Should Universities Have to Spend 5 Percent of Their Endowmen Annually?--Posner

Senator Grassley of Iowa has expressed concern recently about the conjunction of huge increases in the size of the endowments of many universities (and colleges--for the sake of brevity, I shall use "universities" to denote colleges as well) with continued increases in tuition. Both types of increase have far exceeded the rate of inflation in recent years. The senator urges that investment income generated by the endowments be used to reduce tuition, and he threatens to introduce legislation that would require (as a condition of the universities' retaining their favored tax status as charitable institutions) that universities spend a minimum of 5 percent of their endowment every year. That is a condition already imposed on foundations, but universities are exempt. Several major universities have announced recently that they will reduce tuition substantially to children of nonwealthy, though modestly affluent, families. I do not know whether these announcements are a response to Senator Grassley or to the concerns of the public that may have inspired his proposal. The 5 percent rule makes less sense for universities than for foundations. Foundations normally derive all or most of their income from investing their original endowment, and so they are not in competition with each other. Nor have they the spur of profit maximization. They are governed by self-perpetuating boards of trustees; so there is no democratic check either. The idea behind the 5 percent rule is to prevent the hoarding of endowment income, perhaps to provide high salaries and generous perks to staff and to prod the trustees to seek additional grants and thus compete with other foundations. But the prod is slight so long as the average return on investing the endowment is at least 5 percent a year. With inflation currently running at 4 percent, a 5 percent return is easily achieved. Higher education, in contrast to the foundation sector, is a highly competitive industry, even though most universities are nonprofit. They compete vigorously for students, faculty, and grants, which include alumni donations, foundation and other third-party donations, and government grants; state universities also receive money appropriated by the state legislature, but this is a diminishing source of the revenue of major state universities such as Berkeley, UCLA, Michigan, and Virginia. The different sources of income are complementary: good students attract good faculty and vice versa, and a university's academic standing attracts donations and grants. The universities' principal income consists of tuition plus donations and grants plus endowment income, but some universities have income from television contracts for their athletic teams, and others have income from patents developed by members of their faculty. The major universities not only have large endowments but also receive large annual gifts from alumni and others. Generally, wealthier universities are better, or at least more prestigious, than poorer ones, and so they can and do charge very high tuition even though they could "afford" to charge lower, or even zero, tuition; but that would not make economic sense for them. Given the competitive structure of higher education, it is hard to see why government should step in and try to limit tuition. The universities have a competitive incentive to provide financial aid to highly promising applicants who cannot afford full tuition; why those who can afford to pay for it should not be asked to pay for it escapes me. Forcing abolition of tuition would be a subsidy for rich kids. If universities were somehow prevented from charging tuition, moreover, applicants and their families would not have to think carefully about educational options. A free university education would be attractive to many people for whom it would be a poor investment if they had to pay stiff tuition, though it would not be completely free in an economic sense because they would have to forgo income from working. And a 5-percent-fits-all solution would make no sense for universities that had very small endowments and good reasons for wanting them to be larger. The difficult question involves the federal income tax exemption for donations to universities. It is a legitimate question why the federal taxpayer should be subsidizing Harvard, with its $35 billion endowment. The only justification would be if the type of research and teaching that goes on at Harvard or the other major universities generates external benefits that, were it not for the subsidy, would be smaller by more than the subsidy. This seems unlikely. The cost of the scientific research and graduate scientific training conducted in these universities is already heavily subsidized by federal and corporate grants and contracts; and increasingly the scientific research done by universities is applied rather than basic and so is eligible for patent protection. The contribution of nonscientific fields to welfare is not negligible, but one does have a sense that in many of them the marginal product is slight or even negative--is there really social value in having 400 English-language philosophy journals (the approximate number today) rather than 50? Because universities, though competitive, are not profit maximizers, because of age-old uncertainty concerning the effectiveness of various methods of teaching and the value of various forms of scholarship, and because of a tradition of faculty autonomy reinforced by the tenure system, universities have much the character of workers' cooperatives, which are not notably efficient enterprises. Conservatives, who inveigh against big government, should not ignore tax subsidies. There is no economic difference between giving universities federal money and allowing donors to universities to deduct their donations from their federal income taxes. If the exemption were repealed, tax rates could be reduced without any increase in government spending, and in fact government spending would be reduced, since the cost of administering the exemption and the higher cost of collecting taxes when tax rates are higher would be eliminated. Hence all tax subsidies deserve close scrutiny. I am not convinced that the tax subsidy for donations to universities would survive that scrutiny. A few peripheral points merit brief comment. First, the endowments may not be as large, realistically, as they seem. In recent years, a number of universities have been reporting annual increases in endowment in the 18 to 20 percent range. Unless the endowment managers are geniuses, there are only two ways in which they can obtain such returns. One is by generous year-end appraisals of endowment assets that are not frequently traded, so that their market value must be estimated. The other is by leverage, which generates above-average returns in a rising market--and above-average losses in a falling one. Second, the universities' argument, contra Grassley, that many contributions to university endowments come with restrictions that might make it hard for a university to spend 5 percent of its endowment every year is unconvincing. Suppose 50 percent of the endowment could not be spent (or the earnings on it); then to meet the 5 percent requirement the university would have to spend 10 percent of the unrestricted portion of its endowment. That would not be a hardship. Third, Senator Grassley's concern that increased endowment income is being squandered on high salaries for university presidents is also unconvincing. The reason those salaries are soaring is that universities are becoming increasingly large and complex, requiring management skills comparable to those required by substantial corporations.

Comments

[James Garland]

Judge Posner:

You wrote that a five percent return is easily achievable in an environment of four percent inflation. No -- or more accurately, no today. Endowed institutions spend the returns in excess of inflation. Spending five percent when inflation is four percent means earning nine percent. The average investor is not likely to earn nine percent over the long term, for reasons too complicated to explain here.

Because Congress mandates that private foundations pay out five percent, most of those foundations are slowly cannibalizing themselves.

[Diversity]

Looked at from Europe, Th US position of steadily increasing independence of Universities from government control is enviable. And it rests, in part, on the size of the endowments of leading US Universities. Senator' Grassley's meddling is dangerous.

That said, I have been wondering why some of the richer US Universities do not try digging a good deal deeper for the young talent that is still missing out. What seems to me to be a way to go is venture capital rather than loans. Harvard or its peers could well afford to try fishing for talent in say, the early years of high school; offering a selection of promising kids who are likely to drop out before college a deal of support to and through University in return for a share of their eventual earnings. The payback in prestige, good students attracted and eventual cash back to the endowments fund could be very worth while.

[Anonymous]

Judge Posner writes about university presidents:

"The reason those salaries are soaring is that universities are becoming increasingly large and complex, requiring management skills comparable to those required by substantial corporations."

In my view, CEO salaries are out of control and are not justified by the executives' supposed contributions to the corporations. It seems to me that a far flatter salary structure, such as the one that used to exist, would produce results that are not markedly different. In fact, the results might be better, because executives would focus on the long-term health of the corporation rather than on tomorrow's stock price.

The same goes for university presidents. Treating presidents as celebrities does not necessarily improve the university. It just changes the image of the university to a more corporate one. And, I would guess, it fosters resentment among faculty members who make a fraction of the president's salary. It used to be that university presidents were not all that different from the faculty members themselves; they just happened to be gifted administrators. They understood that a college was far more than a business. It would be sad if that academic culture is dying. And, if it is dying, the quality of higher education will ultimately suffer.

[neilehat]

Since this coming out of the UofC, let's look here first. The last time I was on campus, it was looking a little seedy, but then that might be part of its charm. Although, some of the older buildings, specfically those that are brick, limestone, and windowed with leaded glass could do with some major infastructure maintenance and repair. May I suggest looking at the slate roofs first, then windows and frames. This critique can equally apply to any institution across the country.

I know the boards are trying to be fiscally responsible and the like, but maintaining physical plant is vitally important to a functioning University. A five percent investment in physical plant might return some dividends.

[corwin]

It's their money.Let them spend it as they see fit.

[dm]

corwin: it's not really their money if earns artificially higher returns due to federal tax subsidies. In which case, the tax payer should have a say in how it is spent.
James Garland wrote: "You wrote that a five percent return is easily achievable in an environment of four percent inflation. No -- or more accurately, no today. Endowed institutions spend the returns in excess of inflation. Spending five percent when inflation is four percent means earning nine percent. The average investor is not likely to earn nine percent over the long term, for reasons too complicated to explain here.

Because Congress mandates that private foundations pay out five percent, most of those foundations are slowly cannibalizing themselves."

And so they damn well should. Foundations that cannot prove their value by raising new funds should (a) disappear or (b) lose their favorable tax treatment.

A less well known fact is that the endowment building tendencies of universities and other foundations is exacerbated by their right to issue tax exempt debt. Holders of tax exempt debt pay no federal taxes on the interest they receive, making the debt more valuable than the comparable taxable debt, which translates to a lower cost of capital for the issuing institutions.

To highlight the incentive, take the extreme case: a university could hold Treasury bonds at 5% in the endowmnet, issue tax exempt debt implicitly backed by the treasury debt at a rate less than 4% (because holders of the debt would treat it as risk free and carrying a valuable tax exemption). The university would make a guaranteed return with no net outlay, a classic arbitrage.

Lawmakers were and are aware of the potential arbitrage abuses and the relevant tax legislation includes various rules to prevent direct pledging of assets against the debt. Unfortunately, the incentive to build the endowment via tax exempt debt remains intact because implict guarantees are enough: The university will fund new buildings and schools with tax exempt debt rather than spend down their endowment. Debt holders see the endowment as a cushion against risk (ie. an implicit collateral).

[Author, No Sucker Left Behind]

The problem is that the wealthiest schools accept fewer low income students than other schools. So their endowments are not helping many of the students who need the most help. In addition, the schools get many tax breaks for all of their income, not just their endowment income. So the question is, is it fair to make these schools completely tax exempt, and then allow them to hoard billions of dollars for themselves and their wealthy students? I would argue "no." But requiring them to spend their money will not solve the problem. The money needs to be spread to less fortunate students.

[Richard Mason]

If you remove the tax deductibility of donations to educational institutions, then will you do likewise for donations to religious institutions?

Some universities, of course, are avowedly religious institutions. Others have a nominal or historical religious affiliation.

I do not think it is a good idea to place secular universities at a tax disadvantage relative to their religiously-affiliated competitors, or to encourage them to establish a fig leaf university chapel for tax purposes.

[Jack]

Let's look at their mission and their business. Ostensibly it's to maximize their educational "footprint", ie to raise the highest number of students to the highest levels of their potential.

Thus it would seem they could, and should, gradually cannibalize their capital in hopes of creating a great crop of alumni that could be harvested in the future to refill the coffers.

Hoarding, by definition, would mean the institution is investing in bonds, r/e, and stocks rather than investing in education. When their endowments are growing by returns from either alumni or other investments, it seems a clear indication that they can and should invest in more and better education.

Given the risky nature of the market, much of the r/e and poor returns on bonds, it would seem that investing in the education of our 'best and brightest' would also be the prudent path.

[1212]

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[Tim]

Grassley's interference seems dangerous on two fronts: first, by threatening to hamstring one of the indisputable commpetitive advantages this country has in a global economy, and second, by placing additional barriers in front of the proverbial goose that laid the golden egg. How much of America's (and the world's) GDP can be directly traced to advances made via work begun at America's premier research institutions?

[James]

I enjoy harboring a delusion that I am open-minded. But the venerable Judge Posner opened his post with the words "Senator Grassley from Iowa" and immediately my mind snapped shut out of self-defense. I am employed by an Article III judge and I remember all too well when the Senator's primary target was the federal judiciary itself. He ranted for several years (primarily during the mid- to late 90s) about how economically inefficient the federal courts were and spewed forth several questionable suggestions on how that unseemly situation could be remedied. It would be disingenuous for me to claim that I do not witness any financial waste in the federal district in which I work, but I can state with great confidence that it is miniscule. This is especially true when I compare the cost-effectiveness of the federal court system with that of the private sector industries in which I have also been employed (including the oil and gas industry in Texas, a small publishing company, and private law firms). Of course, those other businesses are profit based and I don't want to run too far afield by comparing apples to oranges. My point, as many others have already stated, is that the universities should be permitted to manage their endowments however their trustees, faculty members, students, and alumni feel is best, free from the dictates of the gentleman from Iowa. Both Judge Posner and Dr. Becker have offered better suggestions on the subject of endowments--or at the very least better talking points--than Senator Grassley is capable of providing.

Okay. I feel better now.

[Insurance Mixer]

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[Mr. ADSL]

This system is bizar, when I look how it goes in EU it is also not that perfect. Mr. you should take a look and make the comparison in EU universities (non-private).

I am sure this can be an eye-opener!

[Community college]

I don't have an opinion as to social engineering on campuses. My kids are going to state schools, with community college first. I'm a single mom, and that's all I can afford. Plus I don't recommend they come out laden with debt -- especially my daughter who will end up having to stop work to have a family because probably she will bear the domestic duties, assuming she has a husband. My kids, much like their mother, are brilliant, good looking, talented, hard working, and charming, and that will make up for any ivy-league deficits. ;)

That said, I am concerned this big wad of endowment money has the power to move markets. So if there is a reason to spend it down it is this:

When you have that much money, you can move markets. So you have a self-perpetuating system -- the endowment knows how it's going to move the market and it trades on that. Easy money, the endowment gets richer.

I don't know all the complex financial instruments, but where you are selling and buying at the same time based on your own knowledge of how much it takes to move the market, there is something seriously wrong.

How is the honest investor to have a chance?

This isn't free market any more - it is market collusion on a mega-grand scale.

Privately held funds large enough to move markets should be regulated to the same extent publicly held companies are: the extent necessary to ensure smooth running of the capital markets.

The SEC goes after small time insider trading while this kind of billion dollar + shenanigans goes on all the time. The agency just doesn't have the legislative authority or the regulatory power to do anything about it. Strictly speaking, there is no "insider" information from the publicly held company -- the fund managers are creating their own "insider" information. "Outsider-insider", if you will. The net result is the same either way: capital markets are emptying into the pockets of a few.

Let's be clear: this isn't based on trading talent or merit. The manager of Yale endowment does not need particular talent to program trades so that the buy and sell are based on how much he can move the market with the billions in the endowment. The honest talented traders or those in arbitrage businesses don't stand a chance. (I believe the Yale manager so much as admitted this in an interview recently, where he advised retail folks -- like me -- to forget about participating in the capital markets and just pretty much buy an annuity). I am particularly galled that mega-large fund managers earn a % of the money under their management. And a tax break, too. Nice job if you can get it.

When billions (trillions?) of dollars move in and out on programmed trading, where the managers know what they're doing (creating the "outsider-insider" market moving information), that leaves the honest fund managers (who don't so collude) picking up the pieces, and probably ultimately driven out of business. The rewards are upside down: the scamming rich get richer, and the honest- poor go broke.

Sen. Grassley should be arguing that the endowments should spend down the money so they don't artificially move markets based on collusive insider trading. At least that's taking ill-gotten gains and hopefully using them for some kind of socially beneficial purpose.

Prof and Judge and Senator Grassley, all of you have it wrong. Clean up the private equity scams first, let the smallish endowments do what they want.

[Robert Kurtzman]

I am an Economics and Mathematics student at Pomona College. The points elicited by this debate have been a topic of discussion between me and my peers quite often as of late. You might have known that Harvard and Pomona both got rid of student loans all together, and Harvard raised the median income of its scholarship students. These steps have sparked all sorts of debates. Although I have been enamored by some of Becker's past papers and I have liked the earlier posts on this blog, I was less impressed by this post.
I found much of this post problematic, esp. since we clearly cannot look at universities from a Chicago style perspective, as the authors are doing. The main problem I found, a problem that basically influences the rest of the post, is that the use of the term "rich" was done in poor taste. What did you mean by this term? Someone who can afford tuition? Tuition at Pomona costs over $45,000. Let's say a family with two children makes $200,000 a year. Let's say their portfolio brings in 8% annually. This family would be considered "rich." Let's say one student got into Pomona and the other student is in highschool at Exeter or some other expensive boarding school. This school costs almost $30,000 a year. The family is already dropping $75,000 a year on education. However, notice that $200,000 a year is before taxes. $200,000 after taxes is about $96,100 if you live in California (6.2% SS, 35% Fed, 1.45% Healthcare, 9.3% state) Hence, the family has about $21,000 in Disposable income. But wait, they have a mortgage and other bills piling on. And how much money does that leave for their portfolio? And where does the money from their portfolio go? Into helping out America's struggling industry. How many "rich" families do you think are in this situation? Sure, the Pritzkers shouldn't be getting a free ride...but let's be clear, hurting America's smartest families with high tuition rates does not help America. I believe that this is the point the Iowa senator is getting at. He has the national interest in mind.

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