Careful Cuts

John Hersey

When the great recession slammed into Stanford, the shock wave reverberated in every corner of the University. The value of the school's endowment, which sat at $17.2 billion in late summer 2008, plummeted 27 percent in 12 months, leading to unprecedented cost-cutting measures. Hundreds of staff lost their jobs, salaries were frozen, hiring plans for dozens of open faculty positions were suspended, and several construction projects were put on hold. As years of endowment gains disappeared virtually overnight, the administration mobilized to preserve two key priorities: the quality of the academy and affordability for students.

Nearly $120 million in general funds—which pay for most faculty and staff salaries and many everyday operations at the University—have been trimmed from the 2009-2010 fiscal year budget, effective September 1. In all, according to Stanford officials, the University will absorb approximately $300 million in revenue reductions over the next two years. And the recently expanded undergraduate financial aid program, intact for the moment, faces new funding challenges.

Still, about a year after the budgetary walloping began to snap heads, Stanford is wearing its bruises with a hard-won sense of fortitude. Despite the endowment losses, the University as been able to largely maintain its programs and services. While some academic programs— notably Sophomore College—will offer fewer courses, teaching and research broadly will be only slightly affected. University officials are confident that, for the most part, students won't notice much of a change, save for minor adjustments in advising, library hours, student fees and so on.

Bottom line: The pain and pressure induced by the recession, while serious, did not prove catastrophic. President John Hennessy points out that while the endowment has retreated to its 2005 level, and the University's budget has been recalibrated accordingly, "Stanford was a great university four years ago. It still is a great university."

Some of the more pronounced effects occurred in the office of the vice provost for undergraduate education, with a downsizing to Sophomore College and significant cuts for next summer's undergraduate research funding. Sophomore College scaled back to 16 classes in September, as opposed to a typical 20 to 24. Undergrad research sustained a 20 percent cut of about $1 million and will have funding for roughly 1,200 students instead of 1,500. "These were some of the most powerful cuts," notes Vice Provost John Bravman, '79, MS '81, PhD '85.

Campuswide, faculty recruiting has been aggressively curbed to save costs. More than 50 faculty searches were put on hold. The full impact of that measure won't be known for a while. At the School of Humanities and Sciences, the size of the faculty—540—is about what it was in 2008. But according to Adam Daniel, H&S senior associate dean for finance and administration, that number may mask a future vulnerability. Some faculty likely delayed retirement because of declines in their retirement portfolios, Daniel says. "In the coming year there will be many fewer authorized searches than last year; at the same time, we expect retirements and resignations will likely increase. Thus, we fear that we may begin to see our faculty numbers decline starting in fall 2010."

Demand for courses in physics, statistics, math, political science and psychology has grown in recent years, adds Daniel, and the school is looking at adding teaching assistants to help in some sections. "But this is not a panacea and not a solution for the long run."

The downturn hit in the midst of an ambitious capital improvement program. Some of it will have to wait. Stanford has delayed or suspended an estimated $1.1 billion in construction plans, but decided to continue with buildings already under way. One conspicuous example: Work on the new Graduate School of Business campus, the eight-building Knight Management Center, has been making a steadily productive din for more than a year. "It would be crazy, financially and every other way, to simply stop the projects that are under construction," Provost John Etchemendy told the Faculty Senate. "The one good side of the downturn is that we are saving money on construction. We saved millions of dollars on the Business School project because steel prices have gone down."

Most "units," the term Stanford uses to describe the seven schools and various administrative departments that submit budgets annually, made spending reductions of 12 to 15 percent. Much of that savings was realized through layoffs. The Graduate School of Business acted aggressively early on, letting 49 people go last January. In all, almost 500 positions were eliminated throughout the University. Despite efforts to trim in other areas, there was no way to squeeze out 15 percent of costs without cutting jobs, says Etchemendy, PhD '82. As Stanford's chief academic and budget officer, Etchemendy was called upon to take the lead in resolving the financial crisis.

"We are a people enterprise. Well over 50 percent of our expenses go directly to salaries," he told STANFORD. "The units did everything they could to reduce non-salary expenditures as much as possible. Belts have been tightened. But that doesn't do it."

A salary freeze was implemented for faculty and staff, and many senior administrators, including the president and provost, took voluntary pay cuts.

Athletics eliminated 21 non-coaching staff positions and laid off assistant coaches in men's gymnastics and rowing. But assistant coaches were saved in five other sports—field hockey, lacrosse, men's golf, synchronized swimming and wrestling—by quickly organized fund-raising efforts that generated new donations. The only sport among 35 that faces a potential change of status is men's and women's fencing, which must raise $250,000 in operating funds and $8 million in endowment to avoid dropping from an NCAA to a club sport.

One of the few examples of a change that will affect all students is the slightly reduced hours at libraries, including Green, which this year will close at 1 a.m. instead of 2 a.m. Sunday through Thursday. And in September 2010, the physics library will close, with a small portion of its collection moving into the engineering library and the rest being made available online. The libraries in general will buy fewer books and fewer subscriptions to periodicals.

University Librarian Michael Keller sees the library reductions as part of the more-than-superficial but less-than-extreme cutbacks that typified 2009 at Stanford. The damage was less than it might have been, he says, because of the decisive and skillful actions of senior officers and middle managers. "When our leadership says, 'We've got to do this,' we set to doing it. There's not a lot of whining going on here."

That attitude was evident across campus. Throughout the Stanford community, anecdotes surfaced about the can-do quality of people's responses to the overall budget crunch. Consider these examples:

At the GSB, members of the graduating class are asked to pledge a donation that they'll give to the school over a five-year period. The response often is extremely good, 90 percent of the class or more. "Last year [with Class of '08], they got over a million dollars, including some matching funds, and I thought, wow, nobody's ever going to beat or get close to that," says Dan Rudolph, MBA '81, senior associate dean for operations. After all, the Class of '09 was headed out to an extremely strained job market. So what happened stunned Rudolph. "One hundred percent—every graduating member of the Class of '09—pledged a gift. I mean you never get everyone, right? One person, they're just in a bad mood or they don't want to. Every single person gave. One hundred percent and more than a million dollars."

After one round of layoffs had been announced at the Law School, tenured faculty there unanimously agreed to take 2 percent salary reductions if it would help avoid further job losses. When approached with the proposal, Dean Larry Kramer declined their offer but agreed to consider it if conditions changed. "I was quite moved," he recalls. "I think it says something really good about the community and about the faculty's feelings about the school and the staff."

On a smaller but equally spirited scale, the women's lacrosse team was finalizing arrangements for its first road trip, to Eugene, Ore., just as the budget crunch began to be felt throughout athletics. The team could fly or take a 9½-hour bus trip in each direction. But head coach Amy Bokker had another factor on her mind as well: Going by bus gave her the option of taking all her players on the trip instead of leaving two or three off that travel squad. The team took the bus.

In the wake of the most precipitous endowment drop in history, understanding how investment performance impacts Stanford's budget has never been more relevant. The Consolidated Budget for Operations is a complex piece of machinery with many moving parts, and its relationship to endowment is equally complex.

In 2009-10, about 70 percent of revenues comes from three sources: government, foundation and corporate support of "sponsored" research (30 percent); student income derived primarily from tuition and fees (17 percent); and the endowment (22 percent). The remaining 30 percent comes from a mélange of sources, with the biggest chunk from health-care services related to the School of Medicine. In 2008-09, for the first time in Stanford's history, investment income, primarily from the endowment, was the largest source of budgeted revenue. It accounted for 29 percent—roughly $1 billion—of the University's $3.5 billion in operating revenues.

The endowment slice of the revenue pie has a particularly unpredictable basis. The money it supplies—known as the "payout"—is based on the value of the endowment, which fluctuates depending on investment performance. A payout is made to support the consolidated budget regardless of whether the endowment's value rises or falls. Historically, the payout has been determined by using a "smoothing formula" that is designed to mitigate volatility. The idea is to keep the payout from soaring after a boom year—thereby suddenly increasing spending in a way that's unsustainable— or tumbling too acutely after a bad year, to the point of a budget shortfall that disrupts the University's functions. The target payout in recent years was 5.5 percent—and in a typical year, investment earnings would exceed that amount. Since 1965, the endowment has recorded gains in all but eight fiscal years, including 25 years with earnings of 10 percent or more. The worst of the sporadic down years was a relatively modest 8 percent decline in 1974.

Historical Investment Returns
Information Courtesy Stanford Faculty Senate

Beginning last September, Stanford's endowment plunged with astonishing swiftness, losing more than a quarter of its value in a matter of months. Earlier financial downturns, such as the recession of the early 1990s, were characterized by a protracted slide and slow recovery that allowed for more time to react, notes President Hennessy. In this case, "we saw revenues immediately vaporize."

When the president and provost met last spring to calculate the payout percentage, it was clear that the endowment's staggering losses had thrown the budget assumptions into disarray and called into question whether the smoothing formula was the best method to resolve Stanford's financial dilemma.

Hennessy and Etchemendy faced two unattractive options: radically cut costs in the short term to "rebase" the budget at a lower level, or subject the University to many years of relentless downsizing. They chose the former.

The University suspended its use of the smoothing formula and came up with a much more aggressive plan. The endowment payout will be reduced roughly 10 percent in 2009-10—a contraction of more than $100 million—with an additional 15 percent reduction planned for 2010-11.

Hennessy outlined the rationale in his annual address to the Academic Council in May. "If we were to set the endowment payout by blindly applying the smoothing rule, we would likely see more than five years of decreasing annual payouts and several additional years where the payout would grow by less than inflation. This would lead to many years of successive budget cutting, continuing long after the economy had recovered."

Accelerating the budget cuts provides ample head room to enable future endowment growth, he said in an interview with Stanford. "The math is pretty daunting. At a 5½ percent endowment payout rate, and let's say 3½ percent inflation, you need a 9 percent [annual] return just to stand still. Let's suppose we get our average [return] over the last 20 or 30 years, which has been around 10½ percent. That means we're only increasing the value of the endowment—above inflation plus payout—1½ percent a year. To get the value of the endowment back to where it was [before the recession] takes us more than 20 years. When you begin to do that calculation, you realize that not acting quickly to rebase your budget is a major mistake."

Etchemendy often hears from faculty, students and staff who see the enormous endowment totals and wonder why more can't be spent in bad times to ease cost cutting. "The answer is, we are doing that," he said in an interview in June. "This year ('08-'09) we are spending $1 billion out of the endowment. Was that investment income? No. We didn't have any investment income. We lost nearly 30 percent [of the endowment]. We're spending $1 billion out of the corpus [principal] of the endowment. We're spending it down at a frightening rate, and we can't continue doing it."

A common misperception is that the endowment is one large pool of money that can be easily tapped to offset temporary exigencies. In fact, the endowment consists of more than 6,000 separate accounts, varying in size and type, that often come with stipulations for how the money may be used: to support the activities of a professor in cancer biology, say, or to purchase books in Buddhist studies. That money is not fungible—it can't be used for other purposes. Etchemendy uses a grocery store analogy to illustrate: "Imagine if every customer, when they made a purchase, said to the store manager, 'by the way, I would like you to use this five dollars only to buy broccoli.' You can't buy peaches, or anything else, with those five dollars. It makes budgeting incredibly complex."

Endowment gifts that are unrestricted may be dispensed however and wherever they're needed, and they help underwrite the general funds budget, which provides essential support for everyday operations. So reducing the endowment payout also reduced available general funds.

Last December, a letter from Hennessy and Etchemendy told the Stanford community that the University was studying general funds cuts of up to 15 percent spread over two years. In March, the provost issued an update explaining that the worsening economy made it necessary to take the full 15 percent hit in one year and implement the reductions by September 1, 2009. The final tally was a $120 million general-funds reduction in the 2009-10 fiscal year budget.

As the University focused on putting new fiscal strategies in place, intense work was undertaken by the Office of Development, which has contacted about 600 donors whose endowments fell "underwater," meaning their value decreased below that of the original gift. The terms under which those endowments originally were made specify that only earnings and capital gains, not the original principal, may be spent. But many of the gifts underwrote new programs that might disappear without immediate funding. So the development office sought the permission of donors for more spending leeway.

By late summer, Martin Shell, vice president for development, reported that 90 percent of the donors reached by his office had agreed to let the University tap into the endowments more deeply. Another segment had offered additional gifts. "They understand the complexity of these financial arrangements," Shell says, "and they are philanthropic to start, so they want these funds to be available for urgent and pressing needs."

Perhaps no factor looms larger in fund-raising than Stanford's expansive financial aid program, whose overall cost for the 2009-10 fiscal year is rising more than 6 percent to $218 million. The tab for undergraduate aid is $111.5 million, up almost 8 percent from the previous budget and almost double what the cost was five years ago. The current program covers both tuition and room and board for undergraduate students from families with incomes below $60,000 and eliminates tuition for families with incomes under $100,000. The recession has pinched the program from two directions: jeopardizing funding due to the endowment drop even as families' need increased because of job losses. Enhanced in 2008, the program remains a core priority.

Undergraduate Financial Aid
Information Courtesy Stanford Faculty Senate

"It's the only thing we didn't touch in the University," when making cuts, Hennessy says. "That was kind of our guiding principle: protect students first and foremost."

When reflecting on the University's money management in recent years, Hennessy could find little to second-guess in investment strategies that would have sheltered Stanford from the national economic tsunami. But 20/20 hindsight did give him pause on financial aid.

The "extraordinary" positive returns on investments of just a few years ago, he says, led to a decision to bump up the endowment payout and expand eligibility to more families. "Clearly," he told Stanford, "had we known what was coming, we wouldn't have made that commitment, certainly not on that scale.

"We have an enormous fund-raising objective on financial aid ahead of us. We initially set a $100 million goal for undergraduate financial aid in the campaign. We doubled that when we put the new financial aid program in place and we're going to have to think about increasing it even further because our financial aid gap—that is the difference between what we get from endowment and our total financial aid bill—next year will be about $43 million. About $15 million of that will come from Stanford Fund gifts, assuming our donors continue to be as generous as they have in the past. But that means we have nearly $30 million in uncovered expenses for financial aid. Those are expenses we will have to pay out of temporary one-time reserves of the University, but we can't continue to do that for very long."

Stanford's financial challenges have not been unique, of course. The value of endowments at Yale, Harvard and other leading schools declined as much or more than Stanford's, producing a flood of local and national media coverage about the strains on higher education. However, little of the attention given to Stanford reflected the kind of tensions that came to the fore at some institutions. The headliners in that respect included Harvard, whose troubles were documented most prominently in a lengthy article in Vanity Fair, and the University of California system, where deep cuts prompted student protests and declarations of alarm from faculty.

At Stanford, the mood was never placid in the midst of the cost cutting but neither was it raucous. One of the biggest outcries stemmed from the imposition of a $167-per-quarter fee for services provided at Vaden Health Center. That move provoked particularly strong objections from graduate students, who said it unfairly taxed them for a service they seldom use. Greg Boardman, vice provost for student affairs, explained that the cost of providing health-care service was going up sharply at the same time that general funds were being cut. An across-the-board fee for students eligible to use Vaden was meant to reflect fairness, as opposed to drastically increasing costs for just the ill or injured, or requiring students studying overseas to shoulder the fee as well.

As the 2009-10 academic year began, there was cautious optimism that the worst was over, barring another national economic crisis. Restructuring is continuing because some cutbacks and additional layoffs go into effect on a stretched-out timeline, and the impact of new fees or diminished programs will hit home for many students as the full academic year unfolds. Moreover, the strain of the staff reductions, which have meant reduced hours and frozen positions as well as layoffs, is apparent wherever employees are taking on additional duties and responsibilities. New fund-raising needs have raised blood pressures, and some units have devoted hundreds of hours to analyzing every budgetary option, often with people's jobs on the line.

But there is a general recognition that things could have been much worse. The University has survived one of the most serious financial crises in its history with what appears to be minimal damage. As Hennessy put it, "We'll make it work."