Friday, November 16, 2012

Harvard's Financial Report (III)

Would someone who is better at math than I am please tell me whether I am crazy to regard this statement, from the Harvard Management Company's annual report, with extreme skepticism?
To maintain purchasing power, HMC’s investment professionals aim for a long-term annualized rate of return of approximately 8 percent, so the endowment appreciates even after a normalized 4.5 percent to 5 percent distribution rate. 
Two questions.

1. Who else in this business is these days distributing 5% on the theory that they will be generating 8% returns over the long run?

2. The difference between the planned return and the planned distribution, namely 3-3.5%, results in endowment appreciation only if the inflation rate is less than that over the long run.

And I don't mean the general inflation rate, I mean the rate at which university expenditures inflate. Hard to predict what that will be, but historically it has been more than 3%, I think. For example, "Our benefits cost has doubled in the last 10 years," says EVP Katie Lapp in an interview with the Gazette. Benefit increases are promised to be contained going forward, but Lapp continues that the offer on the table to Harvard's unions entails increases "ranging between 2 and 3 percent in wages."

Under these circumstances, it is hard to see how the endowment is going to grow or even stay level even under the improbable circumstance that the 8% and 4.5-5% figures are accurate. Are the quoted numbers any more than wishful thinking?

And if not, what is going to become of Harvard, especially if it has to survive another recession?

Harvard has a whole risk management office, which monitors everything from data security to the safety of day care centers. Are the governing boards watching Harvard's financial planning assumptions with the same steely eye?

PS. Note that the distribution to the Schools will not be 4.5-5% even under these assumptions, since 0.5% will be retained by the center, as I discussed earlier.


  1. While I can't suggest whether the 8% annual return is reasonable, I would think there would be at least some reasons for hope.

    1) Not explicitly mentioned in the calculation is the standard annual fundraising/additions to the endowment. These seem to have been historically 1-2%? (I think it's been north of $500 million/year for some time, even outside the campaign silent period; not sure how much of this makes it to "the endowment", but 1% certainly seems reasonable.) Assuming that's not part of the 8% annual return, that's a big help.

    2) To the extent that larger inflation arises, that might be offset by corresponding larger gains in the endowment portfolio.

    So it's still possibly very optimistic -- as the performance in the last year might suggest -- but under the assumptions they've made the math might well work out, which seems to be your question.

    1. MM,
      Thanks for that comment. But I wonder.
      (1) As you say, the increase in the endowment due to fundraising would depend on how much makes it to the endowment. But there is a lot of "current use" fundraising right now, so none of that is adding to the endowment. I am sure that is planned as a temporary expedient, but that raises more questions. More than that, some endowed gifts pay for current expenses and others don't. For example an endowed undergraduate scholarship is great, because there is not enough scholarship endowment to pay the entire financial aid budget. An endowed professorship is great too under similar circumstances, but not if you go out and increase the size of the faculty as a result of getting it; in that case it is a wash. Endowing the Mitzenmacher Astrology Center, for example, is a wash even under the best of circumstances since the money can't be used for anything else (and if it doesn't cover all the costs of the Center, it hurts the math).
      (2) There must be inflation assumptions built into both the 8% and 5% numbers. And alas, historically the inflation rate for higher education expenses is higher than the magical government-announed general inflation rate.

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