowments.

How should that money be raised? How should it be invested? And how should it be spent? Questions that were easy to answer in good times are a little tougher to address now.

For the university staff and trustees, the endowment is a source of income to support current projects, and the endowment’s growth will help the entire institution grow. From year to year, though, the relationships between investing, spending, and fundraising will change. “Every university and college has its own endowment with its own role,” says Spence.

But one thing is certain: All higher ed institutions have a lot of stakeholders, including students, parents, alumni, neighbors, faculty, administrators, and staff working at all levels of the institution. Here are some of the things they may well be wondering about endowments but haven’t asked.

Why do you need endowment funds?

This seems like an obvious question. Campuses need endowment money to support the institution into perpetuity. However, many state-supported institutions had operated on the assumption that their permanent capital would be provided by the state taxpayers, so endowment fundraising was not a priority. Now, these campuses have to make their case.

“The finances of state universities have dramatically changed in the last 10 years,” says Steve Relyea, vice chancellor of external and business affairs at the University of California, San Diego. “The reduction in institutional funding from the State of California has been massive.”

In other words, endowment fundraising has gone from being a nice thing to do if a donor is interested to being critical to the future health of the campus. Few on the UC San Diego campus ever expected cuts of the magnitude they have experienced; only 6.5 percent of the university’s funds now come from the state. In addition, the university receives considerable research funding and student support from the federal government, and that may be cut.

UC San Diego is one of many public universities launching a strategic planning process and fundraising campaign to raise funds to accommodate this change. “The people that are closest to us understand it. They get a sense of what has changed so dramatically on our campus,” Relyea says. “Everyone associated with this institution wants to work at one of the world’s great research institutions.”

Unlike state funding, though, donors often don’t want to support administration. They prefer to see their money used for students, research, and buildings. “They want something that’s a little more substantial,” says Robert Iosue, retired president of York College of Pennsylvania and author of Fun and Games on Campus and How College Presidents Earn Their Big Dollars (CreateSpace, 2012). Staffing the bursar’s office isn’t nearly as enticing a proposition as funding students or faculty.

A handful of campuses, including Rollins College (Fla.) and Skidmore College (N.Y.), have been able to entice donors to fund endowed administrator positions within such key departments as community engagement and advancement, as well as at campus museums.

Iosue dealt with the problem in part by paying close attention to how money was spent rather than how it was raised. This helped funds go further, and he noticed that careful spending actually attracted donors. “Donors are the people who have the means to donate. They know what it takes to make a buck,” he says, adding that they liked knowing their donations would be well spent.

How do you decide how to spend the money?

When an institution raises endowment funds, the money is usually to support a specific purpose in perpetuity: a scholarship; a research area; a particular school or program. A gift to create a program in Eastern European literature or to support a deserving chemistry major can’t be used for something else. The exception is when the program is obsolete and the gift terms allow for another use.

Furthermore, only the money that comes from investment returns should be spent; the initial amounts donated should be preserved. These limits make endowment policies complicated. “I’m not sure the broader community understands the interplay between spending restrictions and purpose restrictions,” says Elizabeth M. Mills, attorney in the health and nonprofit practice at the Chicago office of Proskauer Rose LLP.

The spending rule determines how much of an endowment’s net assets are spent, but not necessarily how it is spent within the context of the campus as a whole. Education, research, and production of artistic works cost money. That’s a given. “Much depends on your business model and what you project in your expenses,” Spence says, including the mix of revenues from tuition, annual fundraising, endowment, and government support.

It is legally possible to spend nothing from the endowment, and it may be considered imprudent to spend more than the long-run inflation-adjusted return.

In 2010, the state legislature in New York passed a revision to the Uniform Prudent Management of Institutional Funds Act, which is designed to protect endowment funds in the wake of the financial crisis. Although the law applies only to institutions based in New York State, it raises questions about how spending rules should be developed. Many boards and their legal advisors are thinking of NYPMIFA’s requirements when they assess their budgets because of the emphasis on process, explains Mills.

That being said, NYPMIFA does have one hard-and-fast rule: In most cases, the law says that spending of more than seven percent of net assets should be considered imprudent unless evidence is presented to the contrary. And, in fact, the average endowment posted an annualized return of 5.6 percent over the last 10 years. A seven-percent spending rate would have reduced principal in this period.

Campus funds structured as foundations need to spend at least five percent of funds each year to maintain tax-exempt status. The endowment structure, which is more common, comes with no spending requirements, but it does call for funds to be managed for perpetuity. It is legally possible to spend nothing from the endowment, and, as NYPMIFA indicates, it may be considered imprudent to spend more than the long-run inflation-adjusted return.

Colleges are making investment choices for endowments to be competitive tomorrow, not serve current students.

To manage the fund for perpetuity and to maintain the rule against spending principal, the board of trustees generally determines how much of the endowment to spend each year. Mills says that institutions should follow a process and take the current and future into account when setting the rule. That, she says, is the whole point of NYPMIFA. Boards need to show they have done an appropriate consideration rather than relied on past practices. “The current need for additional financial aid would certainly be something that can and should be taken into account,” she adds.

Spence says that the challenge is to make sure the spending policies do not create too much volatility in the budget and that they do not encourage overspending—a possible issue in periods when investment returns are really high.

For 2011, the NACUBO-Commonfund Study of Endowments reported that the average campus spent 4.6 percent of its net assets, a slight increase from 4.5 percent in 2010. Over the last decade, the rate has fluctuated from a high of 5.1 percent in 2003 (when the average endowment returned 3.2 percent) to a low of 4.3 percent in fiscal 2008 (with an average return of -3.0 percent).

Should investment policies change because of the lessons learned in the financial crisis?

The endowment model is a style of investing associated with wealthy universities, specifically Yale. David Swensen became the campus chief investment officer there in 1985 and pursued a strategy of extreme diversification using illiquid assets. His logic had three parts to it:

  1. An endowment is in place for perpetuity, so very long-term investments are appropriate.
  2. Diversification increases risk-adjusted return, so the more diversification into exotic assets, the better the endowment should be positioned for long-term performance. 
  3. Endowments receive ongoing cash inflows from new donations, so cash needs don’t need to be met from investments.

Yale’s performance has been enviable, both in terms of investments and fundraising. Its endowment was worth $19.3 billion in June 2011, an increase of 16.3 percent from June 2010. In part due to Yale’s influence, the average endowment with more than $1 billion in assets is invested 60 percent in alternative strategies and holds just 3 percent in cash and short-term securities.

The Center for Social Philanthropy at Tellus Institute, a think tank based in Boston, published a paper in 2010 that looked at the effects of the endowment style of investing on six campuses in the Boston area. In the paper, the authors argued that the endowment model not only created avoidable losses in those endowments, but it also contributed to the overall financial crisis because of the speculation in exotic derivatives and opaque partnerships.

As Spence explains, the trade-off for long-term return is short-term volatility. Institutions can protect against that by keeping some sources of cash outside the endowment in the form of operating reserves or lines of credit. Fundraising can also help, with campaigns that emphasize gifts for operations rather than gifts for buildings or for the endowment.

Are endowments in an arms race?

Before the financial crisis, endowments were under fire for raising money but not spending it. Senator Charles Grassley of Iowa held hearings on the spending policies of the 136 largest endowments in January 2008. The issue has faded slightly but hasn’t gone away.

Iosue says that the perceived arms race helps smaller colleges raise money: “Schools are playing a game of being the largest and the best because of the importance of lists in our society,” he says. Many fundraising cases start with a plea to help the institution break into the “top 150” or “top 100.” Donors respond because they want the campus they care about to look good.

The other arms-race issue is investment policy. Economists William Goetzmann and Sharon Oster are both on faculty at Yale. They have found that endowment performance relative to a school’s nearest competitor is associated with the likelihood of changing investment policy. (Competition was measured by the campuses where similar students applied.)

Also, endowments appear to shift their allocations toward alternative investments, including hedge funds, to make their investments look more like those of their competitors. The hypothesis is that a college or university needs to maintain long-term funding equity with its rivals if it is to compete for the same students in the years to come. Thus, they argue, colleges are investing endowment money to be competitive tomorrow, not serve current students—and that means copying current investment strategies.

Goetzmann’s and Oster’s work isn’t arcane; similar investment policies became a problem during the financial crisis, when almost every large endowment faced the same illiquidity problem.

The Tellus report also raised questions about whether the arms-race approach to growing endowments is good for the campus. Specifically, the authors wanted to know why the universities studied cut back spending because of the financial crisis. After all, shouldn’t a crisis of global proportions be the very type of rainy day that a long-term investment is designed to cover? And, should a university be investing in strategies that may have contributed to the financial crisis if it hurts the students and employees? There’s no clear answer here.

An institution's run for perpetuity will change over time, and so will the nation’s economy. There will be a new set of questions when the “new normal” becomes the old routine.