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Why Mandatory Spending Limits for College Endowments Could Backfire

Forcing endowments to spend a certain proportion of their fund’s market value could add too much risk for sustained long-term returns.

Colleges and universities that are fortunate enough to have sizable endowments are also endowed with complex responsibilities. These include the obligation to make decisions regarding investing and spending that ultimately benefit the institution, its students and other stakeholders — today, tomorrow and decades down the line.

Most schools face a core set of objectives, including attracting students by ensuring strong programs and tuition affordability, maintaining and upgrading facilities, compensating faculty competitively, appealing to donors — and doing all of that without spending the endowment into oblivion, so that generations of stakeholders benefit equitably.

Periodically, policymakers and pundits will point to universities and colleges with large endowments and suggest that they be required to spend a minimum percentage of their endowments each year to maintain their nonprofit, tax-exempt status. After all, private foundations are required to spend 5 percent of their endowments’ market value annually. But we believe the call for required minimums on school endowment spending, although perhaps well intentioned, is not only misguided but also dangerous for students and educational institutions alike.

Unlike foundations, which can cope with a reduction in grant making when investment returns are low, universities cannot modulate spending with such agility. University endowments fund several operations that would be devastated by big cuts to research, compensation and student aid. Therefore, universities seek to maintain predictability in their annual dollar level of spending by paying out a lower percentage of assets when market values rise to compensate for their limited ability to readily cut expenditures when market values fall.

Getting spending right is critical for every school. The hard reality is that setting spending rates above reasonable long-term investment returns can deprive future generations of the benefits endowments provide. What long-term return expectation is reasonable? It’s a tough question. Cambridge Associates’ research shows that 7 percent is too high for most institutions. And the 5 percent mandated for foundations could be reasonable for some university endowments but certainly not all.

Here is some perspective. If you look back, after adjusting for inflation, the median university and college endowment surpassed 9 percent returns in less than a quarter of rolling ten-year periods and exceeded 8 percent returns in less than 40 percent of such periods over the past 30 years, according to our data. When you consider that there has recently been a suggestion for an 8 percent annual spending requirement for university endowments, this is sobering. The reason cited is the prodigious growth of a few top-performing funds over recent years.

The 1970s offered a cautionary message about spending and about extrapolating strong recent performance into the future. During the bear market spanning from 1968 to 1982, endowment fund values declined 40 to 60 percent. Faced with rising costs, institutions tried to avoid spending cuts and rapidly drained funds from the bottom of an already depleted barrel. The best-managed endowments did not recover until the early 1990s. More recently, even as college and university endowments have generated stellar returns since the 2008–’09 financial crisis, the vast majority have not yet recovered from their precrisis highs when spending and inflation are taken into account.

Simple math shows that spending less today actually means earning, and spending, more tomorrow. The power of compounding assets — those the university hasn’t spent — enables an increase in endowment support for tuition and other initiatives over time. Take the extreme example of two $100 million endowments spending 5 percent and 8 percent, respectively, each year. Assume investment returns are 9 percent after inflation, which is aggressive. In just 17 years, the endowment spending 8 percent would be spending less in dollar terms than the endowment spending 5 percent. Why? Because the high level of spending would have drained the endowment’s coffers, bringing its market value to just 60 percent of that of the other endowment, which would have spent at a more sustainable 5 percent rate.

The bottom line is that a requirement for endowments to lay out a fixed percentage of market value each year would heighten volatility in operating budgets and risk depleting endowments and, therefore, resources for students and institutions over time.

A related note: Along with calls for a spending requirement, endowments sometimes receive criticism for paying large investment manager fees, particularly to private equity funds, which have been a source of many successful endowments’ coveted excess returns. Yet forward-thinking institutions that invest for the long term focus not on fees in isolation but on terms and returns after fees. It would be wrong to believe that spending less on fees necessarily translates to higher net returns. The reality is that the better the endowment’s performance after fees, the higher the tab.

Ponder the following comparison. The Yale Investments Office’s private equity portfolio returned an annual 36 percent net of fees over the past 20 years. A substitute investment in a fund tracking the Russell 3000 index would have earned less than 10 percent. The difference between the two numbers — the excess return — is more than 26 percentage points after fees. This excess return is now available to support Yale’s operations, including student financial aid.

A school that wants to endure and evolve needs its endowment not only to remain but also to grow at a rate that allows the institution to meet increasing expenses and achieve the goals that serve its overall mission. Each college and university needs to develop its own version of the investing-spending balancing act.

This is a prodigious responsibility, and it belongs in the hands of endowment trustees, who have a legal and fiduciary responsibility to ensure that the endowment provides the greatest possible financial support not only to the current generation but also to those who will follow in their footsteps.

Celia Dallas is the Arlington, Virginia–based chief investment strategist for Cambridge Associates, a Boston-based research and advisory firm for institutional investors.

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