Busting Three Big Myths about College Endowments

With the global pandemic exacerbating financial stress for colleges and universities across the United States, proposed budget cuts have begun to ripple out across the field of higher education. In response, students and alumni alike have criticized school administrations, pointing to “billion-dollar” endowments at some of the top institutions. The truth, however, is different than what you may assume at face value.

While I’m not an expert in endowment economics, I did study endowment design in a few college courses, and I’ve reviewed various colleges’ financial statements while working on a couple side endeavors. As a result, I want to quickly clarify a few myths and misconceptions I commonly hear around college endowments.

Myth #1: The endowment is a pool of money that’s sitting around somewhere

Reality: The endowment is a scattered collection of donations, most of which is invested to provide revenue over time.

Endowments are comprised of many donations given by centuries of alumni. Most of these donations (especially the ones big enough for you hear about in the news) are “restricted,” which means that the initial gift is invested so its returns provide money to help run the university forever.

As a rough rule of thumb, covering $X expenses in perpetuity requires a donation of $25X. That means that a university with a $1 Billion dollar endowment can only use $40 Million a year (maybe a little more in good times, and less in a recession). Spending more than this “safe withdrawal rate” would require dipping into the initial endowment, permanently hurting future generations of students by limiting future withdrawal amounts and/or causing the original donation fund to run out of money.

Of course, there are ways to donate money for more immediate use. Stanford has The Stanford Fund, for example, which disburses donations yearly to help support students with financial aid, campus events, and other activities. While this functions more like the “pool of money” people often picture an endowment to be, and is certainly an important part of supplementing the annual budget, it’s highly dependent on yearly (and usually smaller) individual donations.

By investing collections of donations over time, colleges are limited to a fraction of “the endowment’s” worth each year, but get a more steady stream of income in exchange.

Myth #2: Schools can allocate endowment funds however they want

Reality: most endowment donations are not only restricted over time, but are also restricted for very specific purposes.

People generally endow the university with a lot of money because of a strong emotional connection to a specific area they want to support. A successful violinist would probably want their money to go towards the orchestra instead of the water polo team, and a successful water polo player would instead prefer their donation supports the water polo team instead of the orchestra.

As a result, large donations collected in endowments both only dispense a fraction of the original gift each year (the “25X rule” previously mentioned), and often come with very specific instructions. For example, many professors’ positions are endowed from donations, like “The William A. Ackman Professor of Public Economics” at Harvard (as opposed to a much simpler title of “Professor of Economics”). Similarly, the official title for Stanford’s endowed head football coach position is “The Bradford M. Freeman Director of Football”. Study abroad programs, annual festivals, financial aid, department-specific student grants, and more are often funded (at least in part) by the generosity of past alumni and other donors who want to provide resources to specific departments and organizations over time.

Thanks to a large initial pool of money donated for specific purposes, the university can more reliably count on covering various parts of the budget, safeguarding aspects of these institutions over time. However, the restrictions mean that money can’t be shifted around from the vast majority of the endowment. This causes university budgets to face temporal limitations (withdrawing too much now hurts all future students) as well as categorical limitations (not allowed to redirect funds from the endowed football coach position to pay for new bike racks, or vice versa).

Myth #3: The endowment can cover all expenses

Reality: that’s the goal, but endowments are nowhere near that level yet

We’ve already established that the stated size of the endowment and the actual money that colleges and universities can use each year are two very different numbers, but at a certain point, shouldn’t the endowment’s annual revenues be able to cover all costs? (or, for a more pointed question, “If Harvard has a $40 Billion dollar endowment, why does it still charge tuition and ask alumni for donations?”)

Yes, the ideal end goal is an endowment that permanently covers all expenses, but this ideal comes with major caveats. First of all, many universities with large endowments have even more substantial costs to contend with. This includes building maintenance, professor salaries (and pension plans), dining halls, land leases, and a myriad of other things that add up over time. Even at “Ivy Plus” colleges, endowments only cover an average of 18% of yearly costs. This percentage may seem small, but it is huge compared to most colleges and universities in the United States, where small endowment revenues (often 3-5% of costs at best, and more commonly <1%) mean that tuition is the biggest source of revenue.

Second, the ambitions of universities (and their students) often necessitate increased costs over time. Building a new dorm, hiring top professors, restoring an older lecture hall, expanding financial aid, and creating a new academic department all are additional wants, which require additional revenues to cover and sustain them over time. A building, new or old, will require maintenance and refurbishment; a new department will require hiring new professors and giving them continued resources to aid in their teaching and research. In order to match wants, costs, and revenues, the university will require additional donations to grow the endowment.

 

By busting these myths, we can better understand the true amount of available resources on hand for colleges and universities, as well as the limitations that come with them. If you have departments, organizations, and/or activities that you want to build up or protect, consider donating to your alma matter for that specific purpose, paying it forward for current and future generations.


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s