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Five Percent of Very Little Is Even Less

<em>Endowment spending decisions and restrictions are popular topics in the press.</em>
University Business, Mar 2008

TALK ABOUT NO GOOD deed going unpunished. For the fiscal year ending in June 2007, the average university endowment earned 16.9 percent on its investments, according to the latest Benchmark Study of Educational Endowments by the Commonfund Foundation. This handily beat market indexes, in part due to the aggressive use of alternative investments. The high return is also an indication of the increasing sophistication of university investment offices.

This performance is great, but it may not be sustainable. The financial markets ended 2007 in a muddle, with the Standard & Poor's 500 index up just 5.49 percent and the U.S. dollar down 9.52 percent relative to the euro. At press time, the stock market had already given up 2007's gains.

There's a perception that if colleges simply spent more
from their endowments, tuition would become cheaper.

Commonfund's study also noted that the average higher ed institution spent 4.4 percent of its endowment assets in the 2007 fiscal year. Legally, endowment management teams don't have to spend anything. By contrast, the IRS requires charitable foundations to spend 5 percent of assets each year.

In September 2007, Senator Charles Grassley (R-Iowa) held hearings on hedge fund transparency that morphed into a criticism of university endowment spending relative to performance, with <b>Harvard</b> as exhibit A. After all, according to the 2007 NACUBO Endowment Study, Harvard had a $34.6 billion endowment after growing 19.8 percent from 2006. (As always, Harvard gathers accolades in every field but football.) It's a fine university, but it's atypical. The average endowment can't spend anywhere near what Harvard does, nor can endowment managers make up the difference with performance.

On the heels of strong performance and Grassley's hearings, or maybe just for the heck of it, Harvard announced an overhaul of financial aid policies to eliminate the cost to families with an income below $60,000; families with incomes between $60,000 and $180,000 will pay a sliding fee that is not more than 10 percent of income.

The dollar value of Harvard's announcement is roughly $200 million, an amount larger than the endowments of 259 of the 785 colleges included in the study. But like most colleges, Harvard already provides high levels of financial aid, so the incremental cost should be closer to $20 million to $30 million. Harvard competes directly with very few other institutions; a few of those competitors, including <b>Dartmouth, Stanford,</b> and <b>Yale</b>, followed up with similar announcements.

Although most American families will never pay a Harvard or Yale application fee, let alone tuition, they consider those schools to be the Platonic form of higher education. When they see deeply discounted tuition coming out of the Ivy League, their impulse is to assume all other colleges should follow suit. They reason that if Harvard, the ideal college, offers generous financial aid to families with an income of up to $180,000, any college aspiring to the ideal (which is pretty much all of them) should cough up some dough.

According to the NACUBO 2005 Tuition Discounting Survey, 83.5 percent of all college freshmen already receive some sort of merit-based or need-based tuition discount, with the average discount being 38.6 percent.

"It's not clear yet what effect this will have" on endowment management, says John Griswold, executive director of the Commonfund Foundation. "There may be pressure on a lot of colleges and universities that are trying to become more selective to increase their financial aid. But this has been true for many years." He says there's a perception that if colleges simply spent more from their endowments, tuition would become cheaper.

However, few colleges have large enough endowments to make this happen. For instance, 5 percent of Harvard's $34.6 billion endowment is $1.7 billion, the same as the entire endowment at <b>Grinnell College</b> (Iowa), according to NACUBO data. In turn, 5 percent of the Grinnell College endowment is $85 million, on par with the endowment at <b>Southern Illinois University</b>. At most colleges, the endowment can never be more than a small supplement to the budget: too much money to ignore, but not a replacement for tuition, donations, or government support.

Even for colleges boasting hefty assets, only a portion of the earnings can go to offset tuition. Most endowments have a large percentage of restricted assets, which can be spent only as the donors intended. Funds designated for support of the music school or for research in the college of engineering can't be spent on undergraduate tuition. The courts have repeatedly held that such restrictions must be honored.

Increasing the level of risk taken by endowment funds
wouldn't be enough to solve the problem of college costs.

Because endowments have to serve donor spending requirements but not any from the IRS, they can be run to meet different needs. Some spend nothing, instead building assets for a future time when the institution will be in a different situation. Some endowments are used almost like emergency funds, drawn upon in years when the budget is stretched or a capital problem emerges. Still others are designed to generate a fixed percentage of the budget, a fixed dollar amount each year, or to contribute a set percentage of principal that will, in theory, increase each year because investment returns will be higher than the spending rate.

No matter the size of the endowment, spending 5 percent of the principal responsibly can be an enormous challenge; the more money floating around, the greater the potential for waste, corruption, and general foolishness.

And institutions don't change their spending rules lightly. When university trustees are trying to match competitive spending, they might ask the endowment manager to come up with more money each year. In theory, the manager could make changes in the fund's investments. For example, the manager may take more investment risk. This could generate a bigger return that would help meet increased spending requirements while also, it is hoped, grow the principal at former rates.

Or instead, that person may put more money into bonds and liquid assets, making it easier to generate cash for the spending needs at the expense of much lower growth for the principal.

Finally, the manager may change nothing, figuring that someone else in the budget or development office has the responsibility to find funds that would offset reduced endowment growth from increased endowment spending.

Given the current state of the financial markets, even the hugest endowments could find themselves constrained by poor returns, Griswold explains. He adds that most of the endowment managers surveyed by Commonfund are taking appropriate risks. Still, there is always room for improvement, and while changes could generate small increases, those increases wouldn't be enough to solve the problem of college costs.

"You have to look elsewhere to solve the problem of access to quality higher education," Griswold says. "Getting Harvard and Yale to spend more isn't going to solve the overall problem of higher education costs."

In fact, the silver lining to 2008's poor economic outlook may be that it will reduce the pressure on colleges to spend endowment money. If next year's Commonfund Benchmark Study indicates less spectacular performance, the higher ed news cycle will move on.

<em>Ann C. Logue is a Chicago-based freelance writer who specializes in covering finance.</em>

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