Yogi--stirke three

Another deja

I don’t know when the university began printing an annual Treasurer’s Report. Maybe a couple hundred years ago. I do know that they did one for each of the 17 years prior to the year ended June 30, 2008. I’m now told that the report for that year isn’t late, it’s deceased. "I always thought that record would stand until it was broken." Right again, Yogi.

Bad Season

Fundamentals

Despite the secrecy surrounding the final standings (see post 7-30-09; “Costello: The pitcher’s name?”), one thing is clear—it’s been a bad season for Princeton’s endowment.

So it’s back to fundamentals, namely: what is the purpose of an endowment; what is the amount needed to accomplish the purpose, and what is the right way to adjust any excess?

The first fundamental: For a private university the purpose of an endowment is to provide a supplementary revenue source, because current revenues cannot be sufficient to pay the reasonable expenses of offering a superior education to students while simultaneously affording the faculty a reasonable opportunity to conduct unfunded research.

The second fundamental: To achieve that purpose the market value of the endowment needs to be an amount which, when properly invested, produces inflation-adjusted annual returns equal to the current account deficit (reasonable expenses less non-endowment revenue from recurring sources).

The third, and final, fundamental: If the actual market value of the endowment is greater than needed, it is possible to reduce its size by altering any one or more of the components of the computation—rate of return on investments, non-endowment revenue, and reasonable expenses. [n[i]] If investment risk can be reduced by accepting reduced returns, that alternative should be part of the solution. If tuition has not been eliminated, the alternative of reducing or eliminating it, and thereby reducing non-endowment revenue, should be part of the solution. The final alternative, spending more than is reasonable, never should be considered or accepted as part of the solution.

In 1995, when I first began to wonder about Princeton’s endowment, I did some computations. They showed that Princeton’s current account deficit for the year ended June 30, 1994, was $102,000,000 [n[ii]], and that, to cover that deficit, there would have been $252,000,000 in endowment returns (assuming a low-risk return (8%) [n[iii]]). This bothered me. The computation showed that an excessive endowment return (of at least $150,000,000) already existed and that the excess would spiral to absurd heights in subsequent years. I was bothered enough to write my “Open Letter to Princetonians”. In it I used the phrase “runaway endowment” and advocated an 80% reduction in student charges (which, of course, would have eliminated tuition, being that tuition is less than 80% of total charges to undergraduates).

Princeton turned deaf ears. Tuition was not eliminated in 1995. Instead it was increased throughout the succeeding 14 years [n[iv]], and instead of reducing investment risk the university increased it, precipitously and recklessly [n[v]]—leading to the current crisis of illiquidity and devaluation.

Refusing to lower investment-risk, and refusing to eliminate tuition, the only other way to put a brake on the runaway endowment was the one alternative that never should be considered or accepted—the third alternative—the third rail—i.e., to spend more than is reasonable. Woefully, that is exactly what the university chose to do. In fact, it did more than choose that alternative; it embraced it and binged on it. More precisely, the administration and faculty binged on it, while student families scrimped. To make matters worse, the endowment tossed aside its helmet and with every at-bat took a stance closer to home plate.

And here we are (families and endowment) face down in the dirt.

But dust yourself off—here is the incredible part. If the university were to reduce its spending to a reasonable level [n[vi]], the computation, done in the same way as I did it in 1995, still would show an excessive return on the endowment, and absolutely no need for risky investments [n[vii]] or tuition (the computation is shown in endnote [viii]). This time, unlike 1995, the fundamentals should be heeded, which means that excess endowment return should be reduced legitimately—by eliminating tuition and reducing investment risk, while holding spending at a reasonable level.

If that is not done, and the university again refuses to manage itself properly, the computation shows its dark side. Uncontrolled spending is the university’s invitation to a late night rendezvous with Harriet Bird (n[ix]).

This may seem dry, but it’s moister than the dirt in the batter’s box—so read it again, a little more slowly, and step back from the plate.

[i] A friend of mine (not a Princetonian) advocates a different solution. He says that Princeton should donate its excess endowment to a less fortunate college. Odd as that sounds, initially, his argument isn’t bad. He can post a comment if he wishes to elaborate.

[ii]Excluding items relating to “Plasma Physics Laboratory” (a stand-alone research facility, primarily financed by the U.S. Department of Energy) and “student aid” (a revenue deduction item).

[iii] In 1994 Princeton announced that the average investment rate of return on endowment principal over the previous 15 years had been 15.5% (see footnote 4 to my “Open Letter to Princetonians”). However, in doing my 1995 calculation I used a lower, assumed rate (i.e., a rate reduced by more than one-third (to 10.0%)) to recognize the possibility that the 15.5% rate was not sustainable. The rate of inflation for 1994 was 2%.

[iv] Technically, tuition did not increase for the 2007-2008 school year. It remained the same as the previous year--$33,000. However, room and board were increased by 4.2% (see 2-12-07 “Hidden Ball” post). In every one of the other 14 years between 1995 and 2009 tuition was increased. The lowest increase was 2.9% and the highest was 5.3%.

[v] In the year ended June 30, 1994, 84% of the endowment was invested in “equity” and “fixed income” (we know what those are), with less than 16% in “limited partnerships” (we don’t know what those are). Fourteen years later (the year ended June 30, 2008) the percentage in “equity” and “fixed income” had shrunk to 48% and the “limited partnership” percentage had ballooned to 52%.

[vi] What amount of operating expense is “reasonable” is of course a contentious matter. The university will say that it spends every dollar necessarily and wisely. If one were to accept that, the first line of the computation would be the actual operating expenses for the year-ended 6-30-2008—namely, $952,000,000. I don’t accept the university’s position, because year-by-year, for the last 14 years, I have watched them binge-spend. The university increased its overall operational spending in those 14 years by 220%, while revenue increased by only 58%. In 1994-95 endowment returns paid for 20% of the university’s operating expenses; in 2007-08 endowment returns paid for 50% of the expenses. In those 14 years the university increased its spending for “academic departments, programs, and support” [translation: faculty compensation] by 164%, and it increased its spending for “general administration and institutional support” [translation: administration compensation] by 191%. Because I find that kind of accelerated spending unconscionable, I have made two hypothetical assumptions regarding “reasonable” expenses. The first is that on a per-student basis Princeton should not have to spend more than Brown University spends. That would be $78,000, which, multiplied by 7411 graduates and undergraduates enrolled at Princeton, would produce operating expenses of $578,000,000. Or, for those of you who are not ashamed to look down your noses at Brown, my other hypothetical assumption, as an alternative approach to “reasonable”, is that Princeton should have been content to increase its expenditures over the last ten years at a rate 50% higher than national inflation (28% (national inflation) plus 14% (spendthrift override) equals 42% total spending increase), which, given total operating expenses for the Princeton fiscal year-ended 6-30-98 of $366,000,000, would produce current, “reasonable” operating expenses of $520,000,000. Those of you (primarily faculty) who believe that operating expenses should not be rolled back will find these two hypothetical assumptions to be unworkable (in the same way that you found binge spending defensible, and recurring tuition increases essential), and I expect that you will not be persuaded by my pitches, fat and slow and lazy though they may be (credit: the immortal Bart). I understand how you feel, because you are the problem, not the solution. You are destroying this lovely institution.

[vii] Currently it should be relatively safe and simple (without perpetuating the exorbitant investment management costs of recent years) to obtain a 5.25% rate of return. For instance, if a third of the endowment were invested in utility stocks (e.g., MMUIX 3.48% current yield), a third in high-grade corporate bonds (e.g., VWEXH 8.4% current yield), and the remaining third in treasuries (e.g., VUSTX 3.91% current yield), the return available to cover current account deficit would be $630,000,000 (inflation currently being nonexistent). This portfolio is meant only to illustrate my point. I recognize that the present federal administration is on a fiscal and monetary course that will lead to rampant inflation, and that going forward the endowment would have to include securities that would be inflation-responsive (again, that could be done—i.e., a rate of return sufficient to pay the current account deficit could be maintained without exorbitant management cost, illiquidity, or high-risk).

[viii] (i) current, reasonable operating expenses: $578,000,000
(ii) less: current revenue for y/e 6-30-08: $417,000,000
(iii) equals: current account deficit: $161,000,000

(a) market value of endowment at 6-30-09: $12,000,000,000
(b) multiplied by: low-risk rate of return: 5.25%
(c) equals: available from endowment: $630,000,000
(d) less: needed to cover current account deficit ((iii) above): $161,000,000
(e) equals: endowment return excess: $479,000,000.

“Current revenue” excludes amounts distributed from the endowment. It is assumed that the market value of the endowment has declined 25% in the past fiscal year (although no one seems to know, or be willing to disclose, what the real market value currently is (again, see “Costello” post)).

[ix] The current account deficit would be $535,000,000 if the uncontrolled spending increases are allowed to continue ($952,000,000 expenses, less $417,000,000 current revenues), and the excess endowment return then would be a declining $95,000,000. Still enough to eliminate tuition, but the trend leads down the dark hallway to Harriet’s room.