Monday, October 01, 2007

Why Not the Five Percent Endowment Rule?

By Richard Vedder

2006-7 was a banner year for investors, certainly not typical, so the 25 percent or higher rate of return earned at Yale, Harvard, Duke, Northwestern, Notre Dame and some other schools is a bit unusual. Consequently, universities should be careful and only spend from their endowments an amount that is sustainable in the long run. Yet some endowments are becoming so large that universities are clearly reinvesting some of the endowment earnings in an expanded base of principal, rather than using funds to make college more affordable.

I looked at three schools --Harvard, Yale, and the University of Virginia. At all three schools, less than four percent the average daily endowment base in the 2006-7 school year was spent. If Harvard and Yale had spent 5 percent and dedicated the increased spending to tuition reduction, they could have eliminated undergraduate tuition charges altogether --easily. If Virginia, which is a less well endowed public school, spent 5 percent and dedicated the added spending to tuition reduction for all students from families with less than $100,000 annual income, I would guessetimate that tuition could have been reduced well over $5,000 on average per student --an amount equal to about 60 percent of the in state tuition charges.

What this means is this: rich schools have chosen to charge students high tuition and then use the funds to increase the size of their endowments (especially so at Harvard, Yale, and, I believe, Princeton) rather than relieve financial pain for parents. The IRS requires non-university charities to spend 5 percent out of their endowments if they want to keep tax exempt status. There is a reason for that. Donors making new gifts and universities with investment income are getting a tax break for helping defray the cost of higher education. As Wick Sloane reminds us constantly, these tax breaks can be expressed in "Pell Grant equivalents." Tax policy currently favors the “Harvards” of the world relative to the poor kid needing a Pell Grant.

As an economist, I believe the 5 percent annual payout rate is conservative in meeting the goal of having the principal on existing endowment stay constant over time in an inflation-adjusted sense. Over the long haul, the inflation-adjusted rate of return on fairly conservatively invested endowments is well above that 5 percent rate --at Harvard, Yale and Princeton over the past 10 years, the rate of return after adjusting for inflation averaged well over 10 percent a year, so asking schools to spend one-half that amount is not too much.

Sometimes it is said, "small, poor schools cannot do as well, since that do not have much money to invest, and cannot afford risky investments like Harvard can." Balderdash. Students at my university, working with barely one million dollars in funds and investing in equities, have a long-run rate of return on investing university endowment funds of least 10 percent after inflation. A poor school, whose funds were 75 percent in an index stock fund and 25 percent in bonds, could have spent 5 percent a year over the past decade without eating into endowment. It is time for Congress to act.

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Speaking of endowments, Claremont McKenna College just received a $200 million endowment gift --expanding its already healthy endowment around 50 percent. The donor has chosen to allocate the endowment to promoting economics and finance education for CMC students, which is his right. CMC has a great tradition in economics already (I have taught there and once very reluctantly turned down an offer of a chair there), and this should help the school reach the very top of liberal arts colleges (it is already high on the US News and World Report ranking, remarkable for a school barely 60 years old). Congratulations to a fine school. Let us hope CMC honors the donor's wishes and does not use funds to splurge on conspicuous consumption that does little to enhance learning, truth or beauty.

10 comments:

sciencedoc said...

Who says the goal is

"the goal of having the principal on existing endowment stay constant over time in an inflation-adjusted sense"

I would say the goal is to have the total endowment grow at least as fast as the growth of the economy, not the rate of inflation. Otherwise, the institution falls behind, falls behind the real economy, which is growing much faster over time than the inflation rate.

Furthermore, the total amount expended in gifts and endowment income typically is much much greater than 5% of the value of the endowment. Where I work, it is more like 10% or higher, much higher. The reason? Unrestricted and many other gifts are used for current expenditures, not for building the endowment (even though they could be used for building the endowment in many cases). So this whole 5% business seems like a big fat red herring to me.

Another thing: even if Harvard could offer free tuition, why should it? They certainly shell out a huge amount per student in expenditures each year. Why should that be "free"?

There is something very odd to me about the notion that students are entitled to free tuition just because they can get into Harvard!

Fat Man said...

I think that these institutions should pay taxes just like other businesses.

If they were truly charities they would deserve a tax exemption, but their ability, and desire, to pile up billions of dollars in investments and make billions on those investments while charging astronomical tuitions tells me that they are just businesses.

They should pay taxes like the rest of us.

Ronald Coleman said...

I think you're mistaken about Princeton. It actually subsidizes tuition for all comers -- once you qualify for financial aid, there are no loans; they actually lower your tuition.

Daedalus Mugged said...

I think the solution is relatively minor change in tax law. Rather than making the whole institution of a university taxable, merely make the endowmment taxable to the extent that it does not spend the money on the (tax exempt) university. If an endowment has a 12% return, and they spend 5%, they pay tax on the other 7%.

That is still a far better deal than individuals get. It would either be a tax windfall, or more likely cause a huge amount of endowment money to actually be used for the public benefit of education, which is why they got the tax exempt status in the first place.

Josh said...

"Another thing: even if Harvard could offer free tuition, why should it? They certainly shell out a huge amount per student in expenditures each year. Why should that be "free"? "

Presumably because $40,000-$50,000 per year is inaccessible to all but the very wealthy. Now, if future opportunities for said students weren't affected by whether their degree said "Harvard" or "University of Alabama" (or any other state school), then you might have a point. As it is, such schools are essentially rubber stamping people who are willing to go into serious debt and the very wealthy. And before you decry "rubber stamp," note just how hard it is to fail out of Harvard.

Of course, this only applies if Harvard has the intention of being an educational institution. If they want to be a rubber stamp, that's fine, but in that case they're in it for a profit and should be charged taxes.

"I think you're mistaken about Princeton. It actually subsidizes tuition for all comers -- once you qualify for financial aid, there are no loans; they actually lower your tuition."

This presumes that the threshold for qualifying for financial aid. Presuming that we're talking a tuition of $50,000, what would be a reasonable threshold? Assume for a moment we're talking someone from the Northeast, where there's a good chance of another $5-10,000 in property taxes alone, not to mention paying for a house. What's a fair threshold for that not to cause undue pain? I'm thinking perhaps $350,000-400,000 pre-tax, but your numbers may vary. Regardless, the threshold for financial aid is far lower than that.

TC said...

"I would say the goal is to have the total endowment grow at least as fast as the growth of the economy, not the rate of inflation. Otherwise, the institution falls behind, falls behind the real economy, which is growing much faster over time than the inflation rate."

Wouldn't the "real economy" account for infaltion? Otherwise, what would "real economy" mean?

I may have missed something but I didn't read any suggestion that Harvard offer tuition free education. What I read is that it is possible that Harvard, Yale, and UV could have eliminated undergraduate tuition charges altogether if Harvard and Yale had spent 5 percent and dedicated the increased spending to tuition reduction.

With regard to spending out of endowments, my preference would be to let the principal of the endowment vary and establish a minimum annual payout or be taxed like every other investor - pay income tax on dividends and appreciation for stocks held less than 12 months and capital gains on appreciation for investments held 12 months and 1 day. One of the reasons I would let the principle balance of the endowment vary is to insure wise investments are made. Under this scenario, the endowment would be put to work and would never achieve a zero balance unless the portfolio manager screwed up royally.

This is probably the only case in which I have, or would advocate taxation.

If one wanted to keep the endowment constant, then the 5% would vary - more or less than 5% may be spent.
































































































































I'd like a shot at handling OU's investments

L said...

What Harvard does (along with other high-tuition schools, I'm sure) is charge very high amounts to students whose families are deemed able to afford high tuition, while drastically discounting the amounts charged to the others. The actual tuition level is the sum of all students' net tuitions (after deducting scholarship amounts applied to tuition) divided by the number of students. That is a great deal less than the nominal tuition. The scheme is essentially identical to airline seat pricing. Students who pay full tuition subsidize those who pay less. The top tuition is "what the market will bear" for a very prestigious school, and like all luxury prices has no direct relationship to actual cost of service to the institution. Thus Harvard actually maximizes what it can collect in aggregate tuition while still aggressively growing the endowment corpus. Great financial game, and only a few can play it.

sciencedoc said...

Re accessibility at Harvard: they and many other rich schools have a graduated financial aid policy, which is actually very generous.

It is actually often cheaper even for children of upper middle class people to go to Harvard or the like than to attend the public university where I work.

Re what is keeping up with the growth of the economy if not keeping up with inflation?

It means growing faster than the inflation rate, because the real income and wealth of the American economy is growing faster than inflation. Any institution is actually falling behind if it doesn't grow faster than the inflation rate.

Webrep Tweak said...

The costs of education are incredible and the government response is terrible. Check out this article on higher education costs at http://www.higheredcosts.com

Webrep

sciencedoc said...

! -- are you sure about

"The top tuition is "what the market will bear" for a very prestigious school, and like all luxury prices has no direct relationship to actual cost of service to the institution."

I think it's very likely, or at least entirely possible, that Harvard expends MORE per undergraduate student on THEIR EDUCATION than the total amount if all of them paid the full tuition.

i.e. even those paying the full tuition are getting a good deal, and more than their money's worth.