By Richard Vedder
I believe that the top financial officers of universities should be fiscally conservative. They are spending other people's money. Since fixed costs are high (given tenure and other long term obligations), it is critical to minimize the possibility of major losses with university investments. When I went to college back in the late Ice Age, institutions argued about whether endowments should go mainly into bonds or whether blue chip stock investments were appropriate. Then came the era of go-go financing, which eventually hit universities, and everyone in recent years has talked about dabbling in hedge funds and derivatives. And, in an up market, those who did so heavily, including the bigger endowment funds, profited highly, just as those who bought stocks or expensive houses on borrowed money. But they tended to take massive deterioration in their net worth (sometimes to a negative number) as asset prices fell.
As the major stock averages fall 35-40 percent, endowment funds are taking huge hits. Early returns from some colleges indicate endowment declines in the 25 percent range for the period since June 30. People are saying this will be disastrous for colleges. However, prudence works here to minimize the problem. Most schools spend X percent a year from a three (or in some cases, five) year moving average of their endowment. That should work to cushion losses substantially.
Let us take some mythical university X whose endowment on June 30 was:
$750 million in 2006
900 million in 2007
1.0 billion in 2008, and
$750 million (suppose) in 2009.
In the current year, if the university took an average of endowments at the end of the 2006, 2007 and 2008 fiscal years, the figure would be $883.3 million, and $44.165million would be allocated for this fiscal year to spend, using a 5 percent payout rule ($883.3 million X 0.05 = $44.165 million).
For next year, spending would be the same -- as the 2009 figure would substitute for the 2006 figure in the calculation of the three year moving average (the 2006 endowment figure is the same as the 2009 figure). There would be no reduction in payout despite the 25 percent endowment decline. Suppose in fiscal year 2010, a partial market recovery occurs, and the endowment grows to $875 million. For that year, endowment spending would have to decline by about one percent --not a huge hit. The smoothing out that occurs with the moving average approach helps colleges avoid huge spending cuts. Moreover, the example above ignores increases in the endowment arising from new charitable contributions.
All of this is further reason why Congress should NOT impose an endowment spending rule, particularly one that enforces a five percent payout on a single year's endowment figure. Colleges are literally eating into principle in the short run as it is with ANY payout this year, and in the interests of inter-generational equity (never, to be sure, a concern of a Congress that is letting future generations hang out to dry with Social Security and Medicare deficits), imposing higher spending requirements on colleges is fiscally irresponsible.
In a study I did a few months ago, I argued that IF an endowment rule were established, which I oppose, it should be based on a very long term average rate of return (maybe over 10 or 15 years) on investments after allowing for inflation and enrollment changes. But colleges have legal obligations with respect to endowment funds that are potentially jeopardized by any mandatory spending rule. Raising endowment spending, in any case, will impact at only a few, mostly elite schools. Give up on this bad idea.
Friday, November 21, 2008
The Virtues of Fiscal Conservatism
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