How does a university set its payout?
It must balance the needs of the current generation with the needs of the future. To protect future generations against inflation, the endowment for a specific activity (e.g., a professorship in economics) must grow by the average rate of inflation. If the percentage return from the endowment (net of investment and administrative costs) was constant over time, as was the rate of inflation, then to preserve the real purchasing power of endowment spending the payout rate should equal the difference between the investment return and the rate of inflation. Over long periods, this difference has been in the range of 4 to 5 percent.
Investment returns are not constant, and endowments do not grow at a constant rate. If universities based their spending only on the beginning-of-fiscal-year value of their endowments, their payouts would fluctuate wildly over time. To smooth it out, most universities apply a desired spending percentage to the average value of their endowment over a number of quarters, often twelve. (Cornell's spending rule is somewhat different, but it operates using an analogous principle.) But these smoothing rules never envisioned a decline in returns like our economy is now experiencing. If, for example, an endowment falls by 33 percent (optimistically) during this fiscal year and stays flat for two more years, by the third year spending—according to the twelve-quarter rule—would have declined by 33 percent.
Universities simply do not have the option of cutting back their expenditures by that much. If spending from an endowment covered the cost of a professor's salary, for example, then the reduced spending from the endowment over the three-year period would require the university to finance part of that salary from other funds. Or, given Cornell's financial aid policies, if the spending from our endowment dedicated to financial aid declines, we will have to make this up by spending more unrestricted operating funds (primarily tuition revenues) on aid.
How do cuts in the payout affect a university?
They invariably affect all operations and lead to cuts throughout the university. For an institution like Cornell that currently gets about 11 percent of its budget from endowment income, a 33 percent reduction would create a budget gap of almost 4 percent. For a richer institution that gets 45 percent of its budget from its endowment, the gap would be 15 percent. Of course, the richer institutions have lower payout rates, so if they increase their rates to Cornell's level, that would ameliorate the short-term problem.
Universities with large endowments took a lot of heat from the public and politicians during the booming markets of the Nineties and the early years of this century because when endowments are rapidly increasing, a spending rule based on the average value of the endowment over a number of years will lead to spending a much lower percentage of its current value. Perhaps because of this heat, or because they realized that they needed additional funds for financial aid and strategic academic priorities, a number of universities, including Cornell, decided to "jump" their payout rates several times over the last two decades, to get closer to their desired spending rate as a function of the endowment's current value. In retrospect, these institutions might have been better served if they had resisted the pressure.
Even if a particular endowment is restricted, an increase in the payout rate may benefit activities other than the one the endowment supports, because they sometimes fail to cover the total cost. For example, the spending from a restricted endowment for a professorship may not provide enough resources to cover salary and benefits. If this occurs, part of the cost must come from unrestricted revenues. If the spending rate is increased, the university can reduce its support of the professor from unrestricted revenues and use these funds for other purposes. Of course, universities try hard to accept only those restrictive endowments whose spending will cover the entire cost.
Should universities reconsider their payout formulas?
Wide fluctuations in market valuation do raise that question. For example, these fluctuations may suggest the need to base spending on a longer period, so there will be less variability in the flow coming from the endowment. A few universities already do this. One is the University of Michigan, which has the ninth-largest endowment in the country; it spends 5 percent of a seven-year average of its value, up to a maximum of 5.3 percent of its current value. The downside of basing spending rules on longer periods is that during prolonged upswings in the market (such as we experienced during most of the past twenty years), spending as a share of the current value of the endowment will fall below the target percentage. When that happens, public criticism may mount that universities are not spending enough. But again, in retrospect, it may make sense for universities to take this heat.
During a prolonged upswing, such a spending policy would disadvantage the current generation of students relative to future generations, and the resulting low payout rate would likely discourage giving. To achieve intergenerational equity, it is essential for universities to focus more of their efforts on developing increased flows of unrestricted giving to support current operations. At Cornell, under the leadership of trustee Bob Katz '69, efforts to grow the Annual Fund are already under way. As he is fond of pointing out, if the University could increase its Annual Fund donations by $10 million a year and maintain giving at this level (with only inflationary increases), it would yield an income stream equivalent to a $200 million endowment, assuming a 5 percent payout rate.
How is Cornell's portfolio allocated?
On June 30, 2008 (see Figure 3), the largest share was in hedged equities—that is, investments open to a limited range of investors that often may be leveraged and that can use short-selling and hedging methods. This was followed by real assets (real estate and commodities), foreign equity (stocks of international companies), private equity (equity in companies not publicly traded), fixed income, domestic equity, and absolute return (funds that aim to produce a positive absolute return regardless of the direction of financial markets). Less than 5 percent of the portfolio was in cash and cash equivalents. If you had looked at the endowment of an academic institution twenty-five years ago, it would have been invested in a much narrower set of assets—primarily domestic and foreign equities, bonds, real estate, and cash.