Sunday, December 6, 2015

endowments, public commitment, and coordination

I somewhat avoid the news here, but the news hook here is pretty tangential; Mark Zuckerberg recently announced that he's giving away most of his fortune to an LLC, not a tax-deductible organization.  One of the reasons for that is the 5% rule; most tax-deductible organizations, as part of the terms of their tax classification, have to spend at least 5% of their endowments every year on expenses that are fairly directly relevant to their official charitable purpose.  I don't know whether non-profit universities are typically incorporated differently or are given an explicit exemption, but they are generally exempt; there has been some talk, at the periphery of American political discussion, of removing the exemption.  In all cases, the idea is that an organization that gets some kind of special exemption from tax laws shouldn't be allowed to simply stockpile and invest an ever increasing endowment without substantial ongoing evidence that it is serving a socially beneficial purpose.

Why do universities (and other organizations) build up endowments in the first place?  Imagine two universities, Typical University which establishes an endowment early in its existence and uses some of it over time, in addition to ongoing donations, tuition, etc., to pay for programming, and Paygo University, which happens to receive in donations each year an amount equal to what TU receives in donations plus what TU withdraws from its endowment; each then funds the same programming.  Presumably they do the same social good; the endowment that TU has at any given time is the present value of the amount of donations TU received in excess of those PU received in the past, where the discount rate is the rate-of-return on the endowment.  If TU is simply letting its endowment pile up, then it has received more in donations, while doing less good, but presumably, one hopes, has enhanced its ability to do good in the future; if TU is pulling substantial funds out of its endowment to fund programs, then there is some sense in which it has not so much taken in more donations than PU, but took them in sooner, perhaps largely taking them in at its foundation while taking in less than PU ever since.

The obvious (at least to me) reason to build up a foundation is to smooth variations in both fund-raising and expenditure; often new buildings are accompanied by special fund-raising campaigns, but there will be times (e.g. capital expenditures) when cash-flow expenses are lumpy and times (recessions, or simply random fluctuation) when contributions are lower than usual, and it makes some sense to have an endowment to smooth that out.  Even ignoring the special capital-spending campaigns (and naming rights that are often a part of that), though, this isn't nearly enough to explain the endowments at most large universities.  If they are smoothing over time and saving for precautionary reasons, they are smoothing over generations and protecting themselves from cataclysms.

It may well be that (especially large) endowments are better at investing money than the donors are, in which case it might make sense to accumulate a large endowment for that reason — the donors can be encouraged to give sooner than they would naturally, perhaps discounting at a lower private discount rate than the university's discount rate — and I neglect that possibility, except for this sentence, not because I think it's unlikely to be important but because I don't think it's as interesting as my other idea.  The other idea, though, is that smoothing over generations and cataclysms avoids coordination failures in which the various participants in a university community — donors, students, professors, and quite possibly others — worry that the university could run into trouble in several years, and thereby avoid it, initially to a small degree, but then, as the prophesy begins to fulfill itself, to an ever greater degree.  A large endowment forestalls that possibility in some ways and serves as a coordination device in others; the number itself makes the university look not just sturdy but reputable.  I wonder, in fact, whether university endowments might be an example of the "overhoarding of liquidity" that Tirole has mentioned as a theoretical possibility that is probably of little practical importance in the settings in which we think of it in those terms.

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