Using Endowments to Educate, Not Accumulate

Tuition at UNC-Chapel Hill went up by six percent last year. The school’s endowment rose by 32.1 percent to $2.16 billion. And, according to the annual endowment report of the National Association of College and University Business Officers (NACUBO), the percentage of endowments paid out by colleges for expenses has dropped from 5.1 to 4.6 between 2003 and 2007.

University endowments are granted tax-free status by the government, on the assumption that doing so performs some sort of public good. The question begs asking: what public good is served by universities building up enormous “war chests” while rising tuitions are making higher education less accessible for the middle class? It would appear, on the other hand, that students and taxpayers are helping to finance huge accumulations of wealth at many of the nation’s top schools.

Not only are colleges afforded the same tax-free status that private non-profit foundations are, but they are not subject to a mandated five percent annual pay-out rate as are the private foundations. Recently, some U.S. congressmen, particularly Iowa Senator Charles Grassley, have taken note of the low university endowment pay-out rates, the tuition increases, and the rapid growth of endowments. Grassley has suggested imposing the five percent rule on colleges as well.

Another question arises: do universities provide some greater good so that they should be granted extra privileges beyond private charitable foundations? Given the breadth of functions performed by charitable non-profits, this does not seem to be the case. There is also no difference in scale or fund-raising ability that would indicate a need to give universities an advantage. To the contrary, the top 25 university endowments exceed the top 25 private non-profit foundations by $11 billion. And while private foundations grew by 7.8 percent in 2007, university endowments averaged 17.1 percent growth.

In an attempt to forestall a legislated pay-out rule, the schools with the greatest endowments, Harvard (1st), Yale (2nd), as well as Dartmouth (21st), have all announced that they will restructure their financial aid to effectively lower the tuition for middle-class or even upper-middle class students. However, according to Lynne Munson of the Center for College Affordability and Productivity, Harvard’s new aid policy, which affects students’ from families with incomes as high as $180,000, will amount to $22 million – less than .1% of the school’s $34.5 billion endowment.

Some critics of the proposed rule object to what they perceive to be a further intrusion of government into the free market, with government telling private enterprises how to spend their money. Yet higher education has long ceased to be a free market — a large majority of college students attend public schools. Private universities derive a great deal of their income from government sources, through federal tuition grant and loan programs or research grants. The tax-free status gives non-profit organizations like universities a further advantage over profit-seeking enterprises when it comes to compounding their wealth — at least 62 schools now have endowments over $1 billion.

With tremendous wealth comes an equal amount of power. Unlike other non-profits, universities do not just fund charitable works or research. Universities are greatly influential in many ways – particularly in shaping the opinions of the nation. Having such enormous wealth adds a new dimension of power – universities can operate like large investment banks, only with a tax advantage over their for-profit competition. This situation does not support a free market philosophy, but distorts it, by handicapping the for-profit investment firms.

Also worrisome is the potential for collusion between government and universities. If government continues to enable endless tax-free accumulation by the universities, the universities are likely to respond by promoting support for the constant growth of the governmental power in other endeavors. Some might claim this is already the case.

Another possible problem with enormous endowments is that they permit the universities to escape market forces. According to Fred Fransen, the executive director of the Center of Excellence in Higher Education, a foundation specializing in working with university donors, such endowments “insulate” schools from the demands of students and allow them to pursue agendas other than their “core mission of teaching undergraduates.”

Opponents of the Grassley’s proposition also suggest that the endowments are too complex for a strict spending mandate of five percent. For instance, many donations are tied up with many donor-specified restrictions. According to Fransen, however, “ the biggest category of so-called restricted gifts are scholarship accounts,” which by their nature pay out some amount. The complexity of endowments does not appear to be an insurmountable hurdle, since average pay-outs exceeded five percent as recently as 2003.

According to the Ad Hoc Tax Group, a lobbying organization for the Association of American Universities, colleges cannot easily project their earnings, and it is therefore unfair to mandate a specific pay-out rate. Yet the ten-year average growth rate for all colleges is 8.6 percent, according to NACUBO. This is well above the five percent proposed spending limit, and such a regulation might be imposed only on wealthier colleges, whose ten-year growth endowment growth rates are 11.1 percent.

It might actually be best to limit a spending rate rule to schools with larger endowments. Many colleges have small endowments of a few million dollars that need to be preserved in good years, so that the money can be used to supplement income during lean periods. Such schools cannot always afford full-time fund managers to give them high returns on their investments, nor do they have generations of well-heeled alumni writing large checks, as do more prestigious private schools and large flagship state universities.

Munson said that if inflation had grown at the same rate as tuition since 1980, a gallon of gasoline would now cost as much $9.15, or a gallon of milk would cost $15. The clamor for accessibility to higher education for all will eventually be addressed, either politically or privately. Taxpayers are already expected to pick up a large share of the tuition bill, at least for lower-income students. Opponents of the proposed rule have offered a suggestion that tax incentives be used to encourage donations targeted to scholarship funds. But this again shifts the problem onto taxpayers — the taxes lost through the incentives must be made up elsewhere. The least painful solution relies on using the endowments as they were intended – for the education of the nation’s young and talented. And if university endowment funds are going to receive tax advantages, they should be willing to submit to a reasonable pay-out limit.

To read George Leef’s opposing opinion, click here.