Endowment Payout Rules

By Richard Vedder

One panacea to the problem of rising college costs that gets great attention these days is: have the federal government require universities to expend a certain percentage of the endowments annually, under the assumption that some of the incremental spending will be used to lower student costs.

I chaired an American Enterprise Institute conference on this topic Friday, which also aired on C-SPAN. We had six articulate speakers, three in favor of the endowment payout rule approach, two strongly against it, and the sixth (me) a bit on the fence, although with some reservations about the idea. All did a marvelous job.

While the proponents of the rule were forceful, eloquent, and in fairly good command of the facts, I think the opponents on balance had the better argument. In fact, I have now concluded that a payout rule is probably a bad idea, and it certainly detracts from the more fundamental issues explaining rising costs of higher education -- problems of stagnant productivity, a lack of incentives for efficiency, dysfunctional ways we finance the enterprise, and so forth. Charles Miller (former Spellings Commission chair) and Terry Hartle (senior vice president of the American Council of Education) reinforced my thinking on the point. Below are a few reasons for my negative view on payout rules, such as proposed by Lynne Munson, who has an adjunct relationship with CCAP, and Dean Zerbe, who has been pushing Chuck Grassley and other senators on this issue in his soon ending role as a senior Senate Finance Committee staffer.

First, it is worth keeping in mind that even if spending out of endowment rose sharply --say 200 basis points (e.g., from 4 to 6 percent), the total amount involved is a bit over $8 billion --a little over 2 percent of what we spend on higher education, and barely 10 percent or so of what students spend. Most universities have small endowments, and higher payout rules are of s minor significance, even allowing for the fact that actions by the rich schools impact a least modestly down the line to the Slippery Rock colleges of the world.

Second, it seems to me a one-size-fits all rule is stupid. If college X has a long run rate of return on its investments of 7 percent, and college B has a return of 15 percent, to require them both to spend the same portion of endowment annually is fiscally imprudent. A compromise one-size-fits-all rule probably would lead to overspending by the low rate of return school and underspending by the high rate of return one. If a rule is to be implemented, it should take this into account (my new study on endowments for CCAP, Federal Tax Policy Regarding Universities: Endowments and Beyond outlines how a variable rate rule could be legislated.

Third, philosophically, I have less confidence in federal government bureaucrats to know what is best for universities than university officials themselves (a position Charles Miller forcefully took). In deciding payout rules, decision-makers are deciding on intergenerational equity and economic burdens. While I suspect for most situations the best decision is to show intergenerational neutrality --spending only so much that future generation spending per student in inflation adjusted terms remains the same as for this generation --that decision is best left to the Trustees of universities (as opposed to fund administrators). As several speakers noted, a problem would exist if there was a strong built-in bias to overspend ---presidents who want to go on a spending splurge to make constituents happy. But (somewhat to my surprise), that is very, very rare.

By the way, rates of return on college investments since July 1 have taken a huge nose-dive, I suspect, and, given the risky nature of some college investments, may well have turned negative in some cases. Collectively, U.S. endowments in 1980 were lower than 22 years earlier in inflation-adjusted terms, and as a veteran economic historian I simply don't believe those who say "it couldn't happen again." My guess is nothing is going to happen politically in this election year, and by this time next year no one will dare pushing higher endowment spending given the dramatically lower rate of return of schools. Terry Hartle made this point in a slightly different context, and I think he is correct.

Whatever one thinks, however, the debate has been worthwhile, and the moves by Harvard and Yale, on balance, have been beneficial. But nothing truly revolutionary has happened, and over-focusing on this issue can divert us from more important tasks.