Center for Business and Public Policy
at the University of Illinois, Urbana-Champaign

My good friend Douglas Elliott, who is now a Fellow at the Brookings Institution, just issued a new paper “The Financial Crisis’ Effects on the Alternatives for Public Pensions.”  The paper is yet one more in a growing chorus of voices pointing out the significant fiscal woes facing our state and local pensions in the U.S.  And, as I have pointed out before, Illinois is the poster-child for everything that is wrong with the funding status of our public pensions.  

After reviewing the net losses on pension assets, Doug makes the following simple but astute observation:

“The situation is even worse than those figures show on the surface, because pension funds are essentially walking on a treadmill. They need to earn an expected return each year in order to stay standing in place, since the value in today’s dollars of the pensions they have promised to pay goes up each year as those payouts come closer in time. The situation is analogous to inflation. The public pension funds may have lost 15% over two years on a “nominal” basis, but, if their target return was 8% a year , they lost 31% compared to their targeted level of investment value, excluding the effects of contributions and pension payments.”

I have previously noted in this blog that the Government Accounting Standards Board (GASB) allows public pensions to discount future liabilities using the expected return on plan assets.  This approach has no basis whatsoever in financial market theory – indeed, I have yet to meet anyone with a PhD in economics or finance who believes such an approach is correct or sensible.  Actuaries and plan administrators often defend it, but when you dig below the surface, their defense is often rooted in the political or P.R. ramifications of reporting the true nature of the liabilities, rather than in any good economic reasoning.

Let’s bring this home to Illinois.  Specifically, let’s bring this home to the State Universities Retirement System, or SURS.

According to the SURS Investment Update (see page 3 here), the average annual return on the SURS Total Fund over the 10 years ending February 2010 was dismal 3.4%.  But SURS, in accordance with GASB, uses an expected return on assets that is more than double this amount.  Even worse, SURS credits participants in the old Money Purchase option with an investment return that is far greater than this.  Doing so amounts to an implicit transfer from Illinois taxpayers to Illinois pensioners that is above-and-beyond the standard pension formula. 

As we discuss pension reform in Illinois and other states, here are three related points that are worth considering:

1. We should start with truth in accounting.  Stop hiding behind high discount rates and let’s at least define the size of the problem honestly.  A starting point would be disclosing the size of the public pension liabilities discounted using something more akin to a risk-free rate.  (See here for discussion).
2. Let’s stop pretending that we can achieve higher returns without taking on higher risk.
3. Let’s stop making irrevocable transfers from taxpayers to pension participants on the basis of “average” or “expected” returns.  In SURS, that means bringing the Effective Rate of Interest way, way down from historical levels.   

Earlier this year, I made  a post (click here) in which I suggested that universities might wish to increase their spending out of endowments to help maintain, during an economic downturn, their investment in high-value projects (such as recruiting and retaining top faculty and staff).  Such an approach would be consistent with one possible view of endowments - that they are to serve as a buffer stock or an insurance policy against bad economic times.  Some of the comments I received - as well as a post (click here) by my colleague David Ikenberry - were less enamored of this idea. 

Now, I have research to indicate that most universities, in fact, do NOT behave this way.  Rather, it appears that when universities suffer negative shocks to their endowments, they actually reduce the rate of spending from their endowment beyond what would be implied by their own spending rules.  In essence, they do not use endowments to protect their universities from larger spending cuts.  Instead, they appear to act in a manner consistent with trying to preserve the value of the endowment for its own sake.

Our research goes on to show that following endowment shocks, universities respond by cutting staff - including maintenance workers and secretaries.  Less prestigious schools tend to reduce tenured and tenure track faculty (most likely by not replacing those who retire or leave), whereas more selective institutions tend to do more to  protect their tenure-system faculty.  The only group that is unaffected by the shock is “administrators.”

We also find that when an endowment invests more of its resources in alternative asset classes - things like private equity, hedge funds, timber, commodities, and the like - universities make even larger cuts following a negative endowment shock.  This could be for one of two possible reasons.  First, these alternative asset classes are more illiquid, and thus not easy to access during down markets.  Second, it may be that the reported value of these assets - which are much harder to value than, say, publicly traded stocks - are overstated, and the endowment knows it (or at least suspects it).

These results suggest that university faculty and staff have a clear stake in decisions about how endowments are invested and in the payout policies. 

If you would like to read more about this, I can refer you to the paper itself (click here) or to a write-up about the paper that appeared in “Inside Higher Ed” (click here).

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?

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 …