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

Posted by David Ikenberry on Jan 19, 2010

Filed Under (Uncategorized)

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?

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

  • Lawrence O. Myers says:

    I tend to agree. Rather than invading principal sums in such an emergency we should seek to establish a “rainy day fund”. Most endowments seek to live off their interest income and therefore use fixed income investments as a primary tool. To liquidate such positions now would be nonsensical. Why would I sell my rental property today when the “market value” has dropped? As long as the rent is paid, I’ve done what I set out to do. Now, a rainy day fund would be managed in such a way to allow up to complete liquidation in the event of said emergency. I relish the thought, however, of how large that fund would need to be in such times as these.

    Lawrence O. Myers, BS
    CCBA ’92

  • Jeffrey Brown says:

    Thanks Charles and Lawrence for the comments.

    First, let me AGREE with you both that the University must cut costs aggressively, especially in those places where we have become inefficient, bloated, or spending money on things that don’t add much value.

    But, let me go with your business analogy for a moment. If most businesses were faced with an investment opportunity that had an enormously positive NPV, it would look for ways to fund that project. It might do this from cash reserves, issuing debt, issuing equity, or cutting other expenses. But the point is that it would not be optimal to forego positive NPV projects. And, trust me, I have seen first hand that *some* (by no means all) of the cuts have been the elimination of hires that would have been great long-term investments.

    The University has fewer options for funding good investments. We cannot, for example, issue equity. Seen in this light, I am not sure why it is viewed as such a sacrilegious suggestion to think we might want to use our endowments strategically – borrowing agains them in bad times and building them up as strategic reserves in good times. In this sense, I am simply suggesting the same thing Lawrence said when he called for a rainy day fund.

    Of course, you raise a great point that we may not want to sell off when the market is low. But that simply raises a different puzzle — which is why do endowments invest in such a way so as to generate a positive correlation between the endowment returns and overall university funding? If endowments were viewed as part of a broader portfolio of university assets that includes things such as tuition, gifts, grants, contracts, and state funding, we might want to invest the endowment in a way that helps to hedge some of these other risks – precisely so that we don’t find ourselves needing to sell off when asset prices are low.

    Again, this is just all “food for thought.” At the end of the day, I cannot disagree with the view that we should cut inefficient spending first. The problem is, when spending cuts are imposed across-the-board rather than strategically, we get a lot of cuts in good spending too.

  • jerry l. carson says:

    come on guys–you are all dancing around the may pole!

    why don’t we stretch our creativity and develop a new economic model for higher education? if we solve that puzzle then all these side issues become mute.

    as jeff says if endowments are viewed as one piece of funding then it will be much easier to dictate rules for its use/investment.

    once a reliable, stable funding metrix is established then you can tackle spending levels that match and maximize the achievement of the university’s objectives–be it education, innovation or future funding.

    hey guys–you can call me out for not having more specific solutions but i don’t think you can dispute that the curent economic model is broken. the revenue funding sources are either unreliable and rife with political meddling, out of step with general inflation levels or being minimized by lack of incentives or innovation. the spending levelsare woefully lacking in results based, efficiency and incentivised discipline.

    we’re not going to the moon or developing the atom bomb!! it is merely a project to develop an economically sustaining model that provides a reliable revenue stream that exceeds highly productive spending towards achieving stated objectives.

    don’t get lost in the fringes–concentrate on the basics.

    jerry l. carson