PhD Harvard University
A Financial History of Cooper Union
The “Total Return Concept” of 1970
During the year 1970-71, President White and the trustees formalized a revenue-side practice, the total return concept, to help address cash shortages: “Under this concept, income includes cash income plus average net longer-term capital gains in investments.”[i] White stressed that the portion of the investments “used to supplement cash income” should be a “conservative, carefully controlled portion”. Drawing from investments to pay operating expenses helps meet short-term needs, but comes at a cost to the long term.
The short and long term risks of the total return concept are balanced by an institution’s endowment spending policy, which is set periodically by the governing board. At most institutions, the endowment spending policy is designed to maintain the endowment’s real (inflation-adjusted) purchasing power in perpetuiti, ensuring intergenerational equity. Intergenerational equity is the principle of stewarding assets so that they benefit future generations of students at least as much as they benefit current students.
The best practice in implementing the principle of intergenerational equity in American higher education has been to set the endowment spending policy at roughly 5% per year. The rationale is that if the historical average annual return on the financial markets is 8% per year, and the historical average annual inflation is 3% per year, a withdrawal of 5% per year prevents the endowment principal from losing value. And in order to smooth out volatility in the financial markets, the 5% is often calculated on a moving average of the market value of the endowment over several years.
Technically, Cooper Union’s endowment spending policy has been in line with best practices: 5% of the 20-quarter running average. In practice, persistent cash deficits have forced drawdowns at higher rates – many times 5% since 1990. Legally, only the donor-restricted portion of the endowment (also known as the corpus, sometimes loosely referred to as the endowment) is protected from cash draws below the original principal. Furthermore, institutions often limit the scope of the 5% policy to the donor-restricted portion.
Over a period of decades, this has had two consequences: first, the endowment has not maintained its real value, and second, sparse reinvestment during bull markets prevented the endowment from growing rapidly during strong economic times in order to fund the institution during weak economic times.
When coupled with Cooper Union’s unique model, in which real estate helps to deficit-finance operations, the risks of the total return concept are particularly tricky to analyze risk – indeed, almost opaque to all but experts. First, there is a trade-off between the technical size of the deficit and the magnitude of the draw from investments. If “income includes cash income plus average net longer-term capital gains”, and the technical meaning of ‘deficit’ is income minus expenses, then large capital gains in any given year could produce technical balanced budgets. This was probably the case in the 1980s, when a ballooning real estate market in New York City enabled budgets that were technically in balance, creating an illusion of financial health. The opportunity cost, of course, was that net assets fell steadily relative to those of other high-asset colleges, who took advantage of rising markets to build gigantic endowment portfolios.
At most institutions, the bulk of real estate holdings beyond the campus are managed as part of the investment portfolio, subject to the 5% endowment spending policy, which balances the risks and opportunities of the total return concept. In these cases, capital gains as well as rental income are managed as part of the investment portfolio, and 5% (or whatever alternative policy) is withdrawn each year, regardless of how well the real estate markets perform or how high the rents are. In Cooper Union’s model, in contrast, rental income goes directly to the revenue side of the budget, as it did when Peter Cooper operated stores on the ground floor of the Foundation Building.
Consequently, when Chrysler rental income (and the linked tax equivalency payment) is high and grows fast, as was the case in the 1980s, there is money to offset what otherwise might have been all or part of a deficit. Otherwise, the institution plunges into deficit, as it did when the Chrysler rents leveled off in the early 1990s.
Cash to cover deficits can be taken only from the unrestricted pool of the financial portfolio. The financial portfolio is partitioned into restricted, temporarily restricted, and unrestricted pools, as per accepted accounting practice. The restricted pool of the investment is thus not available to cover deficits willy-nilly, and the temporarily restricted pool typically contains funds that are being held in anticipation of a designated expenditure.
This leaves only the unrestricted pool to fuel deficits. In Cooper Union’s history, the unrestricted pool has served as a unique buffer fund, spent down to cover shortfalls and then replenished whenever possible. In President White’s words:
“In years when the unrestricted portion of funds has exceeded the total needed for current operating expenditures, the excess has, in effect, become a part of the college’s cumulative total of unrestricted endowment and current funds. These are the only source of funds available to meet cash deficits in other years. They are also vitally important in meeting unexpected emergencies and have made possible completion of construction, as in the case of the Hewitt and Engineering buildings, when capital gifts were insufficient.”
While unusual in higher education finance, this strategy – funding operating deficits by using accumulated savings – enabled Cooper Union to stave off disaster for as long as it did. At the same time, this strategy makes for a financial model that is difficult to interpret based on financials of any given year. Only an analysis of the time series of financials over many years reveals the rising and falling of the unrestricted pool, as it is replenished periodically by just-in-time windfalls, real estate deals, and as we shall see in a later section, debt.
[i] John F. White, The Cooper Union Financial Report, 1969-1970.