With university endowments nationwide seeing major losses during the financial crisis, an economist and faculty trustee offers a primer on Cornell’s nest egg. Ehrenberg, the Ives Professor of Industrial and Labor Relations and Economics, demystifies the endowment, explaining the often arcane details of higher education financing.
By Ronald Ehrenberg
An economist and faculty trustee offers a primer on the University's financial nest egg—and explains what the current economic crisis could mean for Cornell's future
University endowments have come under great scrutiny recently. During the last academic year, the U.S. Senate Finance Committee launched an investigation into universities with endowments that exceeded $500 million and required them to file detailed financial reports. Underlying this was some senators' belief that these universities should spend more from their endowments to improve financial aid and limit tuition increases.
This year, our nation's financial meltdown and the large declines in the values of many university endowments, including Cornell's, have led to story after story of schools slashing budgets, freezing salaries, cutting jobs (often by attrition but sometimes by layoff), and slowing down or stopping building projects. But in spite of all the coverage, many people still do not understand what endowments are; how they are used, invested, and managed; how decisions are made about how much to spend from them; and why their declines are having such profound effects.
With so much confusion about endowments, CAM asked Ronald Ehrenberg, the Ives Professor of Industrial and Labor Relations and Economics, to offer a mini-course on the subject. Ehrenberg, an expert in higher education financing, is also a Weiss Presidential Fellow, director of the Cornell Higher Education Research Institute, and a faculty member of the Board of Trustees.
What's an endowment?
Endowment is a general term for collections of financial and real assets held by universities to generate income for current and future operations. But within the broad umbrella of "the endowment" there are different types of endowments, which can cause confusion. "True endowments" are assets that were specified by the donor to be held in perpetuity to support particular activities or programs. Hence, over time, only the cumulative sum of the income plus capital gains that these funds have generated can be spent.
When endowment values are reported by universities, they usually include "funds functioning as endowments"; these are funds that the university has decided to treat as if they were endowments—but if the needs of the university ever require that the principal be spent, it is free to do so. On June 30, 2008, about one-third of Cornell's endowment was actually funds functioning as endowments.
Isn't an endowment like a big savings account?
Data indicate that the average payout rate (spending from the endowment as a share of market value) from fiscal year 2000 to fiscal year 2007 was 5.375 percent for Cornell, the highest among the Ivies.While the public (and politicians) often thinks of an endowment as a pool of funds that a university can use for any purpose, this is not true. Donors often restrict their gifts. Whether or not these really limit what the university does depends upon the nature of the activity and the restriction. For example, a donor may provide an endowment to support undergraduate financial aid. If the sum of that university's endowments for such aid generates less money than it wants to spend on undergraduate financial aid, then this endowment restriction is not a true constraint. That's because the university must use all these restricted funds—and more—to achieve its financial aid goal in this area.
Similarly, if a donor provides an endowment to support a professorship in economics and the university would have employed at least one economist anyway, that does not restrict the university's behavior. On the other hand, if a donor provides an endowment to hire a professor who studies the economics of higher education and in the absence of that gift the university would not place a high priority on employing faculty with interest in this topic, then the endowment truly is restricted, both legally and in practice. Not surprisingly, universities try to encourage donors to make the uses of their endowments as broad as possible.
It is useful to think of Cornell’s portfolio as a mutual fund, and indeed the portfolio is structured this way. When a donor makes an endowment gift, the gift buys shares in the portfolio. Over periods with positive average returns, the restriction that the initial principal of a true endowment cannot be spent is usually not a constraint. But when endowment values decline rapidly, as they have over the past year, the restriction may apply to gifts whose current value has fallen below what they were when they were received. In his case, the only expenditures that can be made from those endowments until they regain their original value are from the income (interest, dividends, rents, etc.) that their assets produce.
How does Cornell's endowment compare to others in the Ivy League?
Before the financial meltdown, Harvard's endowment was more than $36 billion; Cornell's was the sixth largest at about $5.4 billion (see Figure 1, which shows the size of the endowments held by the eight Ivies as of June 30, 2008). But looking at the endowment per student, to control for the varying size of the institutions, gives a very different picture (see Figure 2, which shows data for the 2006-07 academic year). Viewed this way, Princeton was the richest school, with more than $2 million per student, while Cornell was the poorest, with less than $300,000. Of course, all of these numbers would be lower if we knew the precise current values—most of the Ivy schools, including Cornell, reported declines of 20 to 30 percent in the six-month period ending on December 31, 2008, and it is likely that these declines have continued.
How much of its endowment should a university spend each year?
The share of an institution's operating budget that comes from its endowment depends upon, among other things, its endowment's value, the spending rate from its endowment, and its other sources of revenue. Data that the Ivy schools submitted to the Senate Finance Committee last year indicate that the average payout rate (spending from the endowment as a share of market value) from fiscal year 2000 to fiscal year 2007 was 5.375 percent for Cornell, the highest among the Ivies. The three richest Ivies had lower average payouts, from 4.062 to 4.38 percent. Payout rates tend to be lower at richer institutions because they do not need to generate as much spending from each dollar of their endowment to support their operations. Given the return on an endowment and its rate of growth due to new gifts, lower spending rates mean the endowment grows faster; this is one of the reasons that the disparity in endowment wealth among the Ivies has increased over time.
In spite of their lower payout rates, this year Harvard, Yale, and Princeton each is generating between 35 and 45 percent of its operating budget from its endowment. Cornell, which has a large volume of external research funding and (declining) state appropriations for its four contract colleges, is generating 11 percent. So the tremendous fall in endowment values is affecting Cornell's richer peers more than us, in the short run—although they have more leeway to increase their payout rates to offset the decline in their endowments.