Editor’s Note: Today’s story is the second in the Daily’s four-part “Anatomy of an Endowment” series discusses why the University isn’t doling out more of its endowment in the form of financial aid for students. Subsequent stories in the series will try to answer other important questions about the endowment like how the global financial crisis will impact the endowment and how the University’s investors take into account social responsibility and ethics when investing the endowment’s funds. By the end of the series, our goal is to have dissected, described and analyzed in simple terms a massive, intricate financial portfolio — one that is critical to the University’s success.

Infographic by Maureen Stych

In general, a single question has dominated the debate over college and university endowments in recent years: Why can’t more endowment money be used for financial aid?

At the same time that college and university endowments have reported record-high returns, tuition costs have steadily increased at schools throughout the country — and the University of Michigan is no exception.

Here in Ann Arbor, the University’s endowment has nearly quadrupled in the past 10 years. Yet during the same period of time, student tuition rates have increased by more than 50 percent.

This parallel trend of growing endowments and rising tuition costs is often cited by critics who question whether public universities’ multi-million or multi-billion dollar endowments should classify as not-for-profit, tax-exempt organizations under Internal Revenue Service tax laws.

CRITICS PUSH FOR MORE ENDOWMENT SPENDING

This debate over the use of endowment funds culminated in January 2008 when Sens. Max Baucus (D–Mont.) and Charles Grassley (R–Iowa), who serve as the chair and ranking member, respectively, of the U.S. Senate Finance Committee, sent a letter to 136 universities across the country with endowments of at least $500 million, asking them for information about endowment growth, how their endowments are managed and how endowment revenue is spent, specifically with an emphasis on how much is spent on student financial aid.

Grassley told The New York Times in January 2008, “Tuition has gone up, college presidents’ salaries have gone up, and endowments continue to go up and up. We need to start seeing tuition relief for families go up just as fast.”

In the letter, Baucus and Grassley asked how tax policies, which exempt endowment funds and donations to the endowment from being taxed, have affected the management and the use of endowment revenue.

Unlike universities and public foundations, most private foundations are required to pay out a minimum of 5 percent of their assets each year toward their charitable missions. At the time the Senate Finance Committee sent out its letter, there was much talk about instituting a similar rule for universities and public foundations to make them spend more of their endowment each year.

THE UNIVERSITY’S DEFENSE OF CURRENT SPENDING LEVELS

In response to the Senate Finance Committee letter, University President Mary Sue Coleman sent a 21-page response to the Finance Committee in February 2008. In the University’s response, which was submitted by University President Mary Sue Coleman, she addressed 11 key points of concern voiced by Baucus and Grassley.

The response said the University’s endowment had grown 382 percent over the past 10 years as of June 30. At the beginning of 1998, the endowment was valued at $1.99 billion, but by the end of the 2008 fiscal year, the endowment had grown to approximately $7.6 billion. As of December 31, the endowment had lost 14.4 percent of its 2008 value, dropping to $6.5 billion.

On the one hand, the University’s response also said total financial aid awards from the University’s endowment had more than doubled over roughly the same time period. In the 1998 – 1999 academic year, the University contributed approximately $19.7 million to student financial aid through grants and scholarships. By the 2007-2008 academic year, that figure had increased to about $52.2 million.

Student tuition rates, on the other hand, increased during that same time period as well from $6,098 per term in the 1998-1999 academic year to $10,447 in the 2007-2008 academic year.

Responding to public pressure as a result of congressional hearings, Harvard University, Yale University and Dartmouth College announced plans to increase the amount of endowment money spent on student financial aid. The University did not make a similar announcement.

In a January 2009 interview, Coleman said at the time she felt the University was already doing a good job with supporting students’ financial constraints with endowment support.

“We always felt like we were pretty exemplary when it came to both the payout that we did and the amount of money we had committed to financial aid,” she said. “I understand the Grassley criticism, but I think the University of Michigan was already in a position where we were doing extremely well.”

According to the University’s response last year to the Senate Finance Committee, the University aims to meet 100 percent of demonstrated financial need for Michigan residents as determined by an internal formula.

Coleman said in the January 2009 interview that although she understood what Baucus and Grassley were suggesting, she did not agree that it was appropriate for the government to place payout restrictions on colleges and universities. She explained that if the University were to provide a larger amount of financial aid to current students, then students in the future would likely suffer.

“What we objected to is the notion that some government-run agency should dictate what we do,” she said. “We’ve got to plan forever, and I didn’t agree that it was appropriate to somehow spend down our endowment for the today to make students of tomorrow suffer. I couldn’t do that.”

A CONSERVATIVE PAYOUT

Since University leaders don’t think it’s appropriate for government officials to interfere in determining the annual payout of the endowment, the question then becomes how exactly the amount of that payout is decided.

University Chief Investment Officer Erik Lundberg said the University uses a seven-year rolling average to help protect endowed funds, including those endowed for scholarships, from temporary swings of the market.

“We want to insulate the operations of the University from the volatility in the market,” he said, “and the way we do that is through the averaging process.”

Lundberg explained that by taking the past 28 quarters of endowment performance balances, which accounts for the past seven years, and updating them each quarter by replacing the oldest quarter with the newest, the University is able to average its funds over a long period of time to stabilize market performance that would otherwise be unstable.

“By taking the value of the endowment at multiple periods of time rather than at just one, we get a much more stable value,” he said.

Lundberg said payouts from the endowment are treated the same for all endowed funds, and that a formula determines the annual payout. The payout is 5 percent annualized over market average, Lundberg said. This means that 1.25 percent of earnings on investments as calculated by the seven-year average are dispersed from the endowment each fiscal quarter. By doing this, the four quarters of payouts will result in a 5 percent annualized payout.

INCREASING THE ENDOWMENT, INCREASING THE PAYOUT

Despite the recent volatility in the markets, the University’s recently finished fundraising campaign — the Michigan Difference — raised an unprecedented $3.2 billion from the time the campaign went public in 2004.

Through the campaign, approximately $545 million were raised for newly endowed scholarship funds. As of the 2008 fiscal year, the new funds have generated $10 million in student support.

“During the Michigan Difference campaign, donors created 2,045 new endowed funds for financial aid in addition to providing expendable funds for scholarships,” University spokeswoman Kelly Cunningham wrote in an e-mail.

Despite the University’s successful Michigan Difference campaign, Coleman said in the January 2009 interview that the University will likely start another capital campaign in the near future.

“(This) doesn’t mean we stop fundraising,” she said. “There’ll be another campaign in a few years.”

Coleman said private fundraising efforts are essential to the University’s success and contribute to a successful, growing endowment.

“We’ll start another capital campaign because getting that philanthropic support is critical to keeping the University at the high level that it is,” she said.

Coleman said that although the University places a large emphasis on fund development for student support, it is often the donors who ultimately decide for what their donations should be used.

“Now a lot of (our fund development) is dependent on what donors want,” she said. “Fortunately, in the capital campaign that we just finished, we had put a huge emphasis on financial aid.”

Of the Michigan Difference campaign’s final fundraising total, Coleman said the University “got way over our targets on the money we had wanted to raise for financial aid.”

NEW DONATIONS CAN CREATE NEW RESTRICTIONS

When a donor gives money to the University, that person often has an intended use in mind for that donation.

A donor interested in giving a large gift to the University must first enter into a gift agreement with the University, said Gordon Beeman, a University assistant general counsel.

“The purpose of the gift agreement is to document the purpose, restriction and intended use of the donor’s gift … so that there is no confusion or ambiguity at a later time,” he said.

Beeman said the gift agreement also outlines that the donor’s gift will be subject to the University’s bylaws and policies and establishes a payment schedule for the gift. Payment schedules are used to outline how much donors will give over what period of time, if they choose not to donate the gift all at once.

More importantly, Beeman said donors typically have a specific purpose in mind for their gift.

“Certainly with larger gifts, the donors typically have a specific purpose in mind,” he said. “Obviously so long as it’s furthering the University’s mission, we’re delighted to document and apply the gift funds in that way.”

Outlining the purpose of the gift can be more involved than it sounds, as it is sometimes the case that a gift may need secondary specifications, if the primary need cannot be met.

Beeman used a scholarship fund at the School of Education to explain why a secondary purpose may be needed.

“The real purpose (of the gift) was to benefit students from her particular county, which is located in central Illinois,” he said, pointing out that it is very likely that at any given year a student from that county may not be enrolled in the School of Education.

There is a tiered policy so students from Illinois get the next priority, he said. Then, if no one from Illinois qualifies for the scholarship, then the student body at large in the School of Education is eligible for the scholarship, he said.

Additionally, a donor could also specify a gift for cancer research, but may put a secondary purpose in the gift agreement in case a cure for cancer is found, so that the money does not go to waste, Beeman said.

Although donors can specify some purposes or restrictions on their gift, there are certain things the University is not legally allowed to distinguish, Beeman said.

“The University of course is subject to both federal and state law,” he said. “As such we cannot discriminate based on race or gender, and we don’t.”

However, Beeman mentioned a certain concept — the matching pool concept — that does allow a donor to specify some criteria indirectly. Beeman used the example of a donor wanting to benefit a certain gender to illustrate the concept.

“It’s possible for the University to go through its financial aid process, determine the recipients – which of course would be in my example would be male and female – and then from that pool match the donor’s gift to someone who is the gender the donor specified,” he said. “So in that sense, we can accommodate a donor request.”

Beeman said it would also be possible for a donor who wanted to benefit underprivileged students to specify a preference for students from an inner city for a scholarship.

“In that way we’re not selecting based on an impermissible class and yet we may capture what the donor truly has in mind,” he said.

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Daily reporters Andy Kroll and Kyle Swanson will be taking questions all week about the series and about the University’s endowment, in general. Click here to access their Q & A.

Past installments in the “Anatomy of an Endowment” series can be found here.

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