Endowment Matters

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?

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?

Time Preference and Endowment Building

In political economic theory, there is a concept called time preference. A person (or an institution, such as a school) can have a high time preference or a low time preference. High time preference means that the invidividual or institution is markedly reactive to current events and circumstances. By contrast, low time preference means that the individual or institution maintains an even keel, always focused on long-term stability and continued existence.

Schools looking to grow their endowment must come to terms with time preference.

Annual operating budgets reflect an orientation toward high time preference (i.e., new curricular programs, special speakers, environmental initiatives). Endowments, however, are not meant to be high time preference vehicles.

To build an endowment, schools need to have a low time preference. A reactionary approach to finances will not result in endowment growth; in fact, the opposite will result. The school's current needs/wants will override the discipline to increase cash inflows to the endowment, and there will be no sustainable growth. Low time preference guarantees that the school will pursue and maintain regular cash inflows to the endowment, no matter the high time preference issues that may compete for financial attention.

A glance at search announcements for heads of school shows, almost to a school, that heads are being expected to increase endowment as one of their charges. As if growing an endowment were easy! Underlying this desire to increase endowment is a philosophical issue that boards need to grapple with, if they expect to actually experience endowment growth: their time preference.

If schools can't commit to a low time preference vis-a-vis endowment, the next time they search for a new head of school, they will continue to look for a head who can build the endowment. The cycle will not end until the board consciously embraces a low time preference.

Get the time preference right, and get the increased endowment. Get it wrong, and lose current purchasing power to inflation.