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'The Flu Shot' for Your Endowment

Being equipped to withstand a sickly economy
University Business, May 2010

Similar to the cold and flu season, no one is immune to being affected by the current economic downturn. The largest foundations and endowments in the world and most prestigious universities in the nation are also at risk of "getting sick."

It is apparent that the tone of our culture has changed. Everywhere news stories and advertisements reflect the impact of our common financial struggles by invoking the precarious national economy. Recently, due to the sickly economy, the endowments of four of the top 10 universities in our nation have suffered significant losses. After losing 27 percent in what was declared an "unprecedented decline," Stanford is suspending $1.3 million in construction projects. Columbia and Yale are down 22 percent and 25 percent, respectively.

The school facing the worst cuts is Harvard. Their endowment, the largest in all of academia, lost 27 percent of its $36.9 billion fund. Not only did this cause the blood of Harvard's board members to run cold but also its breakfast options. In an attempt to compensate for the streamlined budget, even the hot breakfast options have been replaced with a selection of cold foods such as cereal, bagels, and fruit.

This change is just one of many school programs and initiatives to be pared down. It's important to note that numerous schools, in addition to the four mentioned above, have experienced similar cutbacks as a result of shrinking endowments. And although these losses can be attributed to the economic downturn, it's just as much a result of poor decision making in the boardroom.

As I see it, there are three key factors that lead to bad decisions and therefore to tragic mismanagement of imperative funds:

  • Dominant board players
  • Lack of consensus among committee members
  • Failure to align the board's investment values

When it comes time for an endowment board to check the power of a fund's management, it is important that the most informed and experienced members speak up to make necessary changes. Unfortunately, dominant players can sometimes thwart the efforts of the most knowledgeable. I am using the term "dominant players" to refer to those board members that are large donors, legacy players, or self-proclaimed "investment experts." In some cases, these individuals have no real expertise or background in institutional management, but because of their perceived positions of power they are being allowed to make vital decisions, and sometimes with disastrous results.

Three key factors lead to bad decisions and therefore to tragic mismanagement of imperative funds.

It is imperative that board members who see themselves as being less influential don't allow the more domineering among their ranks to have inordinate influence.

While this is a simple idea in theory, it won't work without free and open communication among board members, which brings me to pitfall number two: lack of consensus among board members.

The climate in the boardroom is largely the responsibility of the chairperson, and it is this person's job to ensure that there is a feeling of safety and consensus among the board members. There must be adequate systems in place to allow all voices to be heard, perhaps even with anonymity; this way members who are new or more reticent to speak out will still play a role in decisions.

Another job of the chairperson is to ensure that new members are properly on board. Without them being brought to speed, making an informed decision is out of the question. Imagine walking into a theater during the middle of a movie, and then be asked to vote on the performance of an actor who was killed off in the first twenty minutes of the film. It would be impossible to make an informed, effective decision. The same thing occurs when new committee members are not brought up to speed, and are then forced to make uneducated decisions. The group should implement a thorough briefing system to ensure that all members are working with the same information.

Making sure that all members are properly on board would also help to alleviate fallout from a lack of alignment regarding the endowment's investment values. It is vital to the success of an endowment that the board has the same thorough understanding of the institution's approach to driving/preserving dollars. For example, the following Five Points of Board Alignment can be used to test member's views and ally values:

  • Provide current resources so all members know what is available
  • Meet competitive goals
  • Practice risk budgeting
  • Integrate with the mission
  • Maintain intergenerational equity

While the first four of these points deal mainly with ensuring that all board members are aligned and have the same understanding of goals and methods to be used while investing, the fifth point is vital to ensuring longevity of the endowment and its beneficiaries. In order to preserve intergenerational equity, it is helpful to use the following capital/liability model to calculate a rate of return target and to set allocations:

Payout + Inflation + Expenses = Return

This model helps to determine a targeted rate of return and set allocations. When focusing on returns, risk can be reduced and course corrections managed over entire market cycles. The model enables one to easily adapt to change in asset base and budget risk for a specific return profile. As a result, utilizing this kind of a model would prevent an institution's spending rate from exceeding its after-inflation rate of compound return, so that investment gains are spent equally on current and future constituents of the endowed assets.

Simply, the ultimate goal of an endowment is to ensure its longevity and its mission to the institution for which it provides. Think of it this way: if during cold and flu season we take the proper precautions to help our bodies fight--making sure to get enough sleep, taking the right supplements and so on--we still might get sick but not with pneumonia. Endowments are the same way. If managed properly, they are able to persevere even in a sickly economy.

Timothy C. Phillips is the founder and chief executive officer of Phillips & Company, a full service wealth management firm.

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