In times of crisis, universities should look to their rainy-day funds: Their endowments.
The COVID-19 global pandemic has had dire consequences not just for the physical health of people all over the world, but also for the financial health of the world’s economies. Institutions of higher education have not been immune to these consequences. Most private universities have long had tuition-driven budgets, but decreases in state funding have made public universities increasingly tuition-driven as well. As universities refunded housing and dining contracts in the Spring 2020 semester, and faced the threat of significantly declining enrollments in Fall 2020 and beyond, administrators were forced into increasingly difficult situations. Many colleges and universities have had to slash their budgets, resulting in cuts to research funds, scholarships, and faculty and staff pay, and even, in some circumstances layoffs. These drastic consequences seem necessary if you think of the university as relying on tuition and fee-for-services arrangements. However, many universities have access to another significant asset: The university endowment.
University endowments have existed as long as institutes of higher education have been around. Comprised primarily of private donations by alumni or other interested donors, the richest U.S. universities have endowments worth tens of billions of dollars. The work of maintaining and investing these endowments requires the efforts of many lawyers and investment advisors focusing on profit-maximization, unconnected to the educational mission of the university. However, university endowments have one important distinction from private investment firms: All investment income earned by the university endowment is tax-exempt.
As educational institutions qualifying as tax-exempt entities under section 501(c)(3) of the Internal Revenue Code, non-profit institutes of higher education (which includes almost all private and public colleges and universities in the United States) do not pay income tax, except in some very limited circumstances. This tax exemption allows them to collect tuition, room and board fees, and even athletic event ticket fees without paying tax on any of that income. In addition, the exemption allows universities to receive investment income on endowment investments without being subject to tax. Charitable organizations are granted a tax exemption because they provide services that might otherwise be provided by the government, and because they do not have private shareholders who profit from the entity’s income. Non-profit entities who fail to comply with the requirements of the law, or otherwise abdicate their charitable mission risk losing their tax-exemption. But this exemption allows universities to continue to accumulate income in their endowments without having to pay tax on that income.
Most universities have an endowment spending policy that limits annual spending out of endowment funds to some fixed percentage, usually around 5 percent of the total value. Because of limitations imposed by donors, some endowment funds can only be spent in limited ways, perhaps by a particular university department, or in support of a particular line of research or student scholarship. However, most of the endowment could be accessed by the university to help fund its broad missions of education, research, and service. Universities regularly think of their endowment funds as sacrosanct, and act as though the primary mission of the endowment is the further growth of the endowment itself. But endowments are in place to bolster the charitable mission of the university, which justifies the endowment’s tax exemption. Growth for growth’s sake is not the same as a university’s charitable mission.
Just as many of us having savings or investment accounts we think of as our ‘rainy day’ funds, universities should think of their endowments as, at least in part, rainy day funds. And there hasn’t been a rainier year in the United States in recent memory than 2020! Rather than treat the endowment as a growth tool, in times of extreme need universities should view the endowment as a tool to allow them to continue their charitable purposes. Indeed, thinking of the endowment in this way honors the intentions behind the gifts that funded the endowment in the first place. Education, research, and service to the community are at the heart of all universities’ missions. While financial health is necessary to maintain those missions, the university need not always maximize its profit. On the contrary, the university should prioritize its charitable mission, even if that means spending down the endowment in times of crisis, in particular if the alternative is turning away students who are dependent on scholarships, or firing faculty or staff, reducing the university’s capacity to fulfill its mission.
The crises created by COVID-19 have forced us to reconsider many of our old habits. We may never go back to shaking hands or blowing out birthday candles. It’s time also to reconsider how we think about university endowments. Donors contribute to endowments to further the university’s mission. Respecting those contributions requires that administrators look to the endowment to help protect that mission.
Jennifer Bird-Pollan is the Robert G. Lawson Professor of Law at the University of Kentucky Rosenberg College of Law, where she teaches and researches federal tax law.