Monday, February 04, 2008

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.


Cowboy said...

There you go again Rich, you hit the nail on the head. Mad Dog and I discussed this issue on a more shallow level and we believe that if universities were forced to spend a minimum amount of their endowment they would simply be more inclined to line the pockets of university personnel by the amount of money over and above their average payout from the endowment. Or they would spend the money in a manner that would in no way improve affordability or to provide productivity improvement incentives. I'm not sure, but do endowments and tuition costs have any positive correlation?

Bill said...

Question: At what point does the desire to enforce higher endowment spending--particularly when it's geared specifically towards lowering undergraduate tuition--butt heads against "donor intent."

Dr. Vedder has come out, in an earlier post, as definitely supportive of the legally enforceable concept of "donor intent." Which leads to the dilemma of what if the vast majority of donated funds that encompass a particular endowment have been given for purposes specifically other than undergraduate tuition aid. How do you violate the donor intent of Donor X who wanted to fund, in perpetuity, research into the polar ice caps or Chinese literature or library acquisitions and use the interest of his donation (I'm certainly hoping that the aim here is NOT the highly non-conservative goal of tapping into the capital) to fund an area of university operations to which he had no intent in supporting?

Which would raise a rather simple data collection question of what proportion of total endowment resources has been donated expressly for the purpose of aiding undergraduate tuition purposes, what proportion has been donated for expressly defined other purposes and what proportion has been donated with open intent. Narrowing the focus, how do these break downs occur among the most highly endowed (for argument's sake say $1 billion+) universities?

Cowboy said...

Bill - That's a great question. Another question might be: At what point does investing donor gifts to grow the endowment corpus butt heads with donor intent?

If the real ROI for the endowment is less then the required minumum expenditure, then the money needed to meet the minimum would come from the principle of the endowment - which goes against the goals of the endowment manager whose job it is to grow the principle by investing donor dollars and possibly some portion of the endowment principle. This could, in effect, erode endowments. And schools with smaller endowments could suffer the most - the variable being: How savvy of an investor the endowment manager is.

Cowboy said...

By the way, I applaud Rich for keeping an open mind and weighing the benefits of each side of the debate.

Bill said...

Hypothetical situation. I am wealthy alumnus X with a degree in diplomatic history. I decide that I want to give back to my alma mater and endow a chair in diplomatic history ($2 million price tag at my institution) in perpetuity.

Now, it's my understanding that the principle remains untouched while the ROI will be broken down in two ways: 1) an annual outlay of 4%-6% to pay the salary and peripheral expenses of the professor who holds the chair and 2)any additional ROI would add to the principle as a hedge against inflation, in other words ensuring that my donation is still funding a top notch diplomatic historian in 25 years.

I just don't see how a single cent of my investment--either the principle or any ROI from it--could be diverted to another use without violating my donor intent.

So again, it brings us to the point that the only funds available would be to force a larger share of the ROI to be disbursed from those endowed funds specifically funded to aid in undergraduate tuition and/or force a larger percentage of unattached endowment funds to be directed towards undergraduate tuition assistance.

What I'd really like to know is how much additional funds are we really talking about generating? Getting away from the hyper-endowments of a few institutions and looking at significantly lower (but still overall high) endowments at institutions such as the Big Ten schools and a few other well endowed publics, which seem to generally fall in the 1-4 billion dollar range (but serve a vastly larger student/faculty base), two questions jump out:

1) What share of their endowment is either specifically earmarked for undergraduate tuition assistance or could legally be redirected for that aim?

2) Raising the minimal annual disbursal by a couple of percentage points would result in how much additional student aid per year?

3) In the context of a 25K-35K undergraduate student body, what level of impact would this ultimately have on an undergraduate's tuition bill?

So far the discussion seems to be taking place on an overall philosophical basis with little nuts and bolts details that would help me decide my position on the issue. I'd be very interested if someone has collected that data and where I could access it?

Bill said...

Oh yeah: substitute principal in the above comment--good thing I'm not an economist!

Also, I don't foresee any situation where the universities would ever be forced to tap into the principal. Any legislation would undoubtedly have an exemption for years where the ROI failed to meet the required minimal disbursal.