July 17, 2020

Should Universities Spend More From Their Endowments?

It’s the first question during a crisis. Given unprecedented disruption, some schools are starting to increase payouts from their troves.

Reported by Sarah Min

During the virus-driven recession, universities are wrestling with whether they should dip deeper into their endowments.

The short answer seems to be no. Whenever top colleges are lambasted for not tapping more of their endowments during an emergency, they remind people that these stores of wealth are not rainy-day funds. Colleges often do siphon off some money from endowments to help maintain operations, pay staff, or award scholarships to needy students. But only to a limited extent.

The question is: How much should they and can they take? The goal is to take out no more (and often less) than the endowment can reasonably expect to earn from its investments.

One impediment to withdrawals is that endowment funds often come with restrictions from donors. And they’re also meant to exist in perpetuity to support the school and its mission. So scooping up an overlarge helping of endowment cash is like raiding your 401(k) to pay rent and buy a car.

Given the pandemic’s unknowable course, financial planning is very difficult for the fall semester and beyond. College administrators, dealing with severe disruptions to their revenue streams, are casting about for different ways to maintain their institutions. So withdrawing more from their endowments is understandably appealing.

Earlier this year, Northwestern University decided to increase payouts from its approximately $11.1 billion endowment to 6%, up from 5.5%, after turning down a federal stimulus package. (Lawmakers had argued that the coronavirus relief should first go to smaller institutions without wealthy endowments). In April, Massachusetts Attorney General Maura Healey offered general guidance allowing endowments to prudently increase payouts or to ask donors to un-restrict funds.

Other institutional investors, like the Ford Foundation, have increased payouts from their endowments to 10%, nearly double what is typically spent. That’s supplemented by issuing debt through social bonds.

More institutions are expecting to follow their example. About 15% of roughly 150 endowment clients, including schools and museums, that global investment firm Cambridge Associates surveyed in June said that they expect to spend more from their endowments in fiscal year 2021, which started just over two weeks ago. Another 20% said that they’re uncertain, but that they may do so.

Those figures may have increased even more since the survey was conducted last month, researchers say. “There is a great deal of uncertainty like we haven’t seen ever before,” said Tracy Filosa, managing director at Cambridge Associates.

Endowments are loath to employ the extra money for ambitious and costly new endeavors. Last year, the vast majority of institutions, around 90% to 95%, planned to stick close to their current spending policies.

“This is a year that really stands out and shows that these organizations are looking everywhere including the endowment to try to figure out how to balance their financial equation,” Filosa added.

Some Hit More Than Others

In the event of a market sell-off, some universities are expected to suffer more than others. For example, at the end of the first quarter, one-fifth of endowment funds went underwater, or below the original gift amount of the fund, according to a June survey from the National Association Of College And University Business Officers (NACUBO). That’s up from the 1.9% of endowment funds that were below the historic value of assets just three years ago, the last time the question was asked in a NACUBO survey, a spokesperson said.

Endowments are more likely to go underwater if they include a larger number of younger funds that have yet to mature enough to weather a crisis. “There’s not as much cushion,” Susan Menditto, director of accounting policy at NACUBO.

That situation could exacerbate a trend already in place in higher education: the growing disparity between larger, wealthier institutions with endowments dating back more than a century, versus smaller, more regional universities that have newer funds.

In addition to smaller pools of capital, these endowments lack access to the more sophisticated investing strategies that could possibly bring higher returns and offer better buffers against adversity. These schools are seldom venturing into hedge funds, distressed debt, commodities, or global real estate. That’s the so-called Yale Model, pioneered since the 1980s by its CIO, David Swensen. Yale’s endowment has ballooned, and now stands at $27 billion, second in the US only to Harvard ($37 billion).

The less-mighty endowments, unable to adopt the Yale Model, must content themselves with more conventional investment approaches, such as the stock market. But equities took a hard hammering in March.

Still, on average, universities weathered the first quarter crash much better than they did during the last financial crisis, when 38% of surveyed institutions by NACUBO were underwater as of December 2008.

Many funds will also have recovered in the second quarter after the S&P 500 jumped 20% in its best rally in two decades. Investors, however, remain nervous that volatility in the stock market will lead to a plummet in the second half of the year.

Different Avenues

Continued high volatility will make higher spending from endowments difficult. They do have more flexibility to take money out of underwater funds, which could work in their favor—or end up harming them if they go too far. Before 2012, federal law forbade them from spending below the initial value of donations to a fund. Then, eight years ago, Congress granted them more leeway, passing what is called the Uniform Prudent Management of Institutional Funds Act (UPMIFA).

But institutions are still required to do so responsibly. Generally speaking, the spending rate at university endowments hovers at around 4% to 7% to ensure that the fund has long-term longevity and can continue to produce returns at a healthy clip.

“A small increase one time is not going to have a substantial impact, but a much higher increase, and especially if it’s for multiple years, can significantly change the market value of the endowment and how it supports the institution going forward,” Cambridge Associates’ Filosa said.

Colleges have other spending tricks available to them. If they deviate from their spending policies and spend more from their endowments, they can first tap unrestricted pools and can ask donors if they can lift restrictions in other funds. They can ask a court of law if they can spend more from restricted funds.

Diversify Assets

Some have also taken the pandemic as an opportunity to criticize the performance of endowments, which has drawn censure in the past decade for often underperforming a simple benchmark portfolio of stocks and bonds. Some critics say that endowments would do better to desert alternative assets altogether, arguing that the asset class will only continue to lag going forward.

“Alternative asset classes have failed to deliver diversification benefits and have had an adverse effect on endowment performance,” wrote Richard Ennis, co-founder of consultant group EnnisKnupp, in a paper. “Given prevailing diversification patterns and costs of 1% to 2% of assets, it is likely that the great majority of endowment funds will continue to underperform in the years ahead.”

But investment leaders generally expect to stick to their overall policies. The long-term investors argue that they walk a fine line between strategies that generate robust returns during rallies, while also mitigating risk in the portfolio during downturns. And are we ever in a downturn.