For my sins, I will try to explain the right way to think about the Williams endowment to Jeff and others. More below for those interested.

1) I have covered much of this in the past. Here are several book chapters worth of reading.

2) Unless I state otherwise, everything here is the standard approach. If Morty or Greg Avis ’80 or anyone else in the know were to write something, this is what they would write. Here is a good introduction to financial issues at Williams.

3) Let’s start with a simple example. You want a $50 trophy to be given to the best soccer player at your high school. Easy! Write one check and the trophy will appear. Then you want the trophy to be given every year. Harder. But if you write a check for 40 trophies then, with luck, your wishes will be carried out for several decades.

But what if you want the trophy to be given out ever year forever. That’s hardest. The solution is to set up an endowment:

A financial endowment is a transfer of money or property donated to an institution, usually with the stipulation that it be invested, and the principal remain intact in perpetuity or for a defined time period. This allows for the donation to have an impact over a longer period of time than if it were spent all at once.

The total value of an institution’s investments is referred to as the institution’s endowment.

So, for your soccer trophy, you might donate $1,000 to create an endowment which is dedicated to your annual trophy. If the money is invested in a bank account paying 5% interest, then each year there is $50 available for the trophy. And then $1,000 endowment stays constant.

But don’t forget about inflation! Keeping the endowment at $1,000 will result in cheaper and cheaper trophies as inflation eats away at the purchasing power of $50. So, if you want to spend $50 in real terms each year, then you need the endowment to grow at least at the rate of inflation. If you assume 3% inflation, then you need to find a bank that will pay you 8% interest (or invest in something else that returns 8%).

So far, so obvious.

4) As HWC rightly notes:

Colleges like Williams are supposed to preserve the real spending power of the existing endowment in perpetuity, even if all future gifts ended today. That is the definition of an endowment. Conservatively managed colleges never include future endowment gifts in projecting return and spending levels. Future endowment gifts allow growth. The current endowment return is intended to preserve the status quo forever.

Exactly correct. This is not just me or HWC talking. Morty or Greg Avis ’80 would say exactly the same thing.

Now, you might argue that this is arbitrary. Perhaps you intend to donate more money toward your soccer trophy in future years. Perhaps you have friends you can raise money from. Given that, why not spend $100 or more on a trophy this year.

You can! But that is not the way that smart people manage endowments. You don’t assume that future money will be forthcoming. If it is, great! But, if you call something an “endowment” then you should manage it like one. That means a) ensuring that the spending power of the endowment remains constant and b) spending the excess above that on your trophies or whatever.

5) The tricky part, obviously, is that you do not know the future. In particular, you do not know what the inflation rate will be nor what the returns on your investment will be. So, you need to estimate the long term values for these numbers and spend accordingly.

Williams (and most other colleges) estimate something like 3% for future inflation. That seems reasonable to me. And, moreover, it doesn’t really matter what number you use here since many/most of your investments will go up at least as fast as inflation.

The key issue is estimating the real return. In our simple soccer example with no inflation, that was simple. The bank was paying you 5% and so 5% was the real return. You could keep the value of the endowment constant at $1,000 by spending $50 each year. Even adding inflation was easy because we just (by assumption!) changed the interest rate to 8%. 3% of that went to maintain the real value of the endowment.

6) Jeff writes:

Five percent is not unrealistic. Assuming the real world grows at three percent, Williams’ investments will grow at three percent. But the real world, unlike Williams, doesn’t have a pool of unusually rich (relative to the rest of the country, let alone the rest of the world) benefactors from whom the college can raise 500 million dollars in the period of five years, every 10-20 years. I think two percent growth from alumni giving plus natural three percent growth is hardly unreasonable.

The error here is that the College is assuming nothing about future giving rates. The 5% assumption (sometimes even listed as 6%) is only investment returns, not giving. (And note that the College already devotes annual giving like the Alumni Fund directly toward operating expenses. We spend that money every year as it comes in.)

Why don’t you look at Williams’ historic growth rate over, say, the last 40 years. I don’t know the numbers, but I’d be pretty shocked if it wasn’t, on average, a LOT more than three percent annually

There has been a stunning bull market for 25 years. Only an idiot would extrapolate that forward for the next 50 years. California real estate has a similarly amazing track record from 1960 to 2007. Think the banks were smart to assume that real estate always goes up? You are making the same assumption.

7) So, the disagreement between me and Morty/Avis not about how to think about the endowment or how to handle adjust for inflation. We agree (as does almost everyone associated with the endowments of elite colleges/universities). This disagreement is over what is a reasonable long-term real growth assumption because, by design, that is the amount that you are allowed to spend each year, just like the $50 on the soccer trophy.

And, on this topic, I am the outlier. Morty/Avis and almost all others think that 5% or even more is a reasonable assumption. But they are wrong because, if they (if the hundreds of billions that are collectively held in college endowments) could grow at 5% real — while world GDP growth was 3% — then the US higher education sector would eventually own the whole world.

Since that is impossible, one of the starting assumptions is false.

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