The Drop in University Endowments and What to Do about It--Posner

College and university endowments have taken a big hit from the drop in the stock market and other asset markets. A drop of 20 to 30 percent is common, and there is suspicion that endowments that contain a significant proportion of assets that are not traded on organized markets, such as real estate, have dropped even more, but without "marking to market" their nonfinancial assets. The effect of a drop in the market value of endowment on a college's or university's finances depends on a variety of factors. I will give a hypothetical example that may help in understanding the issue. Suppose X College has an endowment that before the crash had a market value of $1 billion. In normal times X cashes 5 percent of the endowment each year to contribute to X's budget, 5 percent being a widely used estimate of the average real return of a typical university investment portfolio. Suppose X's total annual budget is $200 million, with a quarter contributed by the income on the endowment (5 percent of $1 billion = $50 million), a quarter by alumni gifts (apart from gifts intended to become part of the endowment), and a half by tuition. In the economic downturn, I'm assuming, the endowment has fallen by 30 percent, to $700 million; tuition net of financial aid has dropped by 5 percent (because of inability of parents to pay tuition, as a result of declines in their income and wealth); and alumni gifts have (for the same reason) fallen by 10 percent. Then College X's income will have declined by 12.5 percent, from $200 million to $175 million, assuming the college continues to treat 5 percent of the (shrunken) endowment as income. What should X do (other than expelling its suddenly impecunious students and replacing them with affluent ones of less academic promise)? The typical response has been to cut spending by the amount of the drop in income: in my example, that would require X to reduce its spending by 12.5 percent, which it can do in various ways, the usual ones being laying off staff, freezing hiring of faculty and staff, delaying construction, deferring maintenance, reducing staff salaries, and curtailing extracurricular activities. At first glance, this seems a puzzling response. Why all this dislocation, instead of either spending capital (that is, taking more than 5 percent out of the endowment) or borrowing? Take borrowing first. Unless a dollar is worth less to College X this year than it will be next year (or whenever its income returns to its normal level), why should it spend less when it can spend the same, with modest effect on future spending, by borrowing (in my example, $25 million)? Lending and borrowing are methods by which the marginal utility of income can be equalized across time when total income varies from year to year. Harvard is borrowing more than $2.5 billion, but it is still cutting its budget by 10 percent. Similarly, although "spending capital" is a familiar example of improvidence, it can make perfectly good sense. In my example, College X is short only $25 million, and if it takes that out of the endowment, the endowment will fall only from $700 million to $675 million. A problem may be that donors of endowment money may have placed limitations on spending, fearing that a gift that they intended to be perpetual would be eaten up if X dipped into the principal of the gift. But not all endowment money is restricted in this way and trustees of trust funds usually have authority to dip into principal in the event of an emergency. However, X may fear that if it does that it will discourage future contributions to the endowment. Given that last concern, borrowing seems the superior alternative to spending capital, and yet most colleges and universities seem reluctant to use borrowing to fill the entire gap between income and expenditure; otherwise they wouldn't be cutting spending. Granted, credit remains tight, but the elite universities, at least, are fiscally sound and have alumni in positions of influence in the credit industry. Maybe the reason the colleges and universities are not borrowing more is that they do not expect their income to recover in the foreseeable future. Nonelite colleges depend heavily on state aid, which is likely to be meager for a number of years--state budgets are in terrible shape. And they draw students from the segment of the population that has been hardest hit by the economic downturn. Elite colleges and universities depend heavily on federal research grants, which may diminish as the government tries desperately to control the rapidly mounting national debt, and on donations by wealthy alumni. Many of those alumni have suffered a permanent reduction in their wealth, and many others are facing the increasingly likely prospect of having to pay higher income taxes, which will make it more difficult for them to pay their kids' tuition. Elite universities may have to limit tuition if they want to attract the best students. A protracted economic crisis has different effects on different industries, because different industries have different vulnerabilities. The current crisis is speeding newspapers, and print media more broadly, to an early grave, and may yet destroy all three Detroit automobile manufacturers. It will not do in the colleges and universities, but it may have a lingering adverse effect on them that may explain and justify immediate measures to reduce expenditures.

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