The Endowment Trap

The wealth of American colleges is massive. Sixty-two schools (not just the Ivies but also schools such as Duke and UNC-Chapel Hill) have endowments in excess of $1 billion. Wealth isn’t limited to big public research universities or famous private colleges. For example, North Carolina’s Elon University has a very healthy $101 million dollar endowment, yet trails 364 other American colleges and universities.

These substantial holdings of financial assets (stocks, bonds, etc.) make non-profit colleges and universities very different from for-profit businesses. Except for the financial industry, for-profit companies rarely own a significant amount of financial assets. They maintain enough for working capital needs and hold financial assets short- to medium-term with an eye to reinvestment in productive assets or for return to shareholders. 

Non-profit colleges, however, hold substantial funds in an “endowment” with no intention of ever spending any of the principal.  In fact, they often do not spend all the income their endowment generates in order to protect the endowment’s purchasing power against inflation.

To illustrate, let’s say a donor has given $10,000 for a scholarship at a state university. That sum would pay full tuition for one student for one year.  But if the donation is treated as a perpetual endowment and the endowment assumes a 4.5 percent real rate of return, then in the first year only $450 will be paid out to a student as a scholarship.  If there is any endowment income in excess of the $450 payout, it will be added to the endowment’s principal. 

In the next year the scholarship payout will still be at 4.5 percent but it will be figured on the higher principal amount. The goal is for payouts to go on forever and gradually increase in amount to match inflation. The purpose of a perpetual endowment is to provide very small annual payouts in perpetuity rather than one meaningful payout today.   

These colleges are like poor little rich kids fixated upon their wealth. Although rich, they constantly complain about not having enough money to cover their needs. Although rich, they constantly try to get more money out of their students and society at large

They continue to build their endowments even though each dollar added to endowment represents a dollar that could have gone to providing an education to current students, researching today’s great problems, or to reducing tuition.

Why do colleges and universities behave this way?

To begin with, there are good reasons for a non-profit college to have a modest endowment. Just like for-profit businesses, colleges need to set aside some assets for liquidity purposes. Although college revenues are very stable, colleges have trouble cutting costs quickly if revenue declines. When a college admits a student, it is making a multi-year commitment to provide services and the biggest cost—faculty salaries—cannot be quickly adjusted downward to deal with reve­nue swings.

In addition, colleges under financial duress have trouble borrowing (their assets are too organization-specific to make good collateral), and non-profit colleges do not have the legal ability to sell equity to raise money. So a good argument can be made that colleges and universities should retain more financial reserves than a similarly sized business.

Another good reason for some endowment is that major dona­tions usually come in big lumps. Often the university can’t rationally spend this money in the short term, so the expenditures are spread out over several years, providing a more efficient use of the donor’s capital. This rationale explains endowm­ent savings for moderate time periods (say, up to twenty years), but not the perpetual endowments that are typical of colleges and universities today.

But there is just one good reason for perpetual endowments—the donor demands it. Regardless of whether the donor’s desire to achieve some immor­tal­ity through a gift is a good motive (it’s certainly not a desire the college can fulfill either physically or metaphysically), the school must put the funds in a perpetual endowment if it wants the donor’s money.

To sum up the positives, it makes economic sense to have some endowment set aside for liquidity reasons, for smoothing out the expenditure of big donations, and in perpetuity if donors demand it. Add the three together, and that should be the size of a school’s endowment.

However, many college endowments far exceed this amount—and have an explicit goal of getting even bigger.

Why the thirst for perpetual endowments?

Colleges rarely make any attempt to justify their behavior, a point made by Henry Hansmann of Yale Law School in the Journal of Legal Studies in 1990. When they do, they argue that the college is providing equity between generations. Hansmann observes that the trustees may see themselves as the “guardians of the future against the claims of the present.” They “assume the institution to be immortal” and thus want to find “the rate of consumption from endowment which can be sustained indefinitely. . . .” This rate of consumption, Hansmann writes,

. . . means in principle that the existing endowment can continue to support the same set of activities that it is now supporting. This rule says that current consumption should not benefit from the prospects of future gifts to endowment. Sustainable consumption rises to encompass an enlarged scope of activities when, but not before, capital gifts enlarge the endowment.

In other words, the benefits of today’s endowment should be shared equally between today’s generation of students and future generations. Unlike most human beings, who prefer consumption in the present rather than the future (a fact that creates the interest rate), the trustees view themselves as having a time preference of zero.

The idea of intergenerational equity may sound noble of the current generation, but it doesn’t hold up under Hansmann’s analysis.

First, he points out:

. . . if a university wants to help future generations, financial investments may not be the best means to that end. Most university activities involve some sort of investment for the future. The research a university undertakes today, the education it provides, the faculty it builds, and the physical facilities it constructs will all yield a return for decades or even generations into the future. Accumu­lating funds in an endowment is worthwhile only if the return to endowment investments exceeds the returns from these other activities.

The task of preserving financial wealth for future generations is for a trust company, not a college.  Colleges and universities best serve future generations by devoting their resources to their educational mission in the present.

Second, building a perpetual endowment only makes sense if you assume that future generations will be poorer than current generations. If students of 100 or 200 years from now will be richer, as they probably will be, why accumulate wealth on their behalf rather than using it to assist students today? Or as Fred Flintstone might have asked, “Why did Bedrock U give Pebbles a skimpy scholar­ship in order to provide the same level of financial benefit to Judy Jetson?”

Finally, even if you buy into the intergenerational equity concept as an ideal, it is not achievable. It’s hard enough to forecast revenue, gifts, and costs out for a few years; to think this can be done into perpe­tuity is to ascribe god-like foreknowledge to college administrators.

While intergenerational equity is not a justification for big endowments, the argument for it does provide a good explanation for college behavior. Colleges today may be over-saving simply because the inter­generational equity argument sounds noble and they really haven’t thought it through.

Alternatively, a huge endow­ment may stroke the ego of presidents, trustees, and alumni. Hansmann refers to it as “conspicuous non-production.” In addition, building an endowment is a measurable and generally achievable outcome. Senior administrators can argue the institution is doing well because the endowment is growing, even though educational quality is declining and tuition soaring.

Whatever the motivation for excess endowment, the end result is the same. Excess endowments are a non-productive use of society’s limited resources. If a college has excess assets, then it should figure out how to put them to a productive use over the next twenty years.  Spend them on research to cure cancer, or start a partner college in Africa, or give full-ride scholarships to low-income students, or build a small cathedral. Or be really radical and cut tuition.  

In the late twentieth century, organization scholars like Oliver Williamson and Michael Jensen found that a large amount of excess resources (organizational slack) leads to low productivity in any type of organization. That excess reduced internal discipline.  Money gets spent without good justification, managers feather their nests at the organization’s expense, and weak performing employees are tolerated.

In the Wealth of Nations, Adam Smith (a college professor) addressed the issue of college endowments directly. He argued that an endowment allows institutions to become irrele­vant (we get our money regardless of whether anybody wants to pay for what we do), faculty to become slothful (the money’s the same no matter how badly I perform), administrators to proliferate (to manage the endowment and control slothful faculty), and all to adopt brother-in-law behavior (if you don’t complain about my sloth and irrelevance, I won’t complain about yours).

Going even further back, the Bible more than once teaches that a focus on the accumulation of great wealth damages the soul. The Teacher in Ecclesiastes (5:13) said:

I have seen a grievous evil under the sun:
wealth hoarded to the harm of its owner.

Today’s colleges and universities should heed his words.

Vance Fried
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The Endowment Trap