Boards Should Reconsider What They Mean by Intergenerational Equity

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By HENRY RIGGS and TIMOTHY WARNER

Trustee committees charged with managing an institution's endowment and approving its annual budget devote much deliberation to the question: What amount should we expend from the institution's endowment to support next year's budget? Most settle on a payout of about 5 percent of the endowment's market value.

Academe has developed a wide consensus that in determining payout, two competing goals must be balanced: first, support of current operations -- preferably in a manner that dampens year-to-year volatility in that support -- and, second, preservation of the endowment to serve future generations. That is, trustees are challenged to achieve so-called intergenerational equity. They must balance the short term and the long term, ensuring that the endowment appropriately benefits future generations of students and faculty members, as well as the current generation.

Plenty of boardroom arguments, some in which we have participated, underscore that college and university administrators -- and faculty budget committees -- lean in favor of current spending and higher current payout rates, while trustees' fiduciary responsibilities push them in the direction of preserving the endowment through lower payout rates. This year, when equity-market forecasters are suggesting that common-stock returns over the next decade are very likely to be much lower than the high returns enjoyed over the past two decades, fiduciary responsibility looms even larger in trustees' minds. Boardroom arguments will heat up.

We believe trustees are being inappropriately conservative when they insist on curbing endowment payouts in the name of intergenerational equity. Is the only measure of equity for future generations the size of the endowment to support them? How about the maintenance of the quality and reputation of the institution? Those attributes might be either jeopardized by squeezing the current operating budget or enhanced markedly by additional current spending. In higher education, quality and reputation are built slowly but can be dissipated rapidly.

Future generations will benefit from investments today in improved quality, while future generations will suffer if, for lack of current spending, institutional quality deteriorates. The question might be posed as an investment-strategy issue: Where will an increment of funds do the most good -- that is, earn the highest implicit return -- for the institution? One answer, but not the only one, is investment in the equity markets. Other possible answers include constructing or renovating physical facilities, increasing student financial aid, closing a faculty salary gap, or strengthening fund-raising capabilities.

We have been pleased that Stanford has recognized those facts and "invaded" its endowment (i.e., spent more than the formula payout rate would allocate) to get through budgetary rough spots. In the early 1990s, when the federal government slashed Stanford's research overhead rate about 20 percentage points (approximately $10-million) to 55 percent, Stanford faced a budget crisis. Excessive preoccupation with future generations would have demanded that Stanford chop its operating budget accordingly.

Fortunately, wiser heads prevailed, recognizing that such a drastic budget cut would hurt the quality of Stanford's teaching and research immediately, harming future generations as well as the current one. After all, rebuilding institutional quality is a long and expensive task. Stanford's trustees bumped its endowment payout rate by about two percentage points (and then scaled the rate back over a number of years) to respond to the crisis. Surely that bump up in spending was wholly consistent with intergenerational equity.

Colleges and universities should recognize, too, that future generations will benefit from future gifts -- including particularly bequests and various deferred trusts now in place, but also predictable, though as yet unrealized, outright gifts. The current student generation benefits from none of those. Nonetheless, current budgets support fund raising and alumni-relations expenditures designed to ensure that future gifts flow. Endowment-payout formulas seem to operate on the assumption that the continuing stream of new endowment gifts will suddenly dry up; we have plenty of evidence to the contrary. And given most universities' proclamation of "no or limited growth" in students or faculty served, those future gifts will be devoted almost exclusively to quality improvement. Even beyond payout rates, then, present endowment-spending policies overreward future generations at the expense of the current one.

Of course, not every operating blip at a university should be justification for bumping up its endowment-spending rate. University governance is an art, not a science. Trustees have the obligation to separate the extraordinary from the routine, fashioning different policies to deal with each. Yale's deferred-maintenance challenge in the 1980s (a long-term problem); Harvard's Allston campus plan (an opportunity); and expenditures to recover from a hurricane, earthquake, or other natural disaster (an emergency) are examples of extraordinary conditions. A couple of new faculty positions or the annual ratcheting up of financial-aid allowances are probably not.

Another often-heard argument for holding down spending rates is the need to "save for a rainy day." Certainly ignoring the possibility of hard times ahead would be imprudent. But in fact the actual spending rates of wealthier institutions over several cycles in the securities markets suggest excessive conservatism.

Using Stanford again as an example, consider its spending rates over the past 35 years. Since 1969 the average actual spending rate has been 4.31 percent of average annual endowment values (excluding the effect of new gifts) compared with the target rate of 4.75 percent for most of this period and 5.0 percent for the past 15 years. Although this period includes the bear market of the 1970s, the payout rate exceeded 5 percent in only six of those 35 years. During the decade of the 70s, the average annual payout rate was 5.08 percent -- hardly an extravagant rate during a period of poor market returns. We believe that a number of wealthy universities were similarly conservative during that decade.

In short, we contend that endowment payouts have been too low over these past three decades. Look at the amazing run-ups in total endowment values at Harvard, Stanford, Princeton, and other well-endowed institutions. These increases have been aided by unprecedented levels of philanthropic inflows, but robust market performance coupled with conservatively low payout rates have been the prime movers. Trustees of institutions with bulging endowments are patting themselves on the back: The future of their institutions is much better secured today than it was two decades ago.

True. And that's exactly why trustees should reconsider just what they mean by intergenerational equity and how endowments can best serve both current students and their successors.

Henry Riggs is president emeritus of Keck Graduate Institute and former vice president for development at Stanford University. Timothy Warner is vice provost of Stanford University.