If Not Now, When: Why Won’t Universities Spend Their Money?

These are tough times for higher education. Even name-brand institutions are announcing hiring freezes and salary cuts, among other austerity policies. This is perfectly understandable if your institution is a community college. Let’s assume the archetypical community college can’t borrow affordably, and it has no savings. It’s not going to sell off its classroom space or the dining hall. So salary cuts it is.

But what on earth explains why Stanford and Harvard are taking similar measures? These are institutions with tens of billions of dollars in endowment savings. Harvard, as I have pointed out elsewhere, could cease operations tomorrow and still cover its bills for twelve years. Equally insane, these are schools with guaranteed donative revenues that are sure to exceed their annual endowment payouts by several multiples. That is, Harvard brings in more money in donations every year than it spends out of its endowment. Any first-year finance student would tell Harvard to borrow against its future inflows by spending out of the existing endowment.

So put another way, the present moment should end forever the argument that university endowments are rainy day funds. If institutions aren’t drawing on their supposed reserves now, when will they ever? This is consistent, incidentally, with their past behavior: institutions with significant reserves actually spend pro-cyclically, with lower payout rates during downturns. (A slightly contrary view comes from CRS, which reports that spending rates were level during the Great Recession, then increased a percentage point or so in 2010).

One possible explanation for why universities act so irrationally is because the law forces them to. That seems to be the argument by two finance professors, in a 2015 paper in the quite-respected journal Review of Financial Studies. According to these guys, sound finance reasoning suggests schools should use their endowment as a reserve fund: after all, they have a large set of fixed costs and a variable revenue stream. They suggest schools don’t because of a 1972 statute they call UPMIFA (there does exist a set of state statutes called the “Uniform Prudent Management of Institutional Funds Act,” though finance guys don’t seem to know that’s the full name), which they think imposes a hard annual spending cap of 7% of endowment value. This cap “prevents the endowment’s use as an effective buffer stock,” since 7% isn’t enough to bail out during a deep recession. They then use this claim to rationalize many of the observations in their data.

You can guess why I’m building this up: it’s because the legal argument is nonsense. UPMIFA was drafted in 2005, then eventually adopted by most states between 2006 and 2012, and it actually repealed most of the spending restrictions (none of which would have mattered for most universities) imposed by its predecessor 1972 statute (which, admittedly, had the confusingly similar acronym UMIFA). So…UPMIFA does not explain why universities have followed this spending pattern through many recessions, back at least to the 1980’s (per Henry Hansmann in his 1990 treatment).

Also, uh, even in 2006, there is no hard spending cap. There is, in some states, a presumption that spending in excess of 7% is imprudent, but this presumption can be overcome by just about any reasoned decision by the governing board. Huge economy-shattering recessions would qualify without question. And this presumption was only enacted by 15 states. (I find in my work that spending in “cap” states grew modestly less quickly than spending in other upmifa-adopters.) Finally, UPMIFA statutes (and their UMIFA predecessors) apply only to donor-restricted funds, so irrelevant to the 55% of “endowments” that are voluntarily set aside by the school. (CRS reports only 45% of 2017 endowment funds were legally restricted).

So yeah, that’s not it. But aren’t endowments legally restricted? E.g., at a university I won’t name, there is a fund of several million dollars dedicated to buying flowers to decorate the campus. No, that’s not it, either: again, 55% have no legal restrictions. In other words, the school itself set the money aside, and can lift those restrictions at any time. In any event, flowers aside, most “restricted” dollars are actually quite flexible (“provide for needy students”), and there is no law that prohibits spending a larger fraction of the restricted funds in service of these purposes today.

Another team of finance professors has what I think is a more persuasive answer (see, I don’t have it in for all the finance types). Their answer is agency costs. Basically, university administrators use endowment as a measure of their own success. As fairly compelling evidence, the profs show that universities do sometimes dip into endowment spending, but almost never to the point where the endowment would fall below what it was worth when the current president took office. Presidents protect their endowment “legacy,” at the cost of their real legacy. (Wharton legal studies prof Peter Conti-Brown also argued this point, albeit with less empirical basis, in his student note; see also this nice paper). One might also observe that many investment advisors are paid based on assets under management; whether this affects their advice to their clients only they can say.

These stories leave me with a few takeaways. First, administrators who are not constrained by ego should be aggressively drawing down endowment spending right now. Sophisticated financial models from a total of six very smart (if not always legally literate) finance guys tell us that. It is true that selling illiquid endowments assets now is “selling low.” But the marginal returns to present spending are very high, and they have lasting benefits. Many cut-backs are hard to reverse and have long-lasting sting (once you sell off your engineering school, it doesn’t come back). Students and support staff are in need. Opportunities to hire or poach faculty away from shorter-sighted schools are highly available.

Another takeaway is legal. Endowment earnings are heavily tax-favored. The only real policy rationale anyone has ever managed to offer for this practice is that it either 1. helps universities save to embark on large capital expansion; or 2. helps protect them against downturns. We’ve now seen, yet again, that theory number two is false. Theory number one could be achieved in other ways, and would imply much more time-limited supports for endowments. This is not to say I support the recent tax on endowment earnings, which I view as the worst of all the ways in which policy makers could constrain university savings. But I do think other policy options should be firmly on the table.