Endowment provides Harvard with adaptability but also exposes it to risks

After years of diligent management, the University commenced this fiscal year with its endowment valued at a record-high $53 billion. 

However, that aggregate figure may obscure several critical aspects. A significant portion of the endowment is not only limited by donors and stored in distinct funds, but a majority of those funds are allocated to one of the University’s 12 Schools. Less than 5 percent of the total amount is unrestricted and directly managed by University authorities.

In the wake of the dispute that surfaced last week between the University and the White House, the Trump administration opted to suspend billions in long-term research grants, with several more “under review.” The president has further contended that Harvard should forfeit its tax-exempt status. 

To a certain extent, endowments can serve to mitigate financial unpredictability and manage unforeseen expenses. Yet, such decisions entail their own expenses. 

In this revised dialogue, John Y. Campbell, who has held the Morton L. and Carole S. Olshan Professorship of Economics at Harvard since 1994, discussed the operational aspects of the endowment.

Campbell’s research centers on long-term investment strategies, asset valuation, and personal financial management. He was part of the board of the Harvard Management Company, which oversees the endowment, from 2004 to 2011. In 2021, he participated in a working group that aimed to reshape endowment management for Harvard’s Faculty of Arts and Sciences, or FAS. 

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In 2024, you contributed to a document on endowment management, using Harvard’s Faculty of Arts and Sciences as an illustrative case. What did your research generally reveal?  

This document aimed to establish a framework to assist the FAS in considering its long-term budgeting circumstances. Together with my co-authors Jeremy Stein and Alex Wu, we were driven by dissatisfaction with the conventional accounting methodology, which focuses merely on balancing this year’s financial flows.

For instance, if you face a cash shortfall and can draw a little more from the endowment, that resolves the issue for this present year. However, it simultaneously diminishes the resources that would be available in the future. It doesn’t contribute to a sustainable solution. 

This represents an economist’s viewpoint on what might seem to be an immense sum of money. You determined that — in the context of FAS — the endowment is already being utilized to address what would otherwise result in a significant budget shortfall. 

That’s accurate: When members of the Harvard community or the general public observe the endowment, they perceive those billions of dollars as funds that can be allocated for any desire of the University at any moment.

There are two distinct issues associated with that perception. Yes, a substantial portion of the endowment is limited — there are strict restrictions on how that money can be utilized. Additionally, we identify another concern: in a particular sense, the endowment’s revenues have already been allocated — to support the ongoing operations of the University. 

The operations funded by the endowment vary considerably: positions for professors, research initiatives, construction projects, among others. Furthermore, roughly one-fifth of the yearly distribution allows Harvard to provide extremely generous financial aid, just expanded once again this spring. 

Absolutely — and I wholeheartedly support that policy. However, it does diminish the revenue that the School might otherwise generate, thereby placing a greater burden on the endowment to cover annual expenditures. 

Then come the external shocks: economic downturns, recessions, and the COVID-19 pandemic. In those instances, a university can — and Harvard has done — increase distributions to compensate for deficits elsewhere. 

That’s correct. Various approaches can be taken. You can opt for a “decap” — allocating endowment funds for current expenditures; you can modify the payout rate; or you can leverage the endowment through borrowing.

In a short-term crisis, such as the pandemic or emerging challenges in the current political landscape, it may be completely justified to proceed in that manner. However, one must recognize that by doing so, you are alleviating budget challenges for this year at the cost of financial strain in the future.

Harvard’s methodology for endowment management, like many other institutions, relies on targets and forecasts: It presumes 8 percent returns on investments, 3 percent inflation, and a distribution of around 5 percent annually. Yet, the past two decades have demonstrated that reality can be significantly more turbulent than those projections.

Exactly. Our perspective on volatility — a view long adopted by Harvard financial administrators — is to find ways to mitigate its consequences in any given year.

If the endowment performs exceptionally well one year — experiencing a 25 percent increase — you now possess a wealth of new resources. However, it is unwise to expend all of those immediately; instead, it is prudent to smooth out expenditures, progressively increasing spending in a deliberate and cautious manner.

At the same time, there are also downturn risks: Following the financial crisis in 2009, the endowment saw a 27 percent decline in value. Currently, billions in federal funding are potentially at risk of being frozen or revoked. What alternatives do we have now? 

University administrators must now engage in scenario analysis using the spreadsheet framework outlined in our paper: “What are the potential worst-case scenarios?” 

If an endowment tax is imposed, or if we lose “x” million dollars in sponsored research funding, one might even need to explore the consequences of Harvard losing its tax-exempt status.

The analysis will reveal that if this situation is prolonged or becomes permanent, it will have significant implications for Harvard’s long-term outlook. Consequently, drastic measures will be necessary: There will need to be substantial changes in expenditures or alternative sources of revenue will need to be identified. 

There’s no need to enact all changes simultaneously. That would be imprudent. The advantage that Harvard’s endowment provides is time — the opportunity to implement changes in a systematic manner. Our framework indicates that if conditions shift leading to a consistent reduction in income, adjustments will ultimately be required.