WINSTON-SALEM, N.C. - Officials at Wake Forest University think they've come up with a way to help university endowments deal with market volatility while maintaining or even increasing contributions to cash-strapped university budgets.
Cuts in public spending are putting pressure on endowments to maintain contributions to squeezed university budgets. But at the same time, shrinking investment returns during the past three years have cut into endowment funding for academic programs.
Treasury officials at Wake Forest are putting forward a deceptively simple solution to that dilemma. Set aside a reserve fund, separate from the core endowment and invested in 90-day Treasury bills, from which to make operating budget distributions, and invest the balance of the endowment more aggressively, in search of higher alpha.
Establishing an "income stabilization reserve" eliminates uncertainty about the size of the endowment's annual distribution to the operating budget and minimizes the short-term impact on the endowment of withdrawals during market downturns, said Louis Morrell, vice president for investments and treasurer at Wake Forest. Although the exact amount of the fund would be subject to institutional interpretation, he said, the idea is to set aside a minimum of two years' distributions and a maximum of five years. The reserve fund would be "reloaded" based on tactical considerations and investment results of the core endowment, he said.
Not widely used
It's an uncomplicated idea, but it hasn't been widely used, he said. That includes Wake Forest's own $800 million endowment. He said he was able to implement the reserve concept while at Radcliffe College, Boston, between 1980 and 1990. Radcliffe's $135 million endowment was folded into the Harvard University endowment when the two schools merged in 1999.
Mr. Morrell said his presentations on the income stabilization reserve have drawn inquiries from several other endowments interested in more information. He said he was not aware of other endowments using the concept in recent months but predicts the idea will expand. Mr. Morrell said he has presented the idea to the investment committee, but it has not yet formally adopted the proposal. He expects the idea to be adopted and implemented later this spring.
Jay Yoder, director of investments at the $810 million Smith College endowment, said he has heard Mr. Morrell speak about the concept and "it sounds like a good idea," but Smith has no immediate plans to implement a reserve fund. "That's not to say that we wouldn't think about it in the future," he added.
Blame it on equities
According to the 2002 National Association of College and University Business Officers Endowment Study, endowments contribute an average of 5.3% of their market value annually to their universities' operating budgets. Like other investors, endowments loaded up on equities over the past decade and benefited from the bull market that peaked in 2000.
But the subsequent fall in stock prices, coupled with funding cuts and a slowdown in donor contributions, left most endowment funds in a difficult position. Many endowments found they could not keep pace with the spending needs of cash-strapped universities. "You had a situation where fixed-cost increases were being funded from variable sources," Mr. Morrell said.
There is a "disconnect" between spending and investment returns in the current environment, he said. There are only a few ways to deal with this, he said: Increase the annual distribution by a fixed amount, regardless of endowment performance; adopt a return assumption in line with the fund's strategic asset allocation; or create an income stabilization reserve.
Mr. Morrell's reserve fund model for Wake Forest - using a $1 million portfolio with a 75/25 split between stocks and bonds and a $50,000 base-year distribution - shows that since 1985, distributions could have been increased by 5% each year while the endowment continued to grow.
"Using income stabilization, you have low-volatility assets supporting an expanding operating budget, and you know how much you will get each year," Mr. Morrell said. Wake Forest's endowment now pays out about $45 million annually, he said. If the university were to put $100 million into a stabilization reserve account this year, "if the market drops next year, we would have a reserve account to use instead of selling securities at a loss, since we know that we will get a call for the operating budget. Then, with the rest of the endowment, we can afford to take more risk," he said. "It allows you to bring contributions and investments together and cope with market volatility."
And while he said the reserve fund helps solve the unpredictability problem associated with making endowment distributions, he acknowledges there might be "opportunity costs" if endowment returns are greater than the risk-free return on T-bills. Income stabilization works best in volatile markets, he said.
Multiple asset classes
Wake Forest already has spread its portfolio across multiple asset classes: 32% domestic equities; 20% non-U.S. equities; 10% venture capital and private equities; 8% domestic bonds; 6% hedge funds; 5% convertible bonds; 4% commodities; 4% Treasury inflation-protected securities; 4% absolute-return securities; 4% high-yield bonds; and 3% non-U.S. bonds. The endowment recently invested $10 million in the new PIMCO Commodity Real Return Strategy Fund to diversify further, Mr. Morrell said. The PIMCO fund is a combination of commodities and TIPS designed to track the return of the Dow Jones AIG Commodity index. Officials for the endowment also have considered adding international hedge funds.
Mr. Morrell has been a vocal and public proponent of the income stabilization idea, pressing his colleagues at industry forums and gatherings to consider the concept.
According to Mr. Morrell's conversations with other endowment officials, "there is general agreement that, based on what has happened in the markets and the economy, they must do something to overcome this volatility. It is going to make investment committees much more risk averse. There is a lot of pressure for people to do something; we have had a lot of calls asking for more information. I wouldn't be surprised to see it catch on."