Bigger Is Not Necessarily Better

Related articles: View all of the advice and commentary from this special supplement on endowments
By HENRY HANSMANN

It seems an article of faith among nonprofit institutions that having a big endowment is good, and having a bigger endowment is better. Often, though, endowment accumulation is a poor strategy. Moreover, even when building an endowment makes sense, currently popular spending rules are generally counterproductive.

We should first recognize that endowments really contain two different types of funds. The first — “true endowment” — comprises donated support, which, by the terms of the gifts, must be maintained as endowment. The second — “quasi endowment” — comprises unrestricted support that has been set aside by the institution’s own choice. For administrators, it is quasi endowment that I’ll discuss here. But my points apply just as well to true endowment — only in that context it is donors who I hope might take heed.

When, principally in the 19th century, American universities and other nonprofit institutions first began to build substantial endowments, there was good reason for it. The private donations that went into those funds came in clumps typically from large individual bequests or capital campaigns that were separated by substantial intervals. In those circumstances, it made no sense to spend the money when it was received. The better policy was to spread out expenditures over time and stabilize operations.

Today, however, gift income, like other forms of revenue, commonly flows at a relatively constant, predictable, and generally increasing rate. Fund raising is now a continuous activity. Even major fund-raising campaigns, when accounted for realistically, often produce relatively modest — and increasingly frequent and regular — swellings in an institution’s flow of cash income. As a consequence, at many institutions gift income need no longer be set aside as endowment to smooth out expenditures. If those institutions nonetheless continue to accumulate gift income rather than spend it, we must look for another justification.

Fundamentally, endowment-building is simply a form of saving. When, for example, a university decides to put a dollar in its endowment, it is choosing to save that dollar for future expenditure rather than to use it for current educational purposes, such as scientific research, more and better teachers and facilities, or student scholarships. And what might that money be spent on in the future? Presumably, on scientific research, more and better teachers and facilities, or student scholarships. Consequently, when an institution adds a dollar to its endowment, it must believe that spending the money later will be either more equitable or more effective.

Let’s first consider equity. It’s often said that building an endowment helps ensure intergenerational equity among an institution’s beneficiaries. Just the contrary, however, is true. The next generation of university students, museum visitors, and foundation grantees will almost surely be more prosperous than today’s, just as today’s are more prosperous than preceding generations. Consequently, when a nonprofit institution saves rather than spends its current income, it deprives the relatively poor to subsidize the relatively rich. A nonprofit college that wishes to pursue intergenerational equity should operate on debt rather than on capital surplus.

What, then, of effectiveness? Should institutions expect to have more productive uses for the money in the future? Will colleges find much more attractive opportunities for teaching and research later than they have now? Will shelters have more compelling reasons to house the homeless a few decades from now? Will bank consortia that make low-interest loans for gutsy start-up businesses in troubled neighborhoods find better entrepreneurs down the line? Will opera companies be more inspired to mount an ambitious production a generation from now? We have no sensible reason to think so.

That is not to deny that there are sometimes good reasons to save. Nonprofit institutions have difficulty obtaining capital on short notice. Unlike business corporations, they can’t raise money by issuing and selling stock, and their ability to borrow is typically constrained by the poor fungibility of the assets they can offer as security. Consequently, if they want to make an unusually large specific expenditure, they may need to save up for that goal.

It might be the construction of major new facilities, or the renovation of existing ones. It may be cautionary planning for a sudden shortfall in income or increase in costs. As recession came on in the early 1970s, for instance, government grants and private donations to colleges both fell off sharply. Then OPEC sent energy costs soaring. Many institutions were badly squeezed. Colleges, like many other nonprofit institutions, are especially vulnerable to such crises since they’re relatively inflexible. Their faculty is tenured, the scale of their plant is relatively fixed, and their commitments to students run for four years or more. An institution that does not save up funds for such rainy days may be forced to make drastic cuts from which it will have difficulty recovering.

But effective management in such cases requires that the money saved is ultimately spent. Such occasions do not justify saving in perpetuity. Yet endowments are commonly managed in just the contrary fashion. Many institutions restrict annual spending to a fixed proportion — typically around 5 percent — of the endowment’s current market value. The objective is to prevent spending down the endowment’s real value. But the consequence is to preclude the use of the endowment to save for large projects, or to draw on when special difficulties or opportunities arise.

In fact, such a spending rule (even when, as is typical, it is based on a value averaged over several years) has worse consequences still. Instead of the endowment serving as a buffer for unexpected variation in income and expenses, the operating budget serves as a buffer for fluctuations in the endowment’s market value. That would make sense only for an institution that sees its primary purpose as the maintenance of a large and steadily growing investment portfolio, with its operating activities — say, sending doctors to war-torn countries or vaccinating children — serving as means to that end.

America’s leading nonprofit institutions are among the few private concerns that have the luxury to plan over a horizon of decades or even centuries. One might think they would take advantage of that opportunity to operate countercyclicly, investing in facilities and personnel when the economy is slack and building their reserves when times are flush. Instead, they’ve chosen shortsighted policies that commit them to the reverse, gratuitously tying their operations to the vagaries of the markets.

Why are they managed in that perverse fashion? One reason perhaps lies in their governance. From a legal and practical view, their board members play the same role as the directors of business corporations. Nevertheless, by tradition they’re generally called “trustees.” In consequence, they may wonder just what they are trustees of. And they may well think that, at minimum, they are trustees of the institution’s endowment, and that they have a duty to protect it. Perhaps reinforcing that attitude, trustees are generally chosen not for their expertise in managing the particular type of institution, but rather because they’re substantial donors or prominent in business or civic affairs. As a consequence, a trustee of, say, an organization that supports cancer research might well feel that she should stay away from serious involvement in education, outreach, or management of overhead costs, but that she should assume strong responsibility for protecting and building the endowment.

Yet another reason, presumably, is the desire of nonprofit managers to have a secure career. That doesn’t necessarily imply that the managers are consciously self-serving. It is just that the importance of ensuring that an institution can maintain its activities at the same scale in perpetuity is naturally most salient to those who are employed by it.

The answer, of course, is not to rush out and spend long-accumulated accounts. Thoughtless spending is no better than thoughtless saving.

Rather, nonprofit institutions should engage in rational long-range financial planning. They should manage their discretionary reserves as a financial buffer, with all the flexibility, and all the difficulty of judgment, that doing so implies. More generally, they should weigh all types of investments — in physical capital, human capital, services, research, reputation, and the stock market — in terms of the effective (social, not just pecuniary) rate of return the investments will yield. There may be occasions when saving large sums for the future is appropriate.

A change in terminology might also be in order. The term “endowment” is now used casually to cover virtually all of a nonprofit organization’s invested funds. That usage implies, in itself, a commitment to avoid the spending out of principal, and probably reinforces that practice. It would be better to confine the term “endowment” to true endowment, and to refer to all other accumulated savings as “capital reserves.”

My fear is that, instead of adopting a more purposive approach, many managers will continue to build endowments until their useful days have passed, when the accumulated savings will finally be spent in a wasteful effort to prolong institutional senescence.

Henry Hansmann is a professor at the New York University School of Law.

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Volume 16, Issue 16, Page B26