Flawed Reasoning on Endowments

Sen. Hillary Rodham Clinton (D-NY) has followed the lead of Sen. Charles Grassley (R-IA) in pushing colleges and universities to make greater use of their endowments echoing a proposal of the New America Foundation. Needless to say, associations representing wealthy colleges have not reacted favorably. Several higher education organizations recently submitted testimony to the Senate Finance Committee outlining why their funds should remain protected. Today, we examine the higher education associations’ arguments.

What Makes College Endowments Special

The Internal Revenue Code currently makes a special distinction between colleges and other types of non-profit organizations. Most non-profits are classified as private foundations, provided they serve one of several purposes outlined in Section 501(c)(3) of the Internal Revenue Code. Private college endowments, however, are considered “public charities” under Section 509(a) of the Code. This is more than a semantic distinction: being a public charity means a college endowment receives all the tax deduction and tax exemption benefits of a non-profit entity, while not being subject to the same regulations that require private foundations to spend 5 percent of endowment funds each year. Failing to meet the 5 percent spending requirement can cause private foundations to lose their non-profit status.

Were colleges held to the same standards as private foundations, most would fail. According to the National Association of College and University Business Officers’ 2006 endowment study, colleges and universities spent on average just 4.6 percent of their endowments. Calculating the spending rate average by weighting the dollar size of the endowments shows that the average spending rate was just 4.2 percent.

The effect of this tax break can be seen by just comparing Carnegie Corporation, a private foundation with a $2.53 billion endowment, with Vanderbilt University, a public charity with a $2.95 billion endowment. Despite the similar size in endowment, Carnegie spent $136.9 million, or 5.4 percent of its endowment in 2006, but Vanderbilt University spent just $120 million or about 4.1 percent of its endowment. The lack of a spending requirement allowed Vanderbilt to keep an extra $27.3 million squirreled away in its coffers rather than doing something good like trying to bring in more-low income students. (Psst: Vandy also hiked tuition and fees $1,838 per student last year, raising a total of $11.8 million. Hmm.)

An Inflexible Defense

The wealthy college associations’ arguments against tapping billion plus dollar endowments generally follow two different tracks: inter-generational equity and inflexibility. The former stems from the claim that requiring colleges to spend down their endowments would deplete resources available to later generations of students a problem that would be especially pronounced in lean economic years.

While we agree that preserving the endowment is a concern, the wealthiest colleges and universities are earning rates of return in excess of 15 percent a year, high enough that they would still have substantial endowment growth even if a spending requirement is imposed. Moreover, Congress could address the issue of economic downturns by requiring the Secretary of Treasury to waive a 5 percent spending requirement for colleges that can demonstrate particularly bad returns on their endowments in a given year.

The issue of inflexibility is far more interesting. In their testimony, the wealthy college associations claim that 80 percent of the assets of public college endowments and 55 percent of those of private college endowments are restricted for certain purposes by donors. While there’s no doubt that some donors put restrictions on their contributions just as private foundation contributors do, arguing about inflexibility is fairly easy when no outside entity can see just where endowment funds are kept and what kind of restrictions are placed on them. By making this argument, wealthy colleges are practically begging policy makers to demand more transparency about how they manage their endowments.

Colleges are quick to claim that payout rates would be “needlessly restrict[ive]” and would limit colleges ability to “meet both their near- and long-term fiduciary responsibilities.” Never mind that private foundations with vastly smaller endowment sizes and their own set of donor restrictions are able to meet the Internal Revenue Code’s 5 percent payout rule. We challenge the colleges to prove that a comparable payout rule is needlessly restrictive and compromises their ability to meet near and long-term fiduciary duties. Crack open the books or crack open the bulging vaults.