Should the University of Illinois Use its Endowment to Avoid a Hiring Freeze?

Posted by Jeffrey Brown on Jan 7, 2010

Filed Under (Uncategorized)

The big news here at the University of Illinos this week is the announcement of a hiring freeze along with mandatory, unpaid furloughs for university administrators, faculty and staff.  These actions were made necessary due to the continued inability of our Governor and Legislature to engage in good fiscal management.  The state has provided only 7% (that’s right – single digit, seven percent) of the promised funds to the university thus far, and given a nearly $2 billion projected state deficit, the short-term does not look bright. 

I could write at length about the fiscal problems of the State of Illinois, or how the University ought to respond, but I will save those posts for later (or for others).  Today, I simply want to tee up a particular issue of whether the University ought to use some of its endowment funds to cover the shortfalls.   

To my knowledge, the University of Illinois system has so far not made any decision to dig deeper into its endowment funds in order to help weather what most believe to be a temporary budget problem (to be clear, temporary could be a few years – the point is that it is not permanent.)  Yet there are some compelling reasons to think we should. 

Yes, I can hear the criticism already of those who might argue that the University should not “raid” its endowment, or that doing so would be “short-sighted.”  But is it?  The answer really depends on why universities have endowments.  On this point, there is a masterful paper that was published in the Journal of Legal Studies nearly two decades ago by Henry Hansmann of Yale Law School entitled, aptly enough, “Why Do Universities Have Endowments?”  In the paper, he rigorously analyzes a wide range of possible justifications (intergenerational equity, rising costs of education, lumpy gifts, tax incentives, and so forth) and finds that many of them are not consistent with how institutions actually behave. 

One of the many possible reasons, of course, is to maintain liquidity by having “a reserve against financial reversals.”  Universities may be less able to borrow than private firms, are unable to issue equity, and have “only limited flexibility in adjusting their scale of operations on a short-term basis” due to the tenure system.  This is one perfectly sensible reason to build an endowment – to serve as a buffer stock that can be drawn upon on rainy days. 

Of course, Universities do not appear to be using endowments for this purpose (I’ll have some new research to share on this point in a few weeks).  As Hansmann points out, “the spending rules … which call for spending a given fraction of the real value of the endowment annually, are directly inconsistent with a policy of using the endowment as a financial buffer.  Such a rule commits an institution to using its operating budget as a buffer to absorb shocks to the market value of its endowment, rather than vice versa.”  In essence, only if a University is willing to spend a LARGER fraction of its endowment during tight budgetary times would the endowment serve a useful purpose as a reserve.  Perhaps that is exactly what the University of Illinois should consider doing – dipping into its “quasi-endowment” funds (those that are not subject to binding restrictions on the timing of their use) in order to help cover current expenses.

To those who don’t like the idea of “spending the principal,” consider this: the primary purpose of the university is the production and dissemination of knowledge.  The University of Illinois has tremendous comparative advantage in this area, and by freezing hiring we are partially divesting from this activity.  In contrast, we do not have a comparative advantage at investing in stock and bond markets.  Does it really make sense to partially divest from an area in which we have a tremendous comparative advantage – and which is core to our mission – just to avoid spending down part of our financial endowment?  Might not the marginal returns to our investment in human capital generate greater social returns over the long-run that our marginal investment in the markets?

Put another way, this is really a question of what type  of investment we want to do.  One form is to invest our resources in hiring outstanding faculty today and continue to support the cutting edge research and knowledge-creation that is vital to our economic progress.  The other form is to invest money in financial markets with the hope of having more money to hire faculty in the future.  Given that many universities are in “hiring freeze” mode, the opportunities for hiring exceptional researchers are probably better now (when there is less competition for good talent) than they will be when the economy improves and everyone starts hiring at once.  

At minimum, we ought to be having the conversation …

7 Responses to “Should the University of Illinois Use its Endowment to Avoid a Hiring Freeze?”

  • jerry l. carson says:

    hi jeff,

    you pose an easy “strawman” question. of course if the university’s survival is threatened you must use your emergency resources–otherwise you die!

    but it begs the essential issue–the university has a broken financial and administrative model. it can no longer function effectively and on an economically sustainable basis. now is the perfect time to seize this opportunity to create a solution.

    if an entity–be it a corporation, individual, or organization–cannot sustain itself economically it will not survive. any entity that prices it’s product or services beyond the general rate of inflation for an extended period of time will not survive. any organization that succumbs to the will of the minority without regard for the majority will not survive.

    i submit that that is where the univeristy finds itself today.

    in the past i have challenged the college of commerce to construct a better economic model for the university. now is the time. president ikenberry’s work force committee’s objective should be just that!

    so what might that new model look like?

    in the simplest terms it is: increased and more stable revenues. lower and more productive expenses. more responsible and representative administration.

    think of the university as a corporation with shareholders. the governing board should reflect the sources of revenue. so lets try to devise a balance of revenue sources–state, alumni, university, and tuition(students). once a reasonable, sustainable combination is reached then board membership is elected from nominees from each group–sort of a representation by contribution.

    once a reliable stream of revenue is established then expenses and productivity should be addressed. in my opinion the university has not adequately incentivised nor capitalized on the tremendous and outstanding research done within its walls. further i am sure that huge savings exist from marginalizing fiefdoms, egos and duplicities.

    if you can construct such an economically sustainable model with the proper incentives, then the university will flourish. no longer will it be administered by political whims but rather from the invested parties and driven by motivated and productive participants. it will not be an easy process but one of emotional and painful decisions. but in the end it will be well worth it. once you have achieved it the university will be free of administrative and financial dependancy on artificial and unreliable influences.

    good luck,

    jerry l. carson
    bs management and economics
    1962

  • Jeffrey Brown says:

    Thanks Jerry for your insights. In my mind, the key word in your comment is “incentives.” As an economist, I basically believe that 99% of human behavior boils down to responding to incentives. For example, a commonly heard complaint across many departments, colleges and universities (by no means unique to Illinois) is that when an academic unit finds a creative way to raise revenue or reduce expenses, within a few years much of the surplus that is generated often gets “taxed away” by one’s college, campus, or university system (such as by changing the allocation of general funds, for example), thus reducing the incentives to engage in such activities. It is absolutely critical that we keep the incentive structure in the forefront of our minds as we face these significan financial challenges.

  • jerry l. carson says:

    i’ll say “ahmen” to that!!!

  • George Molnar says:

    We have a similar problem here in West Lafayette. Specifically, find a way to save $30 M out of a $1.7 B budget. That’s less than 1.8%.

    So what did PU do – appoint a committee of 17 people over two months ago to “form a workgroup to develop a plan to look into the possible options for considering ways to potentially identify actions that might save money”

    Well, it actually wasn’t as bad as that – but it was close. Two months later the head of the committee (provost) has resigned to take a job at NC State – so we start all over again.

    Any day now, any day now.

    A good CFO should be able to wake up at 8:00 AM and save 2% by Noon. Or else they should be fired.

    Maybe I can raise the $$$ by a big bet on tonight’s game. Any point shavers left there at UI?

  • David Ikenberry says:

    Professor Brown poses an interesting thesis that universities like Illinois should consider eating more of their seed corn by spending deeper into their endowments during times of economic stress. What better time than now to invest in our future, might be the argument.

    While I am no expert on the subject let me for the sake of debate share some thoughts. I actually agree with many of the points Jeff raises, yet let’s consider a counter argument.

    Most endowments use spending rules that are in effect a function of trailing three- to five-year market valuations. With well diversified portfolios, these spending rules if managed wisely can have the effect of providing a smoothed stream of revenues, thus dampening the impact of economic shocks from other revenue streams of the sort we are experiencing today. Many schools do have modest discretion in “tweaking the dial” on endowment payouts in some years, yet those changes are subtle.

    Suppose, though, for the sake of debate that we consider spending into endowment principle in a meaningful way to replace at least some portion of lost state support – not a tweak, but rather a material change in endowment payout policy.

    To implement this, we need to first be relieved of a few constraints. Perhaps foremost is that the vast majority of the endowment pool has spending agreements which define how earnings should be spent. Few donors provide unrestricted funds of the sort that could be considered “financial reserves.” That pool of assets we think of as a potential resource to tap into is instead a blending of thousands of little agreements. To implement aggressive spending of the endowment, one first needs to be freed of these legal restrictions to redirect money from supporting project X to hiring faculty member Y. (True, with a “quasi-endowment” as Jeff mentions we have modest ability to accelerate payouts within a given academic area, yet the scale of those investment dollars is often relatively small and unstable. From a policy perspective I am not sure this would be a wise expenditure for what is otherwise a “long-horizon” investment in human capital).

    Next, we might consider the second order effects of such an action. Does the near term gain from the redirection of endowment funds outweigh the chilling effect this action might have toward future donors who might be concerned as to how their designated gift is honored? This argument has two sides of course, yet this policy does set a tone that a donor’s fund agreement may not be the last word.

    For the sake of argument though let’s avoid dwelling on these legalities. Jeff makes brief reference to a key insight that unlike most corporations whose operations are exposed to the capital markets, universities generally do not share the same depth of exposure to these important economic disciplinary forces. Universities for example do not have clear, easily identifiable equity holders. While universities like Illinois can and do issue debt and manage a capital structure, it is hardly fair to say that these external entities have a meaningful impact on academic decision making at the margin.

    And this creates the rub. Universities face only a limited number of natural forces which constrain inefficient academic investment. Tough economic times present one of the few disciplinary forces that require universities to define their academic priorities in a manner consistent with their organization’s economic viability and sustainability.

    I do not wish to advocate the Rahm Emmanuel doctrine here: never waste a good crises. One never hopes for difficult times to beset an organization. Yet by eating into our endowment, do we not avoid the difficult questions of asking who are we and what are our academic goals and priorities? Stated differently, how can we distinguish a temporary shock to our income from the more serious concern that today’s economic stress is the result of long-term structural problems?

    While endowments create a funding stream that insolates to some degree a given academic activity or program from transient levels of support from other sources, to dig into those endowments in a material way opens up the possibility of perpetuating or accelerating inefficient academic investment. How can we commit to our donors that their gifts which were offered to provide perpetual support toward a particular mission will not be inadvertently redirected and squandered (those are my words) on inefficient academic activities that might potentially drag down the overall institution?

    Does that mean each academic program must float on its own fiscal bottom or each faculty member “earn their keep?” Of course not. Universities, for better or worse, cross subsidize various academic activities in pursuit of their missions all the time (another point Professor Brown laments above!). Yet it also seems clear that reduced exposure to external economic pressures allow universities to evolve into administratively inefficient structures, perhaps for long periods of time.

    Jerry Carson responds above with a call to arms saying now is a time to redefine the university’s business model. I cannot disagree with his refined stakeholder definition of the board. Digging into our endowment base, as repulsive as that might be to our donors, allows one the pleasure of delaying the day of reckoning for poorly structured academic organizations.

    Of course, Jeff raises a good point that surely now must be a terrific time to hire great academic talent in the marketplace. Good point. If we assume a benevolent and well informed administration willing to identify which units to support and which to avoid, these would indeed be good if not great outcomes. Yet one problem with a decentralized decision making environment (one without a clearly defined ownership structure) is that inefficient or ineffective academic units can often make similar claims on the central campus, thus potentially perpetuating their status.

    If Adam Smith’s invisible hand is limited to but a few invisible fingers in the context of universities, should we restrain those disciplining forces even further at this crucial time when clear headed decisions today are perhaps our best shot at a brighter future?

  • Jeffrey Brown says:

    Thanks for the comment George. I know they say that misery loves company, but I truly wish others were not in a similar financial boat. Oh, and about that basketball game …

  • Charles F. Dirst says:

    NO NO NO.
    Universities must do what business does during downturns: examine all costs and make cuts. Do not use Endowment funds.