Legal Commentary

How Should Universities React to the Decline in Their Endowments? Becker

By Gary Becker

The values of most university endowments have taken large hits during this financial crisis. The average decline since the real estate and stock market crashes began is probably over 20%, while the value of some endowments dropped by much more than that. Universities reacted to this severe shock with panic, and they often reduced their spending by too much.
I say "by too much" not because of any confidence that stock markets and real estate will return any time soon to their peak values. This is highly unlikely for real estate, and dubious for stock markets. My reason for objecting to large cuts in university spending is that they have usually under spent relative to their endowments. The philosophy behind these spending rates is that universities should not live off of capital, so that they can pass their capital intact on to future students and faculty. In order to preserve endowment values for the future, universities have tried to spend from their endowments only the income yielded, including capital gains, adjusted for year-to-year fluctuations in returns, and for other risks. On average, they have spent between 4% and 6% of their endowments.
This philosophy has not been implemented, if by not living off capital is meant that endowment values would be held rather constant in the long run. For endowments at all the major universities, and many other schools as well, have grown at very good rates during the past 40 years rather than being maintained intact. For example, Harvard's endowment increased many fold from 1960 to its peak at well over $30 billion in the fall of 2008. The University of Chicago was much less successful in its investment and gift-raising strategies than Harvard, but even the value of Chicago's endowment more than trebled from 1960 to its peak in 2008.
University spending has been too little to maintain endowment values constant partly because the annual return on their endowments has been underestimated, and partly because of large annual gifts from alumni and foundations that raised endowments. These gifts were especially big during the past decade as stocks soared, and as financial executives and others received generous bonuses and stock options, but they have not been negligible even during more normal times.
If we conservatively assume that gifts double endowments over 40 years, than in order to account for gifts and maintain endowment values, schools should spend 1 ¾ percent of their endowments in addition to the total incomes yielded by the endowment. Since incomes have averaged over long time periods at about 5-6% of endowments, the additional spending that would tend to keep endowments constant would raise endowment spending by more than one third. This means a very a large increase in total spending for schools like Harvard that get a big fraction of their annual revenue from endowment income. The percentage increase in spending would be significant but smaller for schools like Chicago that are less well endowed, and get a larger fraction of their revenue from tuition and grants.
More fundamentally, the argument that universities should try to maintain a constant, or "sustainable", endowment value is flawed and not compelling for reasons similar to the criticisms of proposals to maintain an economy's capital over time to achieve "sustainable" economic development. Why should schools aim to maintain endowments constant when even aside from private gifts, endowment income provides only a fraction of their annual revenue? Moreover, technological improvements in the efficiency of spending, by schools, such as more effective use of internet learning, may allow smaller endowments in the future to achieve as much in educating students and conducting research as larger endowments do now.
Another reason for spending more out of endowments than the income yielded is that effective spending on training of students and research, and often also spending on sports, are frequently productive in stimulating greater gifts and governmental grants. For example, schools that produce pioneering research, or that attract able and ambitious students who go on to achieve great success, tend to get larger amounts of foundation and other gifts through the favorable publicity they receive. In effect, spending is productive not only in raising student and faculty achievements, but also indirectly in inducing greater gifts that can lead to even greater accomplishments in the future.
In recent years members of Congress have proposed forcing universities to spend a larger fraction of their endowments, so that endowments do not increase as rapidly as in the past. It would not be wise for Congress to get involved in university spending rates, but for the reasons I have given, it is in the self-interest of well-run universities to spend at much higher levels than they have been doing during the past several decades.

Full post as published by Becker-Posner Blog on July 19, 2009 (boomark / email).