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.
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.