Markets are way up over the last year, so it must be time for well-endowed universities to return to business as usual. Right?
No. Don't hold your breath for Harvard University to bring hot breakfasts back to its undergraduate dining halls. A close look at the arithmetic of endowment spending rules suggests that the elite private colleges are in for very tough times over the next few years. But if those institutions draw the right lessons, perhaps they will be able to manage better the next time the roller coaster drops.
First, here is a little math to demonstrate the bind in which private colleges and universities find themselves. Market returns at highly selective, high-endowment universities over the last three years have been around 25 percent, 0 percent, and minus 25 percent. So why the pain? We started at 100, rose to 125, stayed there a year and then fell back to where we started, right?
Wrong. That calculation misses two things. The first is a piece of simple arithmetic. If a number falls from 100 to 75, that's a 25 percent drop. But when a number goes from 75 to 100, that's an increase of one-third, or 33 percent—you're climbing from a lower base than you fell from.
A more fundamental point concerns the fact that every year universities use up some of the endowment to pay for operations. When everything is taken into account, generally about 5 percent of the endowment value is spent. If the return on the endowment were 0 percent every year, a 5-percent spending rate would cut the university's wealth in half within 14 years. So say the endowment goes from 100 to 125. Five percent is spent, taking the value to 119. Spending 5 percent in a year of flat endowment takes that number to 113. It then drops by 25 percent, bringing you not to the old value of 100, but to roughly 85. Spend 5 percent of that, and you end the three years at an endowment of roughly 80. The ride up and down the roller coaster has left you with an endowment that is 20 percent smaller than when you started. In our simple example, the bottom line is that it would require one year with a return of a whopping 31 percent, allowing for the normal spending rate, to bring the endowment back to its pre-roller-coaster value.
Of course, most universities use some kind of smoothing formula, the simplest version of which is to take 5 percent of the three-year average of June 30 market values. That practice cushions the impact of a one-year or two-year fluctuation, in effect stretching the pain out longer but making the drop less severe year over year.
The math becomes a little tedious, but the basic effect of the smoothing is easy to see: The impact of the sharp drop in the endowment is spread out over a couple of extra years, but the impact of improvements in asset values is similarly spread. In our simple example, instead of increasing the dollars taken from the endowment by 25 percent after the big run-up, the three-year rule would have generated a smaller spending increase that year and a slower and smaller annual decline in spending—but a decline for more years after the market tanked. In other words, in this example and in reality, years of struggle lie ahead.
Does this tale of woe for the best-endowed colleges and universities contain any lessons for the future? We think so. The big lesson is that the volatility of spending out of the endowment is much greater than many people—including university leaders—recognize. To cope with that reality, they either need to figure out how to organize their institutions to make such big swings in spending easier to manage, or, preferably, to find ways to moderate those swings.
The problem with making spending swings manageable is that doing so would involve strategies like putting a larger portion of faculty and staff members in temporary positions and programs, making layoffs and program shutdowns easier to achieve in a hurry and to reinstate in good times. But it is hard to believe that you can build a university around such arrangements without seriously compromising quality.
The second option, damping down fluctuations on the spending side of the budget, seems more attractive than building a university that can expand and contract like an accordion. Three-year averaging works well for this purpose for normal one-year or two-year swings. But in the last decade, financial assets exhibited an extraordinary run-up in value. Universities yielded to the temptation to believe that they were earning double-digit returns year after year because they were geniuses, and not because the stock market had departed from its historic norms—and was overwhelmingly likely to return to them.
Those institutions thus allowed their endowment spending to increase by double-digit amounts year after year (pushed, it must be said, by ill-judged efforts in Congress to induce them to spend faster). Nobody worried too much about those remarkable rates of increase, because they didn't foresee the good times ending anytime soon.
A rule that limited annual endowment-spending growth to historically plausible levels would have generated more savings and a bigger endowment to draw on when the collapse came. As it always does. One way of formulating such a rule is just to say that no matter what is happening with the endowment, inflation-adjusted spending from the endowment will never be allowed to go up or down by more than a certain stated percentage from one year to the next.
Institutions did not plan for the volatility they have experienced, and they, their students, and their employees are now paying the price—and not merely in cold breakfasts, but in hiring freezes, construction plans disrupted in midstream, and confusing changes in student aid. With more forethought they can do better next time.