The Effect of Endowment Shocks on University Operations

Universities with endowment portfolios invested in hedge funds, private equity, and other relatively illiquid vehicles, tend to make larger faculty and secretarial cuts [in market downturns] than schools with more liquid, traditional portfolios.

Endowments have become increasingly important funding sources for America's doctoral universities over the past twenty years. In Why I Lost My Secretary: the Effect of Endowment Shocks on University Operations (NBER Working Paper No. 15861), co-authors Jeffrey Brown, Stephen Dimmock, Jun-Koo Kang, and Scott Weisbenner find that although endowment payout policies are designed to help insulate universities from the ups and downs of the economy -- typically by using a multi-year moving average to determine the endowment's payout to the university -- universities tend to reduce endowment payout rates more than expected when markets plunge.

Since the 1970s, university endowments have grown much faster than university expenditures as schools moved from bonds to stocks and, later, from stocks to alternative assets, such as hedge funds, private equity, and venture capital. From 1986 to 2008, the median endowment grew 9.8 percent, whereas the median university budget grew only 5.5 percent. While the growth of endowments generated income for universities, it also made schools more vulnerable to big market downturns.

This study shows that when an economic shock causes an endowment to lose the equivalent of 10 percent of the school's budget, the university typically cuts the tenured faculty, through some combination of restricted hiring, attrition, and dismissals, by 5.1 percent that year and by another 6.6 percent the following year. The authors emphasize that these cuts are relative to what the university would have done in the absence of a shock. Thus, some of these cuts are not absolute reductions but rather smaller-than-expected increases in funding or hiring. Such cuts are far more likely among less selective schools than more-selective universities, the authors find. The less-selective schools then bump up the pay of non-tenured faculty to carry the higher teaching load.

The composition of the university's endowment portfolio is also important. The more it invests in less liquid instruments, which can be difficult to sell in severe market plunges, the more it is likely to make cuts, such as in faculty and staff. Universities with endowment portfolios invested in hedge funds, private equity, and other relatively illiquid vehicles, tend to make larger faculty and secretarial cuts than schools with more liquid, traditional portfolios.

Most universities cut support and maintenance workers after a shock. More selective schools cut financial aid to students the year after the shock, with the size of their incoming freshman class also reduced. Less selective schools don't do this. Also, if a rival university has a big negative endowment shock, the school tends to increase its faculty hiring the following year. "This effect operates independently of the university's own endowment shock, and is consistent with a view of universities competing for academic talent," the authors write.

This study focuses on some 200 U.S. universities offering doctoral degrees from 1986 to 2008, a period that includes one particularly notable downturn: the 2000-2002 bursting of the dot-com bubble, when the value-weighted stock market fell 30 percent and the median university endowment lost 10 percent, with a quarter of schools losing 14 percent or more. The authors also discuss the universities' initial response to the financial crisis in 2008-9. The NACUBO-Commonfund Study of Endowments for the 2009 academic year finds that 43 percent of endowments raised their spending rate while 25 percent lowered it. Although the increase would seem to contradict the authors' findings at first blush, the authors point out that the use of a three-year moving-average rule coupled with the recent downturn in endowment values should actually lead almost all endowments to have increased their spending rate.

"Taken as a whole, these results provide strong evidence that endowment shocks and endowment investment decisions have an important and significant impact on the real operations of the universities that these endowments are meant to support," the authors write.

-- Laurent Belsie