A new study of endowments by the National Association of College and University Business Officers (NACUBO) and the Commonfund Institute has brought good news to college and universities: While endowment returns dropped precipitously in fiscal year 2009 as a result of the financial crisis and accompanying slide in equity markets, they climbed to an average of 19.2 percent for fiscal year 2011.
At the same time, however, 2011 returns were still below the average inflation-adjusted spending rates of educational institutions. In addition, the European debt crisis and continuing economic difficulties in America have resulted in new market volatility since the end of the 2011 fiscal year on June 30.
What does all this mean for endowments going forward? How should boards think about endowment spending, asset allocation, outsourcing, gifts and donations, and institutional debt?
The NACUBO-Commonfund Study of Endowments reports and analyzes return data and a broad range of related information from public and private American colleges and universities. The 2011 study includes data from 823 institutions. Its size and scope make it the most comprehensive annual report on the investment management and governance practices and policies of higher education institutions across the country.
David Bahlmann, president and CEO of the Ball State University Foundation, spoke with John D. Walda, president and CEO of the National Association of College and University Business Officers (NACUBO), and Verne O. Sedlacek, president and CEO of Commonfund, about the results of the study and its major implications for boards.
Bahlmann: John, how do you think the reported fiscal year 2011 average return of 19.2 percent should influence board planning for institutions of higher education?
Walda: First of all, board members have to be delighted with that average return, especially when they contrast it with the returns from the past three years. Last year, the average return was about 12 percent, but in 2009 the average return was negative 18.7 percent, and in 2008 it was negative 3 percent. So, in a sense, there is relief in the board room that 2011 was a successful year.
But a board needs to temper that positive reaction with the understanding that these returns must be big enough that we can perpetuate endowments and be able to afford to invest in higher education assets over the long run. And if you look at the longer-term results, you’ll find that there is reason for some concern. The average annual return has been about 3.1 percent per year over the past three years and 5.6 percent over the past 10 years. Meanwhile, spending rates have been somewhere between 4.5 percent and 5 percent, depending on the year. And an average annual return of 3.1 percent isn’t going to cover that, nor is even an average annual return of 5.6 percent, when you factor in the effects of inflation and related costs for managing the endowment.
So from a board perspective, any jubilation over these returns should be tempered with the understanding of the long-term need to continue to generate 8 or 9 percent on an annualized basis just to keep up.
Bahlmann: Verne, what is your view of the returns? To what extent will boards be able to reinstate some of these programs that were cut during the economic downturn?
Sedlacek: John’s points are exactly right. Forty-seven percent of the endowments still have fewer assets than they did at the peak. The euphoria that has resulted from the 19.2 percent return on top of last year’s 12 percent return is not being felt in boardrooms. That’s because, first, longterm returns are lower than prior periods, and second, significant market volatility occurred after June 30.
You also have to consider the pressure that’s being placed on other sources of revenue in colleges and universities. Public institutions are dealing with significant cutbacks in state support; private institutions are facing diminished levels of giving along with rising discount rates as they strive to attract students. All those things are certainly adding to the stress level.
On top of that, I’ve made the argument for years—as far back as the good old days of the early 2000s—that by using a traditional three-year rolling average, colleges and universities have tended to end up with a spending rate that is too high. Spending increased much faster than the rate of inflation in the 80s and 90s. Now we’re going through an adjustment period where returns are less robust, so spending is coming down. All that leads me to believe that institutional leaders are not feeling that good about the opportunities to reinstate programs or create new ones.
Bahlmann: Effective spending rates generally move in the opposite direction to financial markets because of the smoothing rules used by most institutions. Yet effective spending rates have increased from 4.4 percent in fiscal year 2009 to 4.5 percent in fiscal year 2010 and 4.6 percent in fiscal year 2011. From a trustee’s point of view, what do those steady increases reflect? And are the fluctuations in effective rates linked to any changes in policy spending rates, which seem to be holding steady at 4.5 percent to 5 percent?
Sedlacek: When you look at the data, you will see a significant divergence between the spending rates of large institutions and those of small institutions. They have reacted differently over the last couple of years in response to the volatility of the market and the financial challenges they’ve faced. Last year, a significant number of large institutions increased their spending rates to offset two years of bad returns, whereas this year, you’ll see them decreasing. In contrast, small institutions cut their spending rates last year to an average of less than 4 percent, and then this year they increased them a little bit.
Allocating Assets
Bahlmann: Of course, most of us realize that rates of return are associated with asset allocation. The report seems to discuss or show that asset allocation generally is not showing much change from 2010 to 2011. How should boards view asset allocation decisions in light of the current high-volatility environment?
Walda: It depends on the type of institution. Those with the largest endowments continue to invest more of their assets in alternatives and less in what we would call traditional asset allocations. It has to do with opportunities that are available in alternative investment categories, which are more available in larger endowments than small ones, as well as a concern for risk and how much you can tolerate.
The attitude in the boardrooms of smaller institutions probably reflects that. Those institutions that are concerned about their liquidity will focus more on making sure that risk is minimized. And so you see, in some cases, colleges and universities that have raised the percentage of cash in their portfolios.
Bahlmann: To what extent have the higher returns in domestic and international equities in the past two years affected asset-allocation decisions for boards and investment committees?
Sedlacek: What we’ve seen is that, in general, the larger institutions have continued to move away from traditional asset classes into more alternative asset classes. As John has mentioned, the smaller institutions have increased their level of cash, which is a big concern for me in the long run. Cash, by definition, is not going to end up generating a good enough return to achieve an institution’s long-term goals. I worry that, over a long or even a relatively short period of time, some institutions won’t have the ability to generate intergenerational equity—in other words, to cover inflation plus the spending rate. That will continue to be a challenge for smaller institutions.
Also, one thing that’s buried in the depths of the report is how much larger institutions have increased their allocation to emerging markets. We’re seeing a move from domestic equities to international equities and, within international equities, from those of developed countries to those of emerging markets.
At the same time, although we’ve had two good years in the market, I don’t think there’s been a huge flood into more equity risk because volatility is still high relative to history and people’s tolerance for it. Everybody’s still scarred by 2008, and no one likes to think about the consequences of another 2008 hitting.
Outsourcing Investment Management
Bahlmann: Given the increasing complexity of investment portfolios and the higher level of attention that boards are paying to risk management and fiduciary duties, do you observe a trend toward the outsourcing of the investment function?
Sedlacek: It’s true that, over the last 15 or 20 years, portfolios of almost all endowments have become increasingly complex. The old model—the board investment committee working with a staff person and a traditional consultant—is under pressure today because the level of complexity has grown, the number of different investment managers at most institutions has increased, and the amount of resources involved has remained the same or dropped.
In general, institutions are going in one of two different directions. Larger institutions have tended to add to their internal resources through what I call “in-sourcing”—that is, creating an investment office or adding a chief investment officer and investment staff. In contrast, smaller institutions have tended to move towards the outsourced CIO model. In fact, outsourcing has been an area of significant growth over the last 10 years in the higher education field.
Looking at the survey results, 39 percent of all the respondents have substantially outsourced their investment management. Only about 8 percent of the endowments with more than $1 billion in assets are outsourcing. But almost half of the smaller institutions, those with assets of less than $100 million, have moved towards outsourcing, and 5 percent are continuing to look at substantially outsourcing their investment management going forward. So the complexity, along with the concerns about financial risk management in this volatile environment, has led to a movement toward either insourcing, on the one hand, or outsourcing, on the other.
Walda: I agree, but I think there’s another reason for outsourcing that we need to identify: In a number of institutions with smaller endowments, outsourcing may have occurred as a way to reduce endowment- related expenses. If you have a small to medium endowment, it is usually less expensive to contract with a manager or a firm than it is to hire and maintain an in-house investment staff. So the trend may also be related to the use of such savings to increase the yield at the end of the day, as opposed just to dealing with complexity.
Attracting Gifts and Donations
Bahlmann: The survey found that more institutions reported an increase than a decrease in gift amounts received. That is a favorable turnaround from the trend in recent years, and it could mean an additional source of support for stressed endowments. Based on the result of the study, what should trustees be looking for as they seek to build a more strategic approach to giving?
Walda: Gifts have increased in a number of places as a result of the improvements in the economy. But let me offer a couple of caveats. First, that is probably a regional phenomenon. Colleges and universities that are located in places that continue to have challenging economic environments aren’t seeing those additional gifts.
A second caveat is that trustees need to keep the growth in gifts, or the growth in the size of gifts, in perspective. In the decades before the recent recession, you could reasonably expect that giving to higher education would increase in the neighborhood of 15 to 17 percent a year. I don’t think we’re returning to those days any time soon. As long as institutions are able to eke out an increase of 2 or 3 percent, they should consider themselves to be successful in this environment.
Finally, if long-term returns continue to lag behind what is needed to cover spending rates plus inflation—even by just a few points—gifts will continue to have to make up some of that margin.
Managing Debt
Bahlmann: We have seen in 2008, 2009, and the early part of 2010 that some institutions have looked to debt to try to cover the gaps because of the loss in revenue. Although the study found that average and median debt levels increased from year to year, outside of a few larger institutions, many colleges and universities seem to be deleveraging. How do you think trustees should view the decision to increase or decrease debt in the ultra-low interest rate environment that we’re now in?
Sedlacek: What we’re seeing is a reversal of some of the trends that we saw going on before the crisis. Previously, debt was primarily linked to construction projects and large developments that took place on campus. And larger institutions borrowed to help deal with the liquidity challenge that occurred in 2008 and 2009. We’re seeing some of that declining now.
From my standpoint, the increase in debt over the last 10 years has been driven primarily by the growth in resources of college and university campuses. With the challenges going on in higher education today, I think we will continue to see a decrease or certainly no significant growth in the amount of debt. That relates to tighter budgets, to decreasing gift flow for new buildings. Also, the ratings agencies have taken a fresh look at the debt of colleges and universities. They’re starting to become much, much more conservative in their approach in reaction to what happened in 2008 and 2009.
So while the cost of debt, on an absolute value, is lower today in terms of interest rates, the cost of a lot of the things that go along with it—letters of credit and so on—make it harder to issue. If you combine that with the concerns of the rating agencies, then I think we will continue to see debt levels flat or down.
Bahlmann: What are the one or two key points that boards should take away from this particular study?
Walda: All the data have to be considered in the context of what’s going on in the larger revenue world of higher education. Whether you are a big public university or a small private college, the demands on endowments will only intensify as government support becomes less available for public institutions and as smaller privates continue to experience pressure to keep tuition down because many students and families can’t pay ever-rising prices.
So going forward, while endowments may continue to generate greater returns, institutions will use those returns less to reinstate programs than to replace dollars that aren’t available from public sources or accessible through higher tuition.
Sedlacek: It’s easy for all of us to get excited about the 19.2 return and feel very good about that, on the one hand, or talk about the volatility and feel very bad about that, on the other. But from the perspective of trying to generate returns that equal or surpass inflation plus spending, boards have to think about their endowments over the long haul. Colleges and universities have generally done a good job of sticking to their knitting and not necessarily reacting to the short-term volatility that our economy has experienced.
At the same time, the biggest risk institutions have is not allocating assets in ways that enable them to generate inflation plus a 5-percent spending rate—in other words, not being able to achieve intergenerational equity. We’ve gone through a decade where we haven’t achieved it, and we’ve dealt with significant volatility over the last four years.
So it’s important for boards to think about that from a long-term perspective— about how they can invest, allocate assets, and generate an adequate long-term return. You can’t do it by owning cash; you can’t do it by owning fixed income. Such assets may be protection from the downside, but they are also big drags on being able to achieve the necessary longterm returns.
My second takeaway is a question: Is the spending rate of 4.5 percent too high, too low, too volatile, too static? I continue to be concerned when institutions start spending 4.5, 5, or 5.5 percent. Are you taking from the future to pay for the present? Are you thinking clearly about how you’d go about setting that rate, monitoring it, and smoothing it? To me, those are crucial issues for boards.
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