Trusteeship Podcast Episode 52: Endowments: Spending Policy vs. Practice

Introduction:
Welcome to the Trusteeship Podcast from AGB, the Association of Governing Boards of Universities and Colleges. We cover everything higher education leaders need to know about the challenges facing our nation’s colleges and universities. More important, you provide the facts and insight you need to solve those challenges, and to be the storytellers and advocates higher education needs.

Today, we’re talking about endowment spending policy and practice. As colleges and universities attempt to navigate today’s challenging economic environment, they’re increasingly relying on their endowments to fund operating costs. That sometimes means spending beyond their endowment spending policy guidelines, which presents a difficult dilemma. How do they serve present needs, yet also safeguard the institution’s long-term financial sustainability?

In this podcast, AGB’s David Bass speaks with Cambridge Associates’, Tracy Filosa, about the balance that institutional leaders must strike between on the one hand. meeting current demands, and on the other, ensuring that adequate resources would be available for future generations of stakeholders. David, could you provide some background?

David Bass:
Fitch Ratings recently released its 2025 Outlook Report for Higher Ed which forecasts, “Uneven enrollment, rising competitive pressures, and continued margin pressures that will add further strain on already struggling US colleges and universities.” Looking ahead, a lot of colleges are concerned about demographic-driven declines in enrollment. The enrollment cliff changes and enrollment trends will vary widely by region and institution type, but they will change the competitive landscape of higher ed for all institutions to some degree.

Advancement leaders are concerned about potential declines in alumni giving, older generations of alumni account for enormous proportion of giving to higher education, and younger alumni seem less inclined to give to institutions and may have more transactional relationships with their institutions that could impact new gift flows to endowments. Looking at all of these issues, Tracy, what’s your perspective on how the financial equation is changing for higher education?

Tracy Filosa:
I think you bring up some great points, David, about some of the pressures that are expanding throughout the higher education network, private and public institutions on the revenue side of equation. Those enrollment trends, that those pressures and demographics, I think one of the numbers cited in recent data was a 5% drop in 18-year-olds who are attending college this year. All of that is leaning towards more pressure on tuition revenue and price-sensitive students, and their families are also requiring more financial aid. So the net tuition number, which can be 80% of a college’s revenue is under pressure. It’s hard to continue to increase that number.

At the same time, we’re seeing the inflation affect colleges and universities very similar to other sectors of the economy. So, it’s most often that the net tuition number is not keeping up with expense growth. That’s creating pressures on margins for some institutions, even resulting in negative operating results, which need to be addressed with other forms of funding.

David Bass:
Thinking about the competition for students, roughly half of all endowments I think are restricted for student financial aid. So, endowments become a particularly important factor in institution’s ability to compete and make tuition affordable for students.

Tracy Filosa:
I would say even if the endowment is not specifically earmarked for financial aid, it can help institutions afford that subsidy for students, as well as annual fundraising efforts.

David Bass:
Jumping off of that point, in times of financial stress, governing boards often look to endowment as a means of offsetting shortfalls in operating revenue. I’d also note that policymakers often look to endowments too as a fungible source of funding for institutions, which is probably not entirely accurate. Tapping the endowment is not as straightforward as it sounds. It’s not a savings account. Could you talk a little bit about what differentiates endowment from other institutional assets?

Tracy Filosa:
That’s a great question because we talk about endowment in the singular. In reality, an endowment fund is a combination of funds that donors have given to the institution to serve the institution in perpetuity, meaning it is to provide a funding source for a given purpose like financial aid for current generations and future generations of students in a consistent way. So most of endowments are restricted by donors, and that’s to a level of about 80% for public institutions set in the ’70 for a private institution.

So, most of those funds really do need to be serving the institution year in and year out. So if you deplete those funds, you’re at risk of not meeting your fiduciary responsibilities to those donors. It isn’t just a rainy day fund. It’s a fund that’s supposed to support the institution forever.

David Bass:
Note that younger endowments, including a lot of the endowments of regional public institutions are even more highly restricted than endowments that have perhaps been around for many generations. When I talk with the folks who lead public college and university foundations, they tend to talk about 90-plus percent of their endowments being restricted. So, there’s not a lot there that’s generally fungible in that regard.

When thinking about the possibility of tapping the endowment, I think it’d be helpful for folks to hear about two things. One, who actually gets to decide, who makes the spending decisions about endowment? Then follow-on question to that is what dictates the parameters within which those decisions get made? What are the fiduciary obligations and other constraints that boards need to consider when considering a special allocation from the endowment, not just spending as usual in keeping with policy?

Tracy Filosa:
There are two pieces there. There’s spending policy, meaning what is the intended spending from the endowment each year. That’s usually a calculation that’s described in an organization’s investment policy or board documents. That’s one piece. When we’ve asked clients about who decides this factor, this decision, it’s actually only about 25% of the time that an investment committee is making a decision about investment spending policy on the endowment.

That can often be a surprise to an investment committee that is charged with setting the investment policy for the endowment. Most often it’s a combination of finance committee and the board, and ultimately as a policy decision, it goes to the full board. More frequently, we see that it’s the finance committee or some joint committee of the board, meaning that those who are stewarding the investment process with the investment policy need to be very aware of spending policy decisions. That’s part one.

Then there’s part two, which is how much will we actually spend from the endowment in a given year, which may deviate from investment policy if there’s some kind of crisis or strategic spending that’s deemed really important by the board.

David Bass:
Do you have a perspective on who really should be making decisions about spending policy? Because I would think those decisions would need to be very, very closely informed by and aligned with investment strategy and allocation, and anticipated long-term growth and things which may not be on the radar screen of a finance committee or other board committee.

Tracy Filosa:
It speaks to some of the good governance practices that I’m sure we all talk about at AGB, and Cambridge Associates, and in other places. That communication between these different committees, investment finance resources, committees of the board are very important, as well as the full board. All of these pieces are connected. When we do have times where there are challenges, especially to the financial equation, it’s important that those pieces work together.

It’s important that if you’re going to need additional liquidity from the endowment to support operations for a short period of time, that the endowment is positioned to provide that liquidity. You’re not creating an additional crisis of selling endowment assets in a way that’s going to compromise the endowment even more in the future and sacrifice performance. We conduct a process we think about as an enterprise review. So, it’s really important for the endowment to be connected to its role in supporting the institution. I think it’s important that all of those pieces are communicated.

When you’re spending from the endowment, especially if you’re going to take an additional draw, understanding the timing on that. Is that a one-time need? Is that going to be an ongoing need? If it is an ongoing need, how are you going to balance that financial equation in the future because you’re going to have depleted that endowment resource?

David Bass:
That need to take an enterprise-wide perspective. I think it’s particularly important and challenging for public college and university foundations where the endowment management decision-making may be made in the foundation boardroom. Obviously, the rationale for that endowment in the first place is to help the institution fulfill its mission. So there may be very different perspectives on spending, and information that the institutional leaders are focusing on that might not be as central to the focus of the foundation board.

Tracy Filosa:
It is a balance between current needs, which you need to make sure you survive the current situation to get to the future. Often, I think about institutions. When you do need to spend more, and we certainly understand that that can be a situation. Sometimes these things come on quickly. You have a smaller freshman class. It’s going to be a smaller class for four years, moving quickly to balance this equation. I think some of the FAFSA confusion also affected enrollment, the whole pipeline this year.

So thinking through, maybe pulling additional funds from the endowment to balance the equation in the short term, but also thinking about their strategic use so that, are we spending from this perpetual resource in the short term so that we’re creating a sustainable future? Does it involve creating new facilities that will enable us to grow endowment or invest in a program that we think is going to be a solution, or perhaps fundraising and development professionals who are going to help build some of those financial resources in the future?

David Bass:
What are you actually seeing among your clients and what are your colleagues at Cambridge seeing, or are you seeing an uptick in institutions tapping endowment in these ways?

Tracy Filosa:
We are seeing some. We are not seeing a lot of that at this point, but again I think we are seeing greater financial pressures. I think we’re seeing some institutions that still have a very similar financial equation, strong demand, and some control over the revenue and resources. Also, expenses have grown over 20% in the last few years at many institutions, again in line with inflation across the economy.

So even if you’re doing a pretty good job stewarding your revenue, you’re grappling with expenses including capital costs that are much higher than sometimes have been anticipated. So, no one is completely immune from the environment. It’s a question of which levers you’re going to turn to try to address this.

David Bass:
The inflation is double-edged in that it may lead institutions to be looking for additional revenue sources, but it also changes the hurdle rate for the endowment itself, right?

Tracy Filosa:
Right. So, you might have an endowment that’s been supporting 10% of your budget. As your budget grows, your consistent endowment support might support a smaller amount of that. I think what’s really challenging for the institutions that are turning to endowment, don’t see other ways of balancing the budget.

If you have a $100 million endowment and you’re going to spend for three years at a 10% rate, instead of your typical 5% rate for example. If you had done that over the past three years, you would’ve depleted the endowment to about $75 million instead of a $100 million dollars at the end of that three-year period. Which means if you return to your spending policy, you’d have a smaller amount of funding. So, it becomes a snowballing effect in terms of problem to solve because your endowment would’ve delivered $5 million in your spending policy three years ago.

When you’ve tapped it for additional resources, you end up with $4 million for example, three years from now. So, you’re going to have even less endowment to work with. That’s where you hope that what you have pulled has created some strategic shift, so that you can balance that equation going forward and hopefully replenish the endowment, so it can continue to support at the level needed.

David Bass:
So, it’s a complicated calculus. What types of analyses should institutions undertake if they’re contemplating special allocations from the endowment?

Tracy Filosa:
I think it’s very important to think about the balance sheet as a whole. How is the endowment fitting in? How is your debt structure fitting in? Do you feel confident in your balance sheet? It’s important to watch those margins, and how the revenue and expense pieces do come together because as we discussed earlier, it can shift pretty quickly. I think it’s important to have some stress testing and ways of thinking about stress on the enterprise and how the endowment may accommodate, but thinking about all of the levers in the portfolio.

David Bass:
I want to back up a little bit. This conversation started talking about institutions facing financial challenges and the possibility that those challenges will grow significantly over the next decade or so. Are there key metrics that institutional trustees should be paying attention to, regarding the financial health of their institutions? Are there red flags that they should be looking at and bright lines they should have on the horizon to help guide their thinking on these questions?

Tracy Filosa:
I really appreciate ratios in this context because I think it provides some perspective. So some of my favorite ratios are thinking about a discount rate, for example, in relation to an endowment subsidy. So, is your endowment helping you offset your financial aid to students? Do those numbers start to shift, so that your discount rate might be increasing, but you really don’t have the backup of other subsidies like fundraising and endowment support to fill in that gap? Because the subsidy to the student is very important, but you want to make sure you’re doing it from a position of financial sustainability. So, that’s one key challenge.

Also, keeping in mind the net flow equation and your endowment dependence. So if your endowment is supporting 20% of your budget, but you’re spending at a rate of 8% to 10% in order to have that level of support for the budget, we know that’s not going to be sustainable. Even in a strong investment environment, your job as a fiduciary is to continue to try to provide investment return that’s meeting your spending and your inflation, so it can continue to do this job down the road.

So I think it’s very important to say it’s great that the endowment can have a significant role in supporting the enterprise, but if it’s not sustainable, then you’re reaching a tipping point where you’re sacrificing future generations for the present. The most important piece there is if that is a short term requirement to get through a crisis, setting up the institution for future success by replenishing those resources or figuring out ways that between a combination of other revenue and expense adjustments, you’re going to be balancing that financial equation.

David Bass:
Institutions also don’t just take special allocations within the context of financial challenges. I think some of them look to the endowment for strategic funding for initiatives that they think will over the long-term contribute to the financial well-being of the institution. Are there purposes for which it may be a good and prudent decision to take a special allocation that will benefit in the long-term, both the institution’s financial health and potentially the growth of the endowment as well?

Tracy Filosa:
Absolutely. I think that that is the role of trustees to really weigh resource allocation clearly with the leadership of an institution and think about the future. You are investing in the current programs, but you’re also thinking about the future of an organization. I think a lot of the organizations that we work with are going to have to think about adjustments to their business model, to be current on current needs of students, and employers, and the society that we’re living in. So I think the endowment is an important resource for current support, also strategic support.

If there is some unrestricted endowment, meaning there’s endowment that the board has designated instead of a donor, that also gives you a little more flexibility. It’s important to think of it as ebb and flow, meaning that we might pull a little more from the endowment in a given time, but we also want to think about ways that we can build endowment for the future. Because again if it’s not there, you’re going to have to think about adjusting the other revenues that support the institution or pulling back on expenses.

David Bass:
What advice would you have for an institution? First, in terms of questions it should ask, questions that board members should really understand or issues that board members should really understand related to their regular ongoing policy spending? Then what advice would you have for an institution, as it’s contemplating or if the issue is brought forward to potentially tap the endowment for special allocations?

Tracy Filosa:
I think it’s important for an institution to understand who’s making those decisions and to have a line of sight into these decisions. So I think the most threatening possibility is a complete surprise, because if high spending is required and it’s not anticipated, then the endowment may not be positioned to provide that source of spending, and you might be compromising the future health of the endowment as the institution. So, strong communication amongst trustees, amongst the financial team at an institution.

Where I’ve seen this become most problematic is when the board, when the investment committee, when the finance committee weren’t aware of some of these needs. I think having some sense of what enterprise stress could look like is very important, so that your position to understand how you would address stress if it comes, and who’s making certain decisions so that an investment committee might reposition the portfolio a little bit to make sure there’s liquidity, hoping they don’t need it but knowing it’s there if you do need it, and understanding that it will be the finance committee making a recommendation about spending. That strong communication between those committees is needed.

David Bass:
I would also think looking beyond the committee and the board to the insight and guidance that your investment partners can make, because obviously today, an increasing number of institutions rely on the support of outsourced chief investment officers and other discretionary investment partners. What kind of support can they provide in these contexts?

Tracy Filosa:
I think there’s lots of analysis that can support these efforts. It can include things like looking at a combination of stresses, higher spending, lower endowment performance. Those things can happen at the same time, and that is all part of the long-term investment profile. So, I think it’s important to understand endowments are a long-term proposition. We know returns will go up and down, and you wouldn’t want a short-term moment to undermine the whole long-term expectation and goals. So it’s just making sure that there’s communication and that the investment policy, which is the guiding principle for the endowment in terms of how it will be invested and how it will be supporting the institution, is in line with the role of the endowment.

I think a lot of what we’re talking about today is that the role of the endowment could be shifting. You might need it to play a more significant role in a short-term situation. I think what we try to think about is a way to enable the endowment to do a little bit more in a given point in time, but also making everyone aware of the implications long term, so that it can continue to support the organization in the future which is its job.

As we discussed, there’s only so much additional spending you can do from the endowment. So even if it does provide some near-term relief on a budget that’s under stress, you want to make sure you’re positioning the institution to have these resources in the future, so you’re not creating a perpetual gap that needs to be filled.

David Bass:
I think that’s probably a good place to wrap up. Thank you for this terrific conversation. We’ll be discussing this issue and another topics related to endowment management at the January Foundation Leadership Forum in Washington DC, January 29th to 31st. So I hope you can join us for that, and I will look forward to seeing you there, Tracy. Thank you.

Tracy Filosa:
Thank you, David.