Prescription for Recovery

Linda A. Cicero

President John Hennessy spoke on "The State of the University and the Economy" at the annual meeting of the Academic Council on April 30. This excerpt focuses on Stanford's endowment.

In recent years Stanford has experienced remarkable growth in the endowment, thanks to the dedicated efforts of the Office of Development and the expertise of the Stanford Management Company. For the first time, investment income from the endowment became the largest source of revenue, at least for the current academic year. Unfortunately, that will not be true by next year.

Building the endowment to be a major revenue source has long been a goal of the University. From Jane and Leland Stanford's initial gift, it has grown to encompass about 6,000 individual gift funds. Invested together, they can provide a source of income independent of political vagaries, tuition increases or annual fundraising. Our investment portfolio is highly diversified.

In addition, we apply a smoothing formula to the endowment payout, thus reducing the volatility of the payout. Based on these steps, we thought we were well positioned to ride out normal fluctuations in the market. Indeed, as we progressed through last summer and it appeared that our endowment would be flat or very slightly down, we believed that our normal mechanisms would be adequate.

The situation, however, became radically worse as we entered the last three months of 2008. All assets—natural resources, real estate and private equity as well as public equities—experienced significant downturns in the last quarter; these losses continued in January and February of this year with a small recovery in March.

We have been tracking endowment performance since 1964; 37 of those 45 years, it returned between 2 and 38 percent. In only eight years has the endowment produced a negative nominal return, and the lowest such downturn was minus 8 percent. Until the fall of 2008.

In the first few months of this fiscal year, we experienced an unprecedented 30 percent decline in the merged endowment pool. Although the economy may stabilize during the remainder of the fiscal year, preventing further losses, we are projecting a total loss of 30 percent for the current fiscal year.

As the situation deteriorated in the late fall and early this year, the provost decided to seek a reduction in next year's general funds budget of 15 percent, an amount we initially thought would be the maximum we would cut over two years. A 15 percent reduction requires deep cuts, and we know it will affect hundreds of dedicated employees, but we saw no alternative.

The endowment payout is set by the trustees every year at the February or April meeting. A tentative endowment payout is computed using the smoothing rule. But the smoothing rule was never designed to deal with one-year downturns that are more than two standard deviations from the mean of the historical distributions.

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 endowment would grow by less than inflation. This would lead to many years of successive budget cutting, continuing long after the economy had recovered.

As an additional perspective, consider what it would take for the endowment to recover to the peak value of mid-2008. We would need a 43 percent increase in the endowment from today's reduced value, before accounting for inflation!

If we assume a 3 percent inflation rate—which is slightly less than our rate historically—an 8 percent return for the next five years and a 10 percent annual return after that, it will take more than 30 years for the endowment to recover to its peak value.

If we add the effect of incremental endowment gifts, starting at $150 million next year and increasing to $300 million three years later, it will take more than 15 years for it to return to the peak value. Although we believe that many of the reductions we are making will lower our operating costs, the endowment most likely will need to recover at least half of the value lost in the past year to adequately fund our teaching, research and financial aid programs.

This analysis makes it clear that we must reduce our draw on the endowment and realign expenses with the reduced value of the endowment as fast as possible.

Based on this, we proposed to the trustees to bring the endowment payout down faster than the smoothing formula would dictate. By decreasing the payout by 10 percent next fiscal year and 15 percent in FY 2011, we hope that the endowment payout will begin to recover in three to four years, versus more than five or six.

Of course, this will require additional sacrifices in the next few years, as payouts are aligned with the real value of the endowment. Just as the reduction in general funds affected the schools and units in different ways, the reduction in endowment payout will also impact various parts of the University differentially. Some operating units that depend primarily on general funds will achieve almost all of their reductions for the coming academic year; in contrast, some academic units that rely heavily on endowment will likely see budget reductions for both next year and academic year 2010-2011.

Our success in fundraising has greatly added to the endowment in the last few years, and that complicates the payout issue. Newer endowed funds have experienced a rapid decrease in value. As a result, hundreds of them are under water—that is, their current value is less than the value of the initial gift.

Due to legal restrictions as well as the value we place on the relationships with our donors, we have determined that we need their permission to spend portions of the initial corpus to maintain the funding for the program that the gift enabled. We are in the process of contacting our donors to seek such permission.

Lastly, the drop in the value of the merged endowment pool also affected our expendable funds, or the University's cash. A commitment to protect these funds against investment losses has meant that the central reserve funds will be diminished by about $1 billion. This loss significantly reduces both general funds income and the discretionary funds available to the president.

This "perfect storm" has forced us to think differently about the University's finances going forward. The loss of income will be felt over multiple years and have a significant impact on the way we do business. Throughout the University every unit set to work to help conserve our financial resources.

Earlier this year, hiring freezes were implemented for staff, faculty searches were canceled or significantly reduced, and senior administrators voluntarily accepted salary reductions. Last month, we announced a salary freeze for staff and faculty for the coming fiscal year.

When we realized that layoffs would be unavoidable, we announced an enhanced severance plan for staff as well as enhancements to the Faculty Retirement Incentive Program. We are encouraging employees to take vacation in the year in which it is earned, and over the next few years, we are reducing the number of vacation hours that can accrue. In the next few years, we expect that both salary and benefits increases will need to be very modest.

Some of you have asked about ongoing construction. I can assure you that every capital project has been reviewed. We have delayed or canceled about $1.3 billion in projects.

A related critical issue has been the liquidity of the endowment.

Liquidity is a measure of how quickly an asset can be converted to cash without a significant discount in the price received for the asset. Assets such as publicly traded stocks and bonds are liquid, while holdings in a privately held company or in real estate are considered illiquid.

Because a significant fraction of the endowment assets are in illiquid investments, endowment payout has had to be funded disproportionately by sales of liquid investments, primarily public equities. Such a concentrated sale further reduces liquidity and also distorts our asset allocation from its desired profile.

For these reasons, we raised $1 billion through a bond offering last week. As you may know, a number of our peers have pursued this course, raising in the range of $500 million to $1.5 billion each. Fortunately, we do not have a pressing need to spend the proceeds of this debt, but we believe that the added liquidity will enhance the University's financial stability and provide insurance against a need to raise funds at a time when the market might be less attractive. Of course, we will have to pay these funds back over the next decade, and for that reason, they will be held in a segregated account of highly liquid securities, unless a true emergency demands their use.

Going forward, it is best to think about the process we are going through as a rebasing of our budget, rather than as a series of budget cuts that might be someday restored. In the years ahead, as the financial situation improves and our alumni and friends provide new gifts to the University, we will be able to increase the base budget and make strategic decisions about new opportunities and the best uses for the additional funds.