Endowment Matters

Price Increases versus Inflation: The Reality

This weekend's issue of the Financial Times includes a column entitled "The Week in Numbers" at the end of the first section.

A key figure cited: 16%. The index of meat prices of the UN Food and Agriculture Organization is up 16% over the past year. What is more striking, for those who eat lamb somewhat regularly, is that lamb prices have reached a 37-year high.

Yet we are told that inflation is almost non-existent. My understanding of economics is that inflation is an increase in the money supply; that we have, to be sure. The meat figures cited above represent price increases, which are sometime referred to as inflation (I myself use that term loosely, sometimes).

So, we find ourselves in an environment in which, we're told, core inflation is near 0%, yet here we see that the meat index is up 16% in the past year. I have highlighted this issue before: the CPI number, we must remember, excludes food and energy prices.

There are two lessons here:

(1) commodities can be a valuable piece of the puzzle when it comes to an overall endowment strategy

(2) when independent schools set tuition rates based on CPI, boards of trustees might do well to take a broader look at the increase in prices of goods that are not included in the CPI number. If your school is raising tuition at CPI+2, you may be creating a deeper imbalance in families' pocketbooks by overlooking the fact that they're probably paying more for basic needs (food, for example) than ever before.

Question: how might this scenario affect your endowment strategy? Are you still willing to leave endowment growth on the back-burner?

Outlook on Endowments 2010 to 2014

The next several years will be incredibly difficult ones for endowments, in terms of generating substantial returns. With nothing but economic uncertainty in front of us, here are some suggestions as we muddle through:

• Expect volatility, sometimes severe. Geopolitics will play a role in your endowment portfolio like never before.
• Be sure that your endowment has a good portion of equities with a history of on-time payment (and/or increase) of dividends.
• Do not expect a significant increase in the prices of your assets, what is termed "price appreciation." If there is price appreciation, take it to the bank, but plan for little to none.
• For the fixed income portion of your endowment, screen out as many mortgage-backed securities as you can. This market is exceedingly volatile, and there could easily be further changes to the MBS (mortgage-backed securities) that would be deleterious to the MBS industry.
• Consider allocating some percentage of your fixed income portfolio to TIPS, treasurys that are inflation-indexed.
• Don't put great stock in the CPI numbers that are released, which will indicate low inflation. Some reports have identified inflation as being expected to average 1.6% (approx) over the next ten years. Don't forget that "core inflation" numbers do not reflect food and energy costs; these are expected to rise. Independent school families need food and energy, which means that these prices affect what they will be willing to pay for tuition more than the CPI figures, the prediction of which is questionable at this point. Read my white paper, "The Deleterious Effects of Inflation" for more information.
• Continue to maintain a portion of your endowment in cash. Your investment committee should determine what this allocation should be, but try to make it significant. Here is the reason: should your school need immediate access to cash, it's nice to have it on hand without having to worry about liquidation of equities at a loss. A basic guideline to use is to determine how many days in cash you would need to be in order to continue operations for three to six months. Then, look at your projected cash flow from normal tuition payments, discount it by 25% and use that 25% figure as the target for how much cash you should have. This projection would give you enough cash to continue operations should 1/4 of your tuition payments cease for a period of three months (or six, if you wish to be extra-conservative financially).
• Continue to funnel dollars into your endowment via a budget line item in your annual operating budget plus a minimum of 10% of your annual fund (25% would be better).
• If your endowment is small (<$2 million), don't plan for an endowment draw. There is no IRS rule (not yet, at least) which states that you must take a draw. If your endowment is >$2 million, convince your finance committee to take as small a draw as possible: perhaps 2%. Since these amounts are very small, it would be better to plan for them in terms of hard dollars (tuition revenue) rather than taking a draw from your endowment. Remember: you need to maintain the endowment for the long haul, and it's not going to grow if you continue to draw it down. Short-term pain = long-term gain.

Maintaining stability is the name of the game right now. Recent economic history (the last twenty years or so) shows us that we have a recession, on average, about every four to six years. That means that--potentially--we'll be due for another one sometime between 2011 and 2013. Take the time now to revisit your endowment strategy, and, if you haven't altered course, consider the implications of a possible recession in the short-term and how that might affect your operations. Then plan for it.

Portfolio Challenge Update: End of Fiscal '10

June 30, 2010 marked the end of the first fiscal year of my portfolio challenge. As a reminder, my fictitious endowment for Independent Academy is based on holdings of 2,500 troy ounces of gold. My figures from the past year are as follows:

Starting Dollar Value as of 6/30/2009: $2,321,250   (New York close of $928.50/oz.)

Dollar Value as of 9/30/2009: $2,515,000    (New York close of $1,006) +8.3% from 6/30/09

Dollar Value as of 12/31/2009: $2,741,250   (New York close of $1,096.50) +18.1% from 6/30/09

Dollar Value as of 3/31/2010: $2,781,500   (New York close of $1,112.60) +19.8% from 6/30/09

Dollar Value as of 6/30/2010: $3,106,000  (New York close of $1,242.40) +33.8% from 6/30/09

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A return of 34% is pretty good, given the state of the economy! Independent Academy has done well. Now, two matters remain before we launch into the second fiscal year of an endowment based entirely on gold bullion.

1. Annual Draw. As promised we will take 4.5% of the US Dollar value of the corpus and sell that many ounces of gold. Based on a New York Spot close on 6/30 of $1,242.40, our endowment was valued at $3,106,000.

SOLD: 112.5 oz = $139,770

Endowment Balance = $2,966,230 [2,387.5 oz. of gold bullion]

2. Annual Purchase, based on 15% of Annual Fund donations. Our Annual Fund brought in $500,000, 15% of which equals $75,000.

BOUGHT: 60.4 oz. of gold

Endowment Balance = $3,041,230 [2,447.9 oz. of gold bullion]

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Some Thoughts (Obvious or Otherwise)

When I announced the portfolio challenge, I knew that the sell-buy strategy (1x/fiscal year) was not balanced. However, I wanted to wait for the full set of data to allow me to point out the obvious issues that Independent Academy now needs to study and act on, as does any independent school with an endowment. My point is that most independent schools are not doing enough for/with their endowments in terms of replenishment and building. I have chosen not to allow new gifts to the Independent School endowment, only replenishment. Permit me some thoughts below, which are meant to prompt those of you reading this blog to follow suit.

1. Sustainability. Although Independent Academy's endowment is exceedingly healthy, and although our draw was not immediately deleterious to the Academy, my concern now is that we bought 60 ounces of gold after selling 112 ounces. Over the long term, that inverse relationship could be deleterious, as we must plan for the natural volatility of gold prices. If gold moves downward in the future, we would have to sell more ounces in order to meet our draw. If it continues to rise, we will benefit from the good fortune.

2. Risk. This category is tied into the first, as my last sentence (above) demonstrates. Independent Academy must carefully assess and manage its risk with the endowment; just because it is based on gold--a rising asset over the past ten years--does not mean that it will continue to benefit from increases, despite continued economic instability domestically and internationally.

3. Complexity. Independent Academy wishes to avoid a complex endowment, and it has done so, successfully. However, risk assessment will call for some data modeling. Nevertheless, the Academy's trustees will insist that this data modeling be kept focused on a gold-only endowment.

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Fiscal Year '11

In this new fiscal year, Independent Academy will begin to track a separate data point: the synchronous full replenishment model. This model would have the Academy sell X ounces at 6/30, then simultaneously buy the same number of ounces. The funds to purchase these ounces will, as always, come from the Annual Fund. This approach will cause the Board to reconsider the flexibility of the Annual Fund and how those resources might be better allocated within the operating budget. When we look at the final data on FY 11, it will be interesting to see what the Board thinks at that time.

Endowment Portfolio: Passive Versus Active

Schools with endowments in the small to medium range (say, $2 million to $50 million) should charge their investment committees with studying how their endowments might fare with more active investment oversight, rather than the passive investment policies that so many of these endowments follow.

It's safe to say that The Great Recession had an effect on those schools with passively-managed endowments. Witness the schools that found themselves facing temporarily frozen assets--the ones that were supposed to be liquid. Given the spectacular performance of the markets in the lead-up to Fall 2008, most passively-managed endowments had low liquidity ratios...a real danger for those schools that must have an endowment draw to make the operational budget work properly.

When a school with a $15 million operating budget, 12-15% of which stems from endowment draw, discovers that its endowment liquidity has been compromised, one can imagine the panic which ensues.

Lesson #1 -- increase liquidity levels in your endowment.

Lesson #2 -- encourage more active management of your endowment; be sure that your portfolio manager(s) will be able to sell, reallocate (and so forth) with relative ease, rather than locking you into strict rules about when assets can or can't be sold, etc. Ongoing reallocation is a strategy to be embraced, from here on out.

There is a place for passive portfolio management, but that place is not for independent schools, as we must go out of our way to maintain inter-generational equity for our students and families. Active portfolio management will help us ensure that, by always questioning market trends.

Not unlike our university counterparts, we will have to become much better at managing our endowments.

Endowments at K-8 Schools

K-8 schools have a particularly difficult time creating endowments that provide meaningful support for operations, scholarships, and the like. The usual complaint of development directors, heads, and trustees is that, without a grades 9-12 component that keeps graduates better tied to the school over the years, growing a serious endowment is simply not possible.

What compounds the issue further is that most K-8 schools are small, either by design or by market choice. With fewer families, so the argument goes, the opportunity for gifts to endowment is diminished.

Tuition levels at K-8 schools, however, are not so different from K-12 schools, or, for that matter, from 9-12 schools. After all, it takes money to run the school. From this perspective, K-8s are very much on similar footing with their counterparts. Similar footing equals similar needs; simply adjust for scale.

So, what to do?

1. Adjust institutional mindset. In other words, choose to stop pointing the finger of blame at factors other than what you can control. K-8s are invaluable. Invert your thinking. You're no longer at the bottom of the mountain, you're at the summit. Read Carol Dweck's book on mindsets and choose to have a growth mindset! The fixed mindset gets you nowhere.

2. Adjust your operational budget to accommodate a line item for endowment building. Don't skimp. Few are the K-8s that can run advancement offices with results similar to large K-12s. Choose not to! This line item may hurt; that's OK. It should. If you want a meaningful endowment, this annual number has to be just as meaningful. For instance, if you want to hit $1 million within 10 years, you'd better be allocating $100K per year to this line item. That's your baseline.

3. Reconfigure your Annual Fund so that a certain percentage feeds into your endowment. I would recommend a minimum of 10%, but 25% would be a nice goal. Even higher would be better. For the truly brave and innovative: stop using your annual fund to support your annual budget for a period of five years. If your modest annual fund brings in $300K per year, in five years, you will have accumulated $1.5 million.

4. Ignore the fact that a donor may provide you with a major or planned gift. That being said, choose to pursue these gifts as complements to your other funding. In other words, don't count on them in your data projections: count on hard dollars only, combined with a percentage of your Annual Fund.

5. Ignore the potential endowment campaign. As with #4 above, decide to pursue an endowment campaign as a complement to your other funding, not as a replacement for that funding.

6. Establish a threshold at which point you will begin to draw on your endowment. For instance, maybe once you reach $2 million. That figure will be different for each school. (n.b. That's right...I'm suggesting that you NOT take a draw on your endowed funds until the corpus reaches a target size. With the deleterious effects of inflation, you really can't afford to take a draw on anything less than $1.5 million.)

In case you didn't notice, over the course of 10 years, steps 2 and 3 will produce an endowment of $4 million. And that figure doesn't include any appreciation of assets, dividend payments, or interest payments.

We Have a Small Endowment!

Given the state of the economy, many schools with small endowments are exasperated. My advice: take advantage of the opportunities out there...think BIG!

 

 

Hope Is Not a Strategy

Overheard in the Board Room

"I hope that our endowment performs better this year than last year."

"I hope that we can increase our draw next year in order to provide more financial aid."

"I hope that we can decrease our draw next year in order to counteract our portfolio losses."

"I hope that the new endowment manager will bring our endowment back to what it was pre-2008."

"I hope that the new development director will put together a tremendous capital campaign that will build our endowment into something more meaningful."

"I hope..."

HOPE IS NOT A STRATEGY!

Our Endowment is Fine, Thank You

"Our $15 million endowment is fine. As a school, we're comfortable with it. It helps our operations, and it gives us a bit of a cushion in the event that something nasty happens."

Really?

Have you considered the fact that your endowment will lose 1/3 of its purchasing power by 2020, only 10 years from now? Its face value may still appear large, but, due to inflation, you will have lost a minimum of 3% to 4% each year in terms of purchasing power.

How does that $15 million (or enter your figure here) look now? Its relative purchasing power is $10 million. Imagine how that will impact your operations. How about those scholarships, which are now priced against rising tuition (because you've increased tuition each year at more than CPI, no doubt)?

What is your strategy to continually offset the inflationary factor?

Planning for an Endowment Crisis

Niall Ferguson had a great article in today's Financial Times, addressing the sovereign debt crisis in Greece, which is affecting the European Union. He submits that it's only a matter of time until a similar crisis erupts in the US.

School leaders would do well to consider the potential implications, were such a crisis to occur in the US. The question is this: how can schools best hedge against this kind of crisis in terms of endowment management? If you haven't engaged your asset manager in a discussion of this sort, I would suggest that you do so sooner rather than later, as it may take time for him/her to 1) propose a new asset allocation and 2) execute the reallocation over a fixed period of time. As one example, George Washington University decided last year to reallocate their portfolio to allow 30% of funds to be invested in natural resources and commodities.

How active is your management?

Real Rate of Return

What's your real rate of return?

Your carefully-managed, conservative portfolio returned 8.5% over the past twelve months. Your draw was 4.75% and your management fee was 50 basis points. You still have money to spare, right?

Wrong. Dead wrong.

You didn't factor in the rate of inflation at 3.5%. With that factored in, you LOST money over the last twelve months. You earned -0.25%.

What is your strategy for accounting for the deleterious effects of inflation on your endowment?