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If Harvard, Yale, and Stanford have to make cutbacks due to their endowments' stock market losses, it stands to reason that those losses have caused them deep, and the rest of higher education even deeper, trouble. It stands to reason—but it is not true.
Those wealthy universities are not really in the financial trouble their announcements of belt-tightening imply. And despite their breathless attention to every announcement of shrinking endowments at the wealthy schools, the overwhelming majority of colleges do not have an endowment-loss problem. Why, then, is such wailing about finances coming from our richest schools, and what is going on at the other 97 percent of American colleges and universities?
The irony is that there is a real fiscal problem in higher education, but it is not the huge endowment losses—20 to 30 percent—that are attracting so much publicity. Those losses play only a small role in higher education's current financial dilemma, and then only at a comparatively few colleges and universities—but they are the ones getting the most publicity. Those wealthy few invested in illiquid and risky assets that paid off handsomely for many years but now are causing problems. Endowment managers acted as if high rates of return would never end and continue to act as though a major goal of their institutions is to increase their endowments rather than to use them to sustain programs and services when revenues tumble.
So what is at the core of the “crisis”? Beyond endowment losses, colleges and universities are being struck by a perfect storm of falling investments, credit tightening, declining private contributions from individuals and corporations, declining state funding, and increased student financial need leading to decreased tuition revenue. No one cause is even close to devastating, but together they spell serious problems for an industry that the nation is increasingly counting on to develop the human capital that will enable us to compete in a global economy.
Endowment losses
It has been widely reported that the stock market's collapse has led to large losses—on average, 23 percent—in college endowments. Of course no college (or any other organization) likes losing nearly a quarter of its wealth. However, those losses are much less serious than they appear.
For one thing, endowment drops do not matter at the vast majority of schools, for they have small endowments or none at all and thus suffer no loss of asset value when the stock market plummets. A third of community colleges and 11 percent of four-year nonprofit and public colleges and universities report having no endowment whatsoever; 2.4 million students (14 percent of those attending nonprofit and public two-year and four-year colleges) attend those institutions. Those figures do not include for-profit schools—which also have no endowments—or their hundreds of thousands of students. And 85 percent of the two- and four-year schools reporting data have endowments of under $100 million that contribute, even in good times, only a few million dollars to the school's annual budget—a small portion of the revenues for most schools. For these schools the plight of the stock market has, at most, a tiny effect.
Meanwhile, the Ivies and other wealthy private schools get vastly more attention for their endowment losses, as for everything else, than their numerical importance in the higher education industry justifies. Even before the stock market's plummet, only 3 to 4 percent of all nonprofit and public colleges and universities had endowments of over $500 million, and they educate less than 3 percent of all undergraduate students. For these very wealthy schools, the decline of endowments does involve big money—in some cases, losses of billions of dollars in market value. But the consequences of those losses for the higher education system as a whole, and even for the wealthy schools, are not what they seem.
Why, then, all the fuss?
A war on endowments
It is helpful to put the rich schools' panic over endowment losses into recent historical context. Two years ago they came under attack—not by market forces but by federal and state legislators. Wealthy schools have been worried ever since about how far the governmental war on endowments might go.
In January 2008 the Democratic and Republican leaders of the U.S. Senate Finance Committee wrote to the 136 schools with endowments over $500 million, making it clear that they wanted the institutions to spend more of those endowments and use that money to reduce tuition. A few months later, the legislature of Massachusetts considered a bill calling for a new tax: 2.5 percent annually on all college and university endowments over $1 billion.
The Senate Finance Committee's aim was to reduce tuition, a popular political goal. The Massachusetts legislature was searching for new sources of wealth to tax in a weak economy in which state tax revenue was flagging while university endowments and even their capital gains remained untaxed. But whatever the goals, the impact on the institutional leadership was the same: endowments were under attack even before the recession emerged.
College presidents remain fearful of the financial consequences of such legislative restrictions on endowments or changes in their tax-free status and stoutly and consistently proclaim the sanctity of endowments. In September 2008 Senator Charles Grassley (R-Iowa) and Representative Peter Welch (D-Vermont) held a “roundtable” with a group of college presidents, economists, and other higher education funding experts to press the schools about their endowment spending. The presidents defended their accumulation of endowments; their tuition and financial-aid policies; and the fundamental taxation and subsidy benefits that the schools, as tax-exempt nonprofit organizations, have received for decades. College administrators share the widespread belief that some institutions' increased spending on need-based financial aid and a slowing in the rate of increase of tuition were adequate responses to the legislative threat.
But the economic decline, on top of those legislative fiscal attacks, led to a bunker mentality among university planners, who fear what is happening now and what may well happen in the near future. Already worried about the possibility of increased taxation and pressure to spend down their endowments, which would depress future revenue from them, academic leaders are worried that the attacks will escalate once the economy recovers.
Indeed, the Senate Finance Committee has not forgotten about college endowment spending, and in May 2009, the legislature of Rhode Island joined its neighbor Massachusetts in considering legislation to allow municipalities to tax the property of wealthy nonprofit colleges and universities, as well as hospitals. The recovery may not be an unmixed blessing for colleges if it leads to renewed political pressure to ensure student access by cutting tuition and forces institutions to spend down endowments to offset the loss of tuition revenue.
What endowment losses really mean
Today's endowments have certainly shrunk—but only from their all-time peak values of 2007 and 2008. Endowments, even now, are actually back to what they were only a few years ago. In the six months between June and December 2008, Yale's endowment dropped from $22.9 to $17 billion—which was, as President Richard Levin admitted, what it totaled as recently as January 2006. Brown University's endowment lost 26.6 percent of its value and ended the 2009 fiscal year with slightly more than $2 billion—over 10 percent more than the $1.8 billion it had just four years earlier in 2005. The much-discussed 20 to 30 percent plunge in endowments at wealthy private research universities is an enormous cut in asset wealth. But wealth that has declined from its all-time peak is hardly a crisis.
Still, did the drop in endowments show that Senator Grassley was wrong in pushing for spending down endowments in order to stem the tide of increased tuition? Would it have been imprudent, if not foolhardy, to spend more out of endowments in good times when they could fall at any time? Not necessarily. The purpose of endowments should be to protect programs and services from undesired cuts. If an endowment is large enough to serve the rainy-day function, spending more of it might be entirely appropriate.
What is happening to endowment wealth is not the same question as what is happening to the funding of current programs. Some simple arithmetic shows the surprisingly modest effect of the plummet in endowments on a school's annual revenue. The connection between a drop in a university's endowment and in its annual budget is not one to one—not even close. Here is the actual relationship: First, each year the institution puts a sum of money from its endowment into the budgetary pot for next year. That sum is the average amount of the endowment over the past 3 years, multiplied by 4.5 to 5.0 percent (for most schools)—which is the fund's estimated long-period rate of return, above inflation.
The much-discussed 20 to 30 percent plunge in endowments at wealthy private research universities is an enormous cut in asset wealth. But wealth that has declined from its all-time peak is hardly a crisis.
Now comes the arithmetic, and it is straightforward and eye-opening. Suppose a school's endowment falls by even 30 percent in one year. That means a drop of 10 percent in the three-year average. Thus, the resulting cut in contribution to the revenue pot for next year is about 4.5 percent of that 10 percent drop. How important that drop is depends on how much of the school's total budget comes from the yield on endowment.
In the extreme case, in which this yield on investment was the school's only source of revenue (we can come up with no actual example or with one that is even close), the result would be a gigantic 10-percent cut in the overall budget. But even wealthy schools do not rely on the endowment for a majority of their budgets: one-third of Stanford's budget comes from endowment income, but the University of Chicago supplies less than 9 percent of its budget from endowment earnings.
At the other end of the endowment spectrum—for a school with a small endowment that finances, say, 2 percent of the total budget, the rest coming from tuition, donations, government grants, and the like—the 10 percent drop in revenue from endowment would be a loss of 10 percent of the 2 percent, a barely perceptible 0.2 percent of the total budget.
At the vast majority of schools, the endowments yield 5 percent or even less of the total budget, with the result that a 10 percent fall in the yield is more like 0.5 percent of the total budget. Elon University, for example, draws 5.5 percent of its revenues from its $80-million endowment. Hampshire College's $35-million endowment supplies only 2 percent of its budget. The obvious yet noteworthy point is that the smaller the endowment, the less consequential a drop in its value.
It is true that if the market value of endowment stays the same next year, there would be an additional cut in operating revenue drawn from the endowment, as the first year 10-percent drop of the three-year average falls to 20 percent. Still, for a school with an endowment providing, say, 15 percent of the total budget, the 3 percent reduction in revenue (15 percent of 20 percent) would not be even remotely catastrophic.
Blaming the drop in endowment value for freezing faculty recruitment, cutbacks in salary increases, and postponements of capital projects may seem natural, but when the function of those endowments is recognized as insurance against just such a “rainy day,” it is by no means clear that such cutbacks are justified. As endowments soared in recent years to unprecedented heights, few if any colleges or universities ever asked how much endowment is “enough.” The endowment is not an end in itself; its function is to improve the quality of the school's educational and research programs and to stabilize program expenditures and sustain quality. Cutting programs and services back in order to sustain the rainy-day fund is getting things exactly backward.
Spending “restricted” endowment funds
About half of the funds in the wealthiest institutions' endowments (those over $1 billion) are “true” or “permanently restricted.” But there is a huge and vital difference between a restricted endowment fund and a truly restrictive one. The terms of an endowment may truly be binding, but a restricted gift can free up money the school can spend on something else.
For example, a million-dollar donation specified as permanent endowment with 5 percent ($50,000) to be spent annually on student financial aid would appear to be restricted to its donor's intent. But once the $50,000 is in hand, the college may spend $50,000 of the funds it previously spent on financial aid on something else—such is the fungibility of money. Leaders' common statement that they cannot control restricted expenditures from endowment funds is at best incomplete if not misleading, and at worst disingenuous.
Investment strategies, risk taking, and tightening credit
When investment values were rising, the appeal of risky investments that were bringing above-average yields lured investment managers and the trustees they represent into risky and illiquid investments such as limited partnerships in real estate and standing timber. Higher returns and bigger endowments meant rising in the U.S. News & World Report ranking system, which uses a formula that rewards higher spending on the education of students—and therefore increased earnings from a growing endowment.
In 2007, schools with endowments of over $1 billion, large enough to justify diversification into riskier and less liquid investments, obtained average annual investment returns of 11.1 percent, while institutions with more modest but far more common endowments of, say, around $80 million invested more cautiously. But the latter paid the price for their caution, earning an average of only 7.9 percent. The rich schools got richer and left the rest in the dust.
The endowment is not an end in itself; its function is to improve the quality of the school's educational and research programs and to stabilize program expenditures and sustain quality.
The wealthy colleges and universities were not oblivious to the risks of their investment strategies. They understood that they could, in an economic downturn, not only suffer large losses but could also encounter cash-flow problems in meeting their monthly salary obligations and bills and so have to sell assets at fire-sale prices.
There was a seemingly efficient solution, though: Rather than forego opportunities to make eventually profitable investments, their investment managers could make those investments and also ensure the desired liquidity by arranging “lines of credit” with banks to meet short-term borrowing needs. They could then have the best of both worlds, investing heavily in risky but often illiquid assets that would be likely to pay high average returns over time without having to worry about short-term cash needs, counting on the availability of bank credit.
But since the economic decline late in 2008, it has not only become more difficult for schools to meet their cash needs from their own portfolios, but bank credit has been harder to obtain.
Colleges and universities also relied on ready cash (especially to finance construction projects) for being able to sell short-term tax-exempt bonds—securities that carried low interest rates but that often had to be “rolled over” when they matured. Then new bonds were sold to pay off the previous bonds as they came due. But as credit markets tightened, so too did the market for short-term, tax-exempt bonds. When debt has matured, schools have been challenged by having to pay higher interest rates.
Tight capital borrowing markets are a relatively new source of worry. The bond rating agencies, such as Moody's and Standard and Poor's, have also played a role. They require schools that want to sell tax-exempt bonds, and hence that want an excellent credit rating, to specify the sources of funds they could use to pay off short-term debt if, in the months ahead, they cannot sell new securities to retire the debt coming due. In light of shrinking endowments, the rating agencies see substantially fewer assets for the schools to turn to as “back up” and thus an increased likelihood of their need to sell more bonds. The results: lower credit ratings and higher borrowing costs.
These short-term liquidity problems are not merely theoretical possibilities. In October 2008, more than 900 colleges—not the richest schools—found their holdings of approximately $9.3 billion in the Common Fund for Short-Term Investments, managed by Wachovia, frozen and inaccessible. The schools had thought the funds were fully liquid, but they were wrong. Initially, they were given access to only 10 percent of their assets.
So poorer schools are faced with difficulty covering their operating expenses. The very richest will have no problem. Even their diminished wealth and asset liquidity leaves schools with the highest (AAA) credit rating—such as MIT, Stanford, Northwestern, Rice, Grinnell, and Pomona—still extremely comfortable. Danger lurks for less wealthy schools with weaker credit ratings, as banks are retreating from commitments even to short-term loans.
In short, schools ended up relying too heavily on a combination of exuberant optimism about a never-ending economic boom and faith in the banking system to finance short-term credit needs. The problem was that many college and university investment officers paid too little attention to the possibility that almost all investments would turn bad at the same time—at least that is what some schools would have us believe if we take them seriously when they claim the absolute need to cut program expenditures.
Are we being too critical? Could a liquidity crisis, however unlikely, have been anticipated? Anticipated, yes; predicted, no—but it is anticipation that counts. A homeowner cannot predict whether her home will burn down tomorrow, but she can anticipate the possibility and carry fire insurance. Similarly, investment managers could not be expected to predict a sharp fall in the stock market, but they could do the equivalent of insuring against that low-probability event—and in a number of ways.
They could, and indeed they did, arrange with banks for standby borrowing arrangements. They could, and indeed they did, hold some assets in liquid form—either in U.S. Treasury bills or in stocks and bonds traded on organized exchanges and convertible into cash within a day—so that there would be no problem providing the 4.5 percent of endowment for the annual budget. If endowments are so illiquid that managers “cannot” come up with the 4.5 percent for the current budget, the investment policy was irresponsible—excessively venturesome and risk-taking.
True, liquidity comes at a cost, just as fire insurance does. Over time it is clear that riskier, less liquid investments such as limited partnerships bring higher returns than T-bills and traded securities. But prudence demands paying the price. Endowment managers know that. They also know that with a policy of paying about 4.5 percent of an endowment into the annual budget, the other 95.5 percent of their investment portfolios could be in higher-yielding but less liquid investments. Borrowing would not be required even in the event of a credit market collapse—unless it continued for several years.
Details of individual colleges' and universities' endowment holdings are generally not public information, but it is implausible that managers would be so incautious as to hold virtually none of their portfolios in saleable form. According to the 2008 National Association of College and University Business Officers (NACUBO) Endowment Survey, the larger the endowment, the smaller the percentage investment in liquid assets such as equities (stock traded on exchanges) and fixed-income assets such as bonds. Endowments of under $25 million invest 93 percent of their funds in these essentially liquid assets; endowments of over $1 billion invest only 50 percent in them. But that still leaves plenty of liquidity and leeway for increasing payouts during rainy days, even if those last for a number of years. Of course, if managers are reluctant to take even a loss that has actually occurred, that could be a problem—but it would be psychological, not financial.
Revenue losses
As we have said, very few schools depend on endowment returns or investments for a significant portion of their budgets. Tuition dollars are the biggest part of four-year nonprofit colleges' revenues—31 percent on average. Donations are also vital, especially to nonprofit schools (15 percent) and, increasingly, to public ones as well (now 3 percent). Finally, state funding is a very important portion (27 percent) of public college and universities revenues, which provide education to about 75 percent of all students. All three of these revenue sources are threatened by the current economic downturn.
Tuition revenue is increasingly uncertain. College students and their families are facing financial difficulties in this economy. Midyear requests for financial aid from enrolled students are up at many colleges. Universities such as Michigan State and Ohio State are setting up emergency funds for students who no longer can afford their tuition. Applications at public colleges and universities, with their lower sticker prices than private schools, are up even as state funding is down, leading some state schools, such as those in California and Florida, to turn away students they cannot accommodate.
Some but by no means all private nonprofit schools, with their markedly higher tuition, may be receiving fewer applications. The wealthiest elite schools still admit few of their applicants, but for schools largely dependent on tuition revenue to operate, fewer applicants mean fewer paying students and less revenue.
Students' financial need is growing due to increased unemployment and losses on family savings invested in the stock market. The result: either institutions and governments will have to increase their need-based financial aid, or college access by low-income students will fall. And for colleges, that means declining revenue from tuition.
The National Association of Independent Colleges and Universities reports that 82 percent of the 372 schools it surveyed at the end of 2008 found that demand for financial aid had increased because of the economic downturn. And at least three states have cut their aid funding to resident students attending in-state colleges, leaving public and nonprofit schools in Illinois, Indiana, and Ohio to find alternative aid—most likely loans—or possibly lose enrolled students. Although increases in the Pell Grant are most likely on the way for 2010, they are still in the future.
…very few schools depend on endowment returns or investments for a significant portion of their budgets.
Threatened donations. Although the plummeting endowments are not a major threat to the flow of current income, the weak stock market is cutting revenue in another way—via donations. This loss of income is more pervasive than the effects of falling endowments because donations are a larger share of revenue than endowments for most schools. For decades, individuals' total charitable donations have been rather constant at between 1.9 and 2.0 percent of disposable income. So even though donations do not rise and fall equally among all nonprofit charities, schools are legitimately concerned that a decline in donations will add to their financial problems.
The evidence justifies some concern, as donations to higher education declined about 5.7 percent (after adjusting for inflation) in 2008, according to Giving USA. But not all schools have been equally hurt. A survey in late 2008 by the Chronicle of Higher Education and Moody's Investor Services of 214 colleges disclosed that 41 percent had experienced no drop at all. And since donations to nonprofit colleges and universities are, on average, 15 percent of their total revenue, a drop of 5.7 percent of that 15 percent is only 0.86 percent of total revenue. As with endowments, such a revenue cut is not, itself, of crisis magnitude.
States are cutting higher education funding. The declining economy is cutting state governments' revenue from sales and income taxes and is increasing pressure to expand spending on welfare programs. One of the casualties is state support for public colleges and universities, which may drop in some states by as much as 20 percent.
Maryland cut $15 million from its university system's operating budget in fall 2008, and further state revenue shortfalls require university system employees to be furloughed for up to five days in order to save an additional $16 million in salary costs. In Tennessee, lower state revenues are forcing the state university system to cut $75 million from its spending, including money to recruit and fill tenure-track positions and fund library purchases. California's budget crisis has led to $2 billion in cuts to its higher education funding. The University of California system will suffer a loss of over $800 million in funding, and the California State University system's state revenues will plunge by $584 million.
Are these severe cuts? Maryland's $15 million cut in state grants is not so severe—under 0.4 percent of its $4.1 billion budget. But the University of Tennessee system's $75 million cut is a significant 4.5 percent of the system's $1.65 billion budget. And California's massive cut in state funds, which provide 20 percent of the University of California system's $15.7 billion budget, will reduce that budget by 5 percent. In response, the UC regents are raising tuition by 10 percent, mandating unpaid furloughs of 11 to 26 days for 80 percent of UC employees, and curtailing core functions such as library hours.
The California State University schools' budget relies even more heavily on the state's contribution—66 percent of their $4.52-billion budget comes from the state—and they are losing 13 percent in revenue. CSU is also furloughing faculty and staff, effectively reducing their salaries by 10 percent, as well as refusing additional student applications for the 2010 spring term and raising tuition and special fees.
The “perfect fiscal storm”
Endowment losses; tightened credit; and shortfalls in tuition, donations, and state funding—each is manageable, but all have come at the same time. No one of them has caused a serious problem; together, they have. But even this is true only for some schools. When a drop in endowment of 25 percent occurs, the three-year average falls about 8 percent at a school where 15 percent of the budget comes from endowment, but the decline in total revenue of 15 percent of the 8 percent—1.2 percent—is tractable. So too is the effect of a drop in donations of the anticipated average of 5.7 percent, since when donations are about 15 percent of a school's total budget, the loss of 5.7 percent of that 15 percent is just another 0.86 percent budgetary decline. And if a school receives 20 percent of its revenue from the state and the state cuts its allocation by a significant 10 percent, the decrease of 10 percent of the 20 percent is another 2 percent of total revenue. Cuts, individually small, are adding up.
Now we can begin to see the college fiscal problem in perspective. Schools are experiencing a very “rainy day,” as the perfect storm of cuts in multiple sources of revenue produce a torrent of fiscal stress. While the losses could not all have been predicted, we all know, as do college officials and trustees, that a financial rainy day, or several, will occur sometime. This is precisely why we save as a form of rainy-day insurance. A rainy day is not a time to panic. It is what endowments are for.
Riding out the storm. The bubble of expanding college budgets—fueled by escalating stock market values, high and rising tuition revenue, and increased donations—has burst. Higher education is but one of many industries being hurt. But there is an upside. The weak economy is giving colleges the opportunity to make needed, and perhaps long-wished-for, changes. They need to reexamine their long-run business plans and diversify their revenue sources and savings such as endowments for a financial rainy day when most or even all of the sources “turn south” simultaneously. They need to remember that endowments exist to fund expenditures during rainy days like this.
Schools, especially the privates and flagship publics, also need to reexamine their financial aid policies and the consequences of their choice to privilege merit-based over need-based aid. State institutions need to reexamine the long-run effects of their rapidly declining support from their state governments (a decline that is by no means new), support that has given these schools their historical character as providers of high-quality higher education for most high school graduates. All institutions of higher education, public and private nonprofit, need to reconsider their risk-management policies as they balance efforts to increase the returns on their endowment investments, which requires taking greater risks, against the greater security and liquidity provided by more conservative investments.
This crisis will pass. What will remain, though, is the need for schools, on one hand, and government, on the other, to rethink long-term fiscal strategies, not only for institutions' survival but to ensure a high-quality higher education system. Expanding and retrenching as the economic wheel turns is not the way to create a vibrant or stable system. Smoothing the ups and downs of revenue is essential. That is what an endowment should do. Now is the time to rethink endowment policy, for today is not the last rainy day for higher education.
Burton A. Weisbrod is John Evans Professor of Economics and a faculty fellow of the Institute for Policy Research at Northwestern University. His publications include The Nonprofit Economy (1988) and To Profit or Not to Profit: The Commercial Transformation of the Nonprofit Sector (1998), as well as nearly 200 articles.
Evelyn D. Asch is research coordinator at the Institute for Policy Research at Northwestern University. She has taught research and writing at Loyola University Chicago and at DePaul University and is the author (with Sharon K. Walsh) of three college texts on writing and research in the Wadsworth Casebook in Argument series. Weisbrod, Jeffrey P. Ballou, and Asch are the authors of the recent book, Mission and Money: Understanding the University (Cambridge University Press, 2008).
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