President John Hennessy writes: During the past year, interest in university endowments, financial aid, tuition and other aspects of university finances has increased among the media and government officials. Because I believe these are such important issues, I asked Provost John Etchemendy, PhD ’82, to share his insights on these subjects in place of my regular column for this issue. I hope you find his ruminations as illuminating as I did.
By John Etchemendy
There has been much discussion and criticism in recent months about the large endowments of many private universities. The criticism focuses on three main points: the size of these endowments compared to those of public universities, the total percent of the endowment spent each year, and the proportion of the endowments used for financial aid.
The way we fund colleges and universities in the United States is much more complex than other countries, where almost all funding flows directly from the government. We have by far the most diverse system of higher education. This includes everything from large state universities and small community colleges to private institutions such as Stanford and Harvard, with their broad array of undergraduate and professional training and billions of dollars in research, and small liberal arts colleges like Skidmore and Pomona, that provide outstanding undergraduate education in more intimate settings.
This diversity is a huge advantage, and the main reason American colleges and universities are the envy of the world. What is not often recognized, however, is that these different kinds of institutions also depend on entirely different financial models.
Endowments play a crucial role in the finances of private universities. It is true that the largest private endowments dwarf the endowments held by public universities. Let’s use the University of California and Stanford as examples. The UC system—really 10 separate universities—has a total endowment roughly a third the size of Stanford’s and less than a fifth of Harvard’s.
But this comparison misses the point: public universities and private universities are built on different financial models. The main sources of revenue for a public research university, like UC, are state general funds, sponsored research funds, and student tuition and fees, in roughly that order. This year the UC system will receive more than $4 billion from state tax funds. This is the equivalent of having an $80 billion dollar endowment, assuming a responsible 5 percent spending rate. Actual endowment income, in contrast, accounts for only a tiny fraction of the revenue that UC depends on.
Private research universities also rely heavily on tuition and sponsored research. But with rare exceptions, they receive no state general funds to support their operation. This revenue source is replaced by endowment income and yearly donations. In 2007, 30 percent of UC’s nonhospital revenue came from the state general fund and only 2 percent from endowment income. In contrast, none of Stanford’s revenue came from state general funds; roughly 20 percent came from its endowment.
Endowment income is to the private university what state tax revenue is to the public university. Should endowment revenue be taxed if the endowment exceeds a certain size, as some have proposed? This would be like taxing state general funds flowing to a public university when the flow exceeds a certain size. Both state and private universities educate our populace, train our doctors, teachers and engineers, find new cures for disease, and develop the technological breakthroughs that fuel our economy. Given this crucial role, society benefits when either increases: endowment to the private university, state funding for the publics.
Next, private universities have been accused of “hoarding” their endowments, of spending too small a percentage each year. Indeed, prominent members of Congress have proposed mandating that universities spend at least 5 percent of their endowments each year, noting that in recent years most universities have fallen below that level.
A 5 percent “payout” is a reasonable spending rate. An endowment is meant to support the university in perpetuity: both now and a hundred years hence. This theory of endowment spending is based on the goal of intergenerational equity: the endowment should provide the same benefit for future students as it does for today’s. To ensure this, the endowment’s investment returns must, on average, both keep up with inflation and cover the current payout. If they do not, we will steadily spend down the endowment and shortchange future students.
Most universities assume that their endowment managers can, over the long term, achieve an average return between 9 and 10 percent a year. If 5 percent is spent for current operations and any remaining return reinvested in principal, the endowment should maintain its inflation-adjusted value.
So why have universities been spending less? Most universities have a “target payout rate” of around 5 percent. Stanford’s target has traditionally been 5 percent, though last year it was increased to 5 ½. But in determining the actual payout, every university uses a so-called smoothing rule: a formula that dampens the volatility of the endowment payout so the university’s budget is not whipsawed whenever the stock market soars or falls. Many formulas are used, but the simplest is to pay out, say, 5 percent of the endowment’s average value for the past three years. This turns the sharp peaks and troughs of your investments into the rolling hills and valleys you need for the budget.
But notice that all smoothing rules have the following consequence: during periods of exceptional investment returns, because your endowment is growing, the actual payout rate falls below the target rate. Conversely, during periods of poor investment return, the actual payout rate moves above the target rate. This is how a smoothed payout is achieved.
Recent years have seen extraordinary investment returns, and that is why actual endowment spending has dropped below the target spending rate. It is not because universities are hoarding their endowment (what university provost wouldn’t like more money to spend?), but because universities are practicing responsible budgeting principles. One need only look back to the negative endowment returns of 2001 and 2002 to realize that good times do not go on forever. Mandating a minimum annual payout of 5 percent assumes that they will.
Finally, what about financial aid? Many Americans are rightly concerned about their ability to finance a college education for their children. Are private universities spending enough of their endowment on financial aid? Are they using their endowments to keep the cost of education down? Last year, Stanford spent a total of $156 million in combined undergraduate and graduate financial aid, the equivalent of 25 percent of our total endowment payout of $609 million. But could we have spent more?
There is a sense in which we did. Every dollar of endowment supports some aspect of the University’s mission of teaching and research. Donors create endowed funds to support different parts of this mission. One might create a fund to support cancer research, another to support a program in Islamic studies. A third might establish an endowed professorship in economics, while a fourth might endow an undergraduate scholarship. In each case the payout from the fund must be used to support the specified purpose. And only in the last case will the payout be reported as financial aid.
But that’s misleading: any endowment that allows the University to enhance the education it provides is also, in a sense, financial aid. It allows the University to improve the quality of the educational program without charging that enhancement to tuition. Endowed professorships allow us to decrease the student-faculty ratio, to offer more and smaller classes, without requiring any students to pay for this through tuition. An endowed program provides more educational choices for students, again without adding to their tuition.
So-called “financial aid” endowment holds the quality of the educational program fixed, but reduces the cost for students who can’t afford full tuition. Other types of endowment improve the quality of the program, while holding the tuition fixed for all students, whether they receive explicit financial aid or not. Both forms of endowment allow students to receive a high-quality education without paying its full cost.
Note that this is not unique to private universities. Exactly the same point can be made about California’s general fund investment in the UC system. General funds allocated to financial aid hold the quality of the educational program fixed while reducing the cost for low-income students. General funds used to hire faculty and add programs increase the quality of the education, without charging those enhancements to any student’s tuition. Both are, in effect, financial aid.
Asking whether “enough” of a university’s endowment is being used for financial aid is simply the wrong question. The right question is whether the university is affordable for all students, regardless of their family’s financial circumstances. And for the universities whose large endowments have attracted so much attention, the answer to this question is yes. Every one of these universities practices need-blind admissions: they do not factor financial need into the admissions decision, but instead guarantee sufficient financial aid so every admitted student can afford to attend.
Indeed, thanks to recent financial aid enhancements, for close to 90 percent of U.S. families, attending Stanford next fall will cost less than attending UC—a persuasive argument, in my opinion, for increased state funding for the UC system.
None of this is to say that universities should be exempt from financial accountability or using the highest standards in managing their resources. Just as we take seriously our obligation to maintain endowment resources for future generations of students, we are deeply mindful of the trust placed in us by our current students, their parents, and state and federal governments. This partnership is a uniquely effective model for teaching young adults and producing advanced research—a model that is admired by every other nation in the world.
