What is the spend rate, and how does the College calculate it?
The spend rate is the percentage of its endowment that an institution spends each year to cover operating expenses. The College calculates this rate in a simple two-step process.
Step 1: Find the average of the values of the endowment for the past three years.
Step 2: Compute the amount of the endowment spent on the operating budget this year as a percentage of the three-year average value of the endowment from Step 1.
What are typical values of the spend rate, and why?
For many years, the Board of Trustees has stated a normal target range for the spend rate of 3.5 percent to 5 percent. While views on the optimal spend rate vary somewhat among experts in the field of endowment management, the 3.5 — 5 percent range is typical for long-lived non-profit institutions and is based on analyses of the tradeoffs between the benefits of higher current spending and the risks of depleting or exhausting an institution’s endowment.
The target spend rate is a range rather than a single value so that the College can partially insulate its annual spending from the potentially substantial year-to-year fluctuations in the value of the endowment. If the College always spent, say, exactly 4 percent of the endowment each year, then we might be spendthrifts in years with unusually high endowment growth and would have to do uncomfortable and quick belt-tightening in years when the endowment’s value fell. The 3.5 — 5 percent target range for the spend rate allows us to implement a lower spend rate (that is, closer to 3.5 percent) when the endowment is growing rapidly and to implement a higher spend rate (closer to 5 percent) when the endowment shrinks or fails to grow, while still meeting the needs of the annual operating budget and protecting the endowment’s long-term value. Economists call this consumption smoothing. Individuals do it, because we typically want our consumption spending to be smoother over time than is our income; and institutions like the College do it, because they want their operating budgets to be smoother over time than the performance of their endowments.
Why does the College look at the spend rate based on a three-year average value of the endowment rather than just the current year’s value?
The value of the endowment fluctuates from year to year for many reasons, some internal to the College (for example, a particularly successful or unsuccessful year of fund-raising) and some external (for example, the overall performance of financial markets in which the endowment is invested). In general, the needs of the College’s annual operating budget don’t fluctuate dramatically from year to year, but increase more smoothly over time. Calculating the spend rate based on the endowment’s value averaged over three years smoothes the endowment’s contribution to the annual operating budget. Put differently, if the value of the endowment declines suddenly in a particular year, the College doesn’t typically want to reduce its operating expenditure sharply, because students still expect their financial aid, Valentine still needs to pay the food bills, and staff members still expect to be paid. This is just consumption smoothing again. The College’s 2007 Annual Report clearly articulates these policies:
“College policy requires that the spend rate be held within a range between 3.5 percent and 5.0 percent of the three-year average endowment value. This rate is maintained at a conservative level, as the Administration and Trustees feel strongly that while increased endowment support is beneficial, it is important that the College not become over-reliant on the endowment, or allow the rate to approach the top of the range in periods of positive investment returns. The cushion in the spending rate that this provides should allow the operating budget support to be maintained during market downturns.” [p. 6, emphasis added]
So, the 3.5 — 5 percent target spend-rate range based on a three-year average value of the endowment builds in two mechanisms to help the College smooth its spending. In financially good years, the spend rate can be held to the lower end of its target range; in financially bad years, the spend rate can rise toward the upper end of its target range. And, by calculating the spend rate as a share of the endowment’s value averaged over three years, especially good or bad endowment performances are averaged out in the calculation
Before the recent financial crisis affected the endowment, what had happened to the College’s spend rate, and why?
Table 1 reports the College’s spend rate for 2002—03 through 2006—07. This was before the financial crisis began to reduce the value of the endowment in 2008. Between 2002—03 and 2006—07, Amherst’s spend rate rose from 3.7 percent to 4.5 percent. This is notable because these years were a period of historically high endowment returns (see Table 1). The endowment-management policy cited from the College’s Annual Report above suggests that the spend rate should have remained in the lower end of its 3.5 — 5.0 percent target range because, even with a low spend rate, the fast growth of the endowment itself would have funded substantial increases in the actual operating budget.
But, what actually happened? Even though the endowment “pie” was growing very fast, the College was “eating” (that is, spending) a relatively large and rising share of the fast-growing pie.
Table 1
Year Spend Rate Percent Change In Endowment Value Annual Net Investment Return on Endowment
02-03 3.7% 4.8% 2.0%
03-04 4.1% 16.1% 13.1%
04-05 4.4% 19.3% 16.2%
05-06 4.6% 18.9% 15.8%
06-07 4.5% 27.8% 24.3%
Source: Amherst College, Office of the President, “Response to Senate Finance Committee Inquiry,” February 22, 2008, pp. 10, 15.
Why? Perhaps because of political pressure from Washington. During the period in question, politicians, best exemplified by Senator Chuck Grassley, publicly excoriated well-endowed educational institutions for continuing to charge tuition while spending less than 5 percent of their endowments. Educational administrators, including those from Amherst, struggled to explain the consumption-smoothing logic which suggests that high spend rates during periods of such rapid endowment growth could place institutions at high risk of financial problems in the event of an economic downturn. Or, in the case of Amherst, perhaps the spend rate rose dramatically because a new Administration and new Board leadership took office, eager to pursue the priorities for the College summarized in the Committee on Academic Priorities (CAP) Report. Or, perhaps spending accelerated in anticipation of the proceeds from the comprehensive campaign now underway. Of course, we now know that a large part of the proceeds of a successful “Lives of Consequence” campaign will go toward replacing the endowment value lost since 2008.
Were concerns raised during 2003—07 about the increases in the College’s spending and their potential effect on the institution’s long-term financial health?
Yes. During 2004—07, the Committee on Priorities and Resources, of which I was a member, repeatedly raised these concerns, which are reflected in the CPR minutes, most notably in the Fall of 2006. On Jan. 19, 2007, the faculty and student members of the CPR met with the Budget and Finance Committee of the Board of Trustees and noted with some alarm the overall trend in College spending.
The CPR, especially its student members, expressed concerns to the Trustees that the number of students at the College would rise (CAP Recommendation No. 5) before, or even without, the promised increase of 18 in the number of tenured and tenure-track faculty Full-Time Employees (FTE) (CAP Recommendations No. 6—9, 17, and 19), resulting in a potential dilution of the quality of an Amherst education, particular in already oversubscribed departments. [Since then, the number of students at Amherst has risen from 1,620 to 1,675 and is scheduled to rise by an additional 95 to 1,770 — an overall increase of more than 9 percent. The number of tenured and tenure-track faculty FTEs has risen from 165 to 167 and is scheduled to rise by one to 168 by 2012 — an increase of less than 2 percent.]
More generally, the CPR called the Board’s attention to the rapid growth of administrative and staff positions on campus, the creation of large new offices on campus, and significant new financial-aid commitments. The nature of each of these areas of rapid budget growth meant that they represented permanent commitments to an ongoing higher level of spending; and the CPR noted its view that endowment funds were not yet in place to support those commitments. CPR members — both students and faculty — voiced fears that financial realities would result in these new areas of spending displacing, rather than augmenting, other vital areas of the educational enterprise.
With the exception of some private support expressed after the meeting by individual trustees, the Board seemed not to be interested in the CPR’s fiduciary concerns. Several trustees made clear in the meeting that the issues raised by the CPR were not in line with the Board’s priority, which was to “change Amherst College,” in ways that were not articulated or explained.
Why does any of this matter?
Members of the Amherst community who have been here for only a few years, whether students, faculty, staff or administrators, have lived their entire Amherst lives during the period depicted in Table 1 and the ensuing period of financial crisis. Therefore, it may be understandable for many to see the period 2003—07 as normal and to assume that the College can soon return to a rate of spending growth similar to that experienced during those years. However, 2003—07 was a period of confluence of a rapidly rising spend rate and historically high endowment returns. This leads us naturally to several questions; and I hope that you will find the information I’ve outlined here useful in thinking about them: To what extent is the College’s current financial condition a simple reflection of the worldwide economic contraction and its effect on Amherst’s endowment? Even without the external financial crisis, could the rate of spending growth of 2003—07 have been sustained? Or, given the rapid growth of the College’s permanent spending commitments during 2003—07, would even a modest economic downturn have quickly pushed the spend rate well above the 5 percent ceiling? Had the College stuck more closely to the spirit of its stated policy not to allow the spend rate to “approach the top of the range in periods of positive investment returns,” might some of the past year’s disruption and divisiveness in the community have been avoided?
The point isn’t to tell you the answers. Reasonable people can disagree. I do hope that you will think about both the facts and the questions presented here as the campus continues its discussion and debate about the financial and educational future of the College.