Defending Harvard

I’m going to go out on a limb here. Harvard was not wrong to accept $8.7m as part of the CARES Act coronavirus relief package. This is true notwithstanding their oft-cited $41bn endowment. How are these things not in conflict?

Let’s take a step back and look at this famous (infamous?) endowment first. In 2019, Harvard’s endowment supported 35% of its operating budget. That means that of all the money that the university needs to run (a total of ~$5.2bn in 2019), more than $1 in $3 came from the endowment. In absolute terms, the endowment paid out $1.9bn to the university, a pay-out ratio of ~4.6% of its total endowment. (This ratio is pretty typical, even a bit low, for university endowments. Note that charitable foundations in the US must meet a pay-out ratio of at least 5% to retain their tax-exempt status.)

These are big numbers to wrap your head around. Think of $41,000 in your savings account at the beginning of last year. You spent $5,200 during the course of the year, of which $3,300 came from your salary. You took $1,900 from your savings account last year to make up the balance.

Let’s say last year your savings account earned a return of 8% (bear with me – I know there aren’t many savings account paying much interest anymore, let alone 8%, but let’s suspend disbelief to keep with the analogy of Harvard’s endowment). By the beginning of this year, you have $42,200 (assuming you started with $41,000, spent $1,900, and made 8% on the balance). Your spending goes up (5%), your salary goes up (5%) and now you’re spending $5,500, of which you get $2,000 from your savings account. By the end of this year, your savings account is at $40,200. Lower than that $41,000 about two years ago.

What if your spending had gone up, but your salary had not? Or what if you hadn’t earned as much interest in your savings account? Or what if your spending had gone up, your salary was the same, and you earned less off the savings account balance? All of a sudden, $41,000 doesn’t seem like that much, because over the foreseeable future – maybe 10 years, maybe 20, maybe more – that savings account is gone.

So back to the question – with $41bn today, why couldn’t Harvard tap the endowment for the $9m it ‘took’ from the government? In the analogy, why couldn’t you just take another $9 from your savings account? The short answer is – you could.

But not without consequences. Namely that your savings account will run out faster because (1) you took more out of it and (2) there is less money to earn returns on.

(Sidenote: It is easy to think of 4.6% as a low payout rate. It’s just 4.6 cents for every $1.00. But is it so small? It’s about the same rate as something that occurs once every three weeks. Say – once every 3 weeks you have a fight with your partner or a friend. Once every three weeks you have a bad hair day or a breakout and you have to get on that Zoom call anyway. Once every three weeks is actually fairly frequent.)

Back to Harvard. (And Cornell, Columbia, Yale and Princeton – among others.) What should hopefully be clearer after the savings account analogy is that the thing about endowments – even really large ones – is that they’re not infinite. The mission of a university, however, is. A university’s goal is to exist in perpetuity. Which means funding itself for longer than the ~20 years it could last by simply spending ~5% per year. (Sidenote: Verger Capital Management has an excellent article discussing the importance of risk management for endowments, which is relevant far beyond the context of this article.)

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An important thing to remember about an endowment is that it’s not a giant Harry Potter vault full of cash. The savings account example assumed an 8% rate of interest. (Again, this was a misnomer. 8% would not be ‘interest’ that a bank paid for your deposit anymore. 8% would be a rate of return from investing in, say, the stock market and maybe the bond market. Which is to say, putting your money at risk in hopes of generating a return. And 8% would be quite a good outcome even from these risky investments.)

An endowment invests its capital. It needs to generate a return because, again, the goal of the university is to last forever and if the capital does not earn a return, eventually it will run out.

Endowment pools are invested differently, but many of them have very high proportions invested in equities (i.e. stocks), and in particular private alternative investment funds (including hedge funds, private equity, and others).

Money invested in public equities (i.e. the stock market) is probably pretty easy to convert to cash by selling the stocks. In other words, public equities are highly liquid investments. On the other hand, private funds (with some exceptions) are less liquid, less easy to sell. Hedge funds may let you redeem (get your cash back) every month or every quarter. Private equity locks up your money generally for 8-10 years. You may get some of it back along the way (‘distributions’), but the timing is uncertain so it’s unwise to count on that.

So, let’s pretend you had your $41,000 savings account invested as follows:

A.    $14,350 (or 35%) in public equities (let’s say the S&P 500 via an ETF)

B.    $14,350 (or 35%) in private vehicles (hedge funds, private equity, etc)

C.     $10,250 (or 25%) in fixed income (say an aggregate bond index fund)

D.    $2,050 (or 5%) in cash

In theory, you can quickly sell A or C, and D is already cash. Except… instead of being worth $14,350, A is now worth about $11,400 (using the -20.6% YTD decline in SPY through end-March). C is luckily worth about $10,580. D is more or less unchanged. Your total savings account – assuming, generously, that B is down by -10% – is now about $37,000. And you haven’t even taken out the $1,900 you were planning to use for your spending.

In other words, (1) Harvard’s endowment is unlikely to be worth $41bn at this moment and (2) it cannot simply convert any portion of that $41bn (or $39bn, or $36bn) to cash any time it chooses. If it distributes the same $1.9bn to fund the university’s budget, that now likely represents a higher payout ratio than 5%. Furthermore, the university’s spending needs may well have gone up (higher operating budget), and other sources of funding for the university’s operating budget – tuition, donations – will drop. Suddenly, the endowment will need to fund 37% or 42% or 50% of the operating budget, instead of 35%. Even after cutting costs, the endowment may be asked to pay out $2bn or $2.3bn or $2.6bn to keep the university going. Very quickly, the payout ratio will breach its 10-year high of 6.1% and the endowment will be meaningfully smaller.

Will that matter today? Or this year? Or even next year? No, probably not. But if that situation persists for a few years, the mission of the university to exist in perpetuity is suddenly at risk.

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Harvard may not be a great example. On average, endowments fund 10% of their university operating budgets. Most universities have much smaller endowments, as well as smaller budgets than Harvard, so their payout ratio is roughly the same at ~4-6% but the absolute numbers are smaller. They share Harvard’s mission of existing in perpetuity.

Given the smaller share of the operating budget that is funded by the endowment at other schools, they are necessarily more reliant on other revenue – tuition and donations being the primary sources. For public schools, state funding is both critical and invariably cut as state budgets are squeezed with less tax revenue and more spending needs. (Of course, Harvard is not a public university.)

During a recession, demand for higher education rises. But it takes time for this rise in demand to trickle down to a rise in enrollment, due to the time it takes for prospective students to evaluate options, apply, and ultimately matriculate. When enrollment numbers tick up, the rise is not equally distributed across all colleges and universities. During the 2008 recession, community colleges and for-profit universities saw the biggest bump. Experts expect online universities (which now include more non-profit schools in addition to the for-profit schools who benefited in the GFC) to benefit from a surge in demand following coronavirus-related upheaval.

Philanthropic support also dries up during a recession, intuitively and as evidenced here using data from the impact on UNC – Chapel Hill. Harvard’s donations may be somewhat more resilient in the context of massive gifts as there is arguably a certain status-by-association effect. (However, it is worth noting that gifts of any size, and especially ultra-large gifts, may come with numerous strings attached.)

Therefore, at a time when other sources of operating income are faltering, a university’s endowment becomes that much more important – both as a stop-gap source of immediate funding and as a perpetual pool of capital that can sustain the university’s mission over the very long term.

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One final comment – the CARES Act explicitly included funding for institutes of higher education. $14.3bn of funding, not including the $3bn distributed to states to allocate to local education agencies as they see fit. There were ~3,400 non-profit public and private colleges and universities in 2017, so using straight division, each school ‘should’ receive $4.1m. In reality, the Department of Education applied a 75% weight to the proportion of Pell Grant recipients (i.e. students demonstrating financial need) and a 25% weight to overall enrollment, graduate and undergraduate. Accordingly, the top 20 recipient colleges are public schools (given their enrollment levels are highest). The full list of recipients and the amounts received is here.

Long story short: It is more appropriate that Harvard availed the CARES Act funding than drawing down on its endowment.

NB. The views expressed reflect the author’s opinion alone. The author has no affiliation with Harvard beyond the fact that her cousin is employed by the university. This cousin had no input into or knowledge of the above article.