Endowments Are Not a Luxury

Related articles: View all of the advice and commentary from this special supplement on endowments
By DENNIS R. HAMMOND

Many, if not most, trustees and officers of nonprofit institutions cannot imagine operating without endowments. Prudence demands, and common law encourages, institutions to set aside some of each year’s unspent earnings, together with gifts given in perpetuity, to help maintain operations in future years when revenues, earnings, and gifts to the annual fund are inadequate.

The rationale is simple: Save today, spend tomorrow. Preservation and growth of seed capital have long been basic tenets of financial strategy, and especially so for nonprofit institutions whose annual expenses are not consistently matched by revenues. Financial needs are not static. Over the past two decades, for instance, higher-education costs have grown faster than inflation. If costs continue to outstrip inflation, substantial endowment growth will be necessary to keep tuition in check.

States have substantially cut support for higher education, and more cuts may be in the offing if legislatures favor retirees’ entitlement programs over student grants and loans. Threatened federal legislation, including the elimination of estate taxes, reduction in aid to colleges and universities whose tuition rises faster than stated norms, and tuition caps, add to the fiscal uncertainty. Combine that budgetary haze with growth in programs and curricula, capital spending and maintenance, and scholarship awards (or discounting), and the need to set aside permanent accounts becomes obvious. The expected growth of entitlement programs also presents risks for noneducational charitable organizations that receive government grants. Discretionary federal expenditures may be squeezed, which would necessitate an even greater reliance on the private sector for funds.

Over the last century many farsighted institutions persevered in fund raising, saving, and investing. According to the Foundation Center, a clearinghouse for information about American philanthropy, foundations had $477-billion in assets as of 2001. The National Association of College and University Business Officers reported endowment assets for its membership at $230-billion as of June 2003. That represented a decline from the peak of $241-billion at the end of the 2000 fiscal year, but an improvement from the $222-billion reported for the 2002 fiscal year.

Such wealth has been a great benefit to eleemosynary institutions. The Foundation Center reports that private and public foundations granted more than $30-billion dollars in 2002 for numerous charitable purposes including health care, education, and arts and culture. Higher-education endowments provide substantial support to operating budgets. The Commonfund, which manages investments for nonprofit institutions, reports that the average college or university finances 13 percent of its operating budget from its endowment. While that may appear high, we know that a significant number of independent institutions rely heavily on their endowments, drawing from them more than a quarter of their operating budgets as well as student aid. How different would those institutions be today had past generations not had the foresight to create those reserves?

Providing necessary support through thick and thin has long been the raison d’être for endowments. Institutions should and do rely more heavily on endowment sustenance in periods of declining operating revenues or market values. That doesn’t conflict with the principle that endowments are created in perpetuity. Rather, the notion that endowment capital is inviolate, regardless of institutional need or market environment, is foreign to the basic premise for its existence.

The elimination of income-only spending approaches through the adoption by most states, over the last several decades, of the Uniform Management of Institutional Funds Act was a huge step in the right direction. However, the act’s prohibition of spending below “historic dollar value” put many institutions in a bind following the recent bear market. (The historic dollar value is the original endowment principal plus the value of subsequent gifts.) The current proposal by a drafting committee to eliminate that language in the act is another constructive change. Endowments are valid vehicles to provide a sustained source of institutional funds so long as they are allowed to do just that, and are not constrained to preserve capital at all costs and regardless of institutional need. Otherwise, the endowment itself becomes the sacred cow, and the institution’s needs become secondary. At the end of the day, which do we wish to preserve, anyway?

Consider endowment spending through recent difficult periods. Some smaller private colleges and universities experienced financial difficulties in the 1990s because of their competitive position, as the “baby bust” reduced the proportion of college-age students. Endowment support for those institutions certainly helped to mitigate cuts in operations and to upgrade their campuses to improve competitiveness. Those institutions are now better positioned to capitalize on the “echo boom.” What would have happened had they not had the foresight to raise money and save?

And what of the most recent “rainy days” of 2000 through 2002? Did institutions look to their endowments, or their operational budgets, as buffers for the bear market? For most, endowments were the cushion. Through the bear market, from the 2000 to 2003 fiscal years, the average spending rate for Nacubo institutions increased from 4.8 percent to 5.4 percent. To be sure, a number of institutions cut spending rates in the face of investment losses. On average, however, endowments, not operations, have been the shock absorbers.

Overspending can certainly deplete endowments. Incursions into principal accelerate that decline. However, over the long term, occasional underspending can mitigate occasional overspending, and principal judiciously spent can be replaced as soon as conditions allow. Institutions became accustomed to ever-rising distributions produced by the two-decade bull market. As long as an endowment was not sitting in cash, double-digit growth rates were earned relatively easily in the ‘80s and ‘90s. Of course, those gains could not continue forever. When the party finally ended and the hangover ensued, not only did the growth halt but many institutions were facing declining income, based on their plummeting asset values.

Calculations, used by many organizations, that were based on average fund values over the previous three years did not allow for sufficient savings from the outsized gains of the late ‘90s. That and the recent bear market suggest that institutions should reconsider their spending formulas. Instead of the three-year calculation, endowments may wish to adopt “floor and ceiling” spending formulas that save more in good years to offset the inevitable rough years. A floor-and-ceiling approach typically increases the prior year’s spending by inflation regardless of the endowment’s market value, so long as the spending amount is below a percentage cap of the endowment’s value (e.g., 6 percent) and above a percentage floor (e.g., 4 percent).

Some analysts argue that future generations of patrons, students, and donors will be wealthier than today’s, undercutting the intergenerational-equity rationale for endowments. That supposition wishfully assumes away the need for saving. After all, if consumers and donors will have more money tomorrow than they do today, perhaps they will be willing to part with a larger share of it to purchase higher education or support charitable efforts. Unfortunately, the argument is to prudence as gambling is to saving. Unquestionably, the two-decade bull market had a significant positive impact on donations. However, if the market proves less kind over the next two decades, will charitable giving remain high?

It is tempting to put today’s needs ahead of tomorrow’s, especially when current decision makers won’t be around to ascertain the outcome, or be held accountable for it. Nevertheless, the concept of intergenerational equity cannot be abandoned. An endowment, properly managed, will support the same programs 50 years from now, net after inflation, that it supports today. The income from new additions to the endowment may be used to finance new programs, offer additional scholarships, or simply provide a deeper bulwark against the distant unknown.

There will be inevitable periods of conflict between short-term operational needs and the long-term need for growth and maintenance. Board members must evaluate their institutions’ idiosyncratic needs during market or operational shocks. But in that ambiguous art of balancing present and future demands, one fact remains unambiguous: Endowments are not a luxury but a necessity.

Dennis R. Hammond is managing director and senior consultant of Hammond Associates, a St. Louis company that provides advice on institutional investment.

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Section: Endowments
Volume 16, Issue 16, Page B26