These minutes reflect
discussion and debate at a meeting of a committee of the
Minutes
Senate Committee on Finance and Planning
238A Morrill Hall
Present:
Charles Campbell (chair), Stanley Bonnema, David
Brown, Daniel Feeney, Joseph Konstan, Michael Korth, Yi Li, Cleon Melsa, Richard
Pfutzenreuter, Terry Roe, Rose Samuel, Kate VandenBosch, Susan Van Voorhis,
Warren Warwick, Susan Carlson Weinberg
Absent:
Calvin Alexander, Brittny McCarthy Barnes, David
Chapman, Thomas Klein, Timothy Nantell, Charles Speaks, Thomas Stinson, Alfred
Sullivan, Michael Volna
Guests:
Stuart Mason (Chief Investment Officer)
[In these minutes: (1) endowment investment strategy;
(2) a personnel matter; (3) financial structure of the University]
Professor
Campbell convened the meeting at
1. Endowment Investment Strategy
Professor
Campbell then welcomed Stuart Mason, the University's Chief Investment Officer
for the University endowment.
Mr.
Mason explained that Professor Campbell had asked him to talk about the current
investment strategy for the University's endowment (which has a value of about
$560 million). He handed out copies of a
report he made to the Board of Regents in September on asset allocation
strategy prepared by Cambridge Associates.
There were two goals. One was to
examine the existing portfolio and evaluate the impact of different market
scenarios: How vulnerable is the portfolio? The report indicated the portfolio is quite
vulnerable to market swings since it is weighted to public stocks, which are
more volatile than other investments.
The result was that the value of the endowment increased sharply in the
late 1990s and 00-01 and then declined steeply in the recession.
Professor
Campbell asked Mr. Mason about the relationship between his office and the
The
Foundation is organized about the same way as the management of the endowment
is, Mr. Mason said, and has the same long-term investment objectives: they want long-term growth. Both organizations are in the equities market
rather than bonds because historically the return in the equities market is
9-10% while the bond market typically produces 5-6%. A long-term investment strategy usually
consists of a mixture of stocks and bonds.
The endowment is 75-80% equities and 20-25% bonds.
Cambridge
Associates spent about six months evaluating model portfolios and made
suggestions regarding which asset classes the endowment should be invested in. He has talked with the Board of Regents about
moving to more private investments (real estate, hedge funds) rather than
traditional stocks and bonds. Mr. Mason
drew the attention of Committee members to a graph and table entitled
"Efficient Frontier Analysis," which depicts the optimal balance
between the risk one takes and the investment return one should expect. The endowment wants a return that will allow
it to pay out 5% annually, keep pace with inflation (approximately 2.5%), and
pay operating costs of about 0.5%, so it needs to earn about 8% per year. (It will not earn that amount each year; the
endowment in any given year could be up or down 20%.)
How
much of the decision is based on risk adversity, Ms. Samuel asked? And who makes the decision? Mr. Mason said that his office makes the
decision, in conjunction with the Finance and Operations Committee of the Board
of Regents. He noted data on the table
he had distributed. There are various
categories in which endowment funds might be invested: U.S. equity markets, non-U.S. equity,
alternative investments (hedge funds, venture capital funds, private equity,
real estate investment trusts, oil and gas, timberland), and fixed income
investments. The "efficient
frontier analysis" suggests ranges on the amount of endowment funds that
should be invested in each (e.g., 30-50% should be in
41.2%
21.7 non-U.S.
equities
16.1 alternative
investments
21.0 fixed
income investments
The risk in the stock market is about
15%: it is highly volatile and difficult
to predict. They are trying to reduce
the risk while not giving up too much in return on the investments. If one is invested in the stock market, the
data suggest, one should earn 10-12% annually.
Mr. Mason said he believed the risk could be reduced to 10%, which would
still permit a return of 8.5-10%. The
risk would be much less.
Professor Konstan asked about the
endowment's approach to rebalancing the investments, and how that approach is
modeled in the simulations. Mr. Mason
said they revisit the balance as they examine the investment targets (and the
ranges for each target category). They
take a serious look at rebalancing annually when they reset the ranges and the
target. This annual rebalancing is
reflected in the simulations.
The
idea is to be as close as possible to the efficient frontier, Professor Roe
observed. It is, Mr. Mason agreed; the
efficient frontier provides the maximum return with the minimum risk. The graph had a line plotted showing the
efficient frontier, plotted on points reflecting risk on the X axis and average
annual return on the Y axis; the current endowment is not on the line (it is at
a point on the graph where the risk is higher and the return is lower than
optimal). Could they get closer to the
line if they just sit longer and wait, and not rebalance, Ms. Samuel
asked? To a certain extent that is what
the University did with the endowment before he took his position about 13
months ago, Mr. Mason said, although doing so was not part of a plan. Ultimately, rebalancing regularly is a better
idea. They have conducted retroactive
analyses and concluded that if they had rebalanced in the late 1990s and early
2000s, the endowment would have done better.
Getting the targets right means the endowment will do better over the
long term.
The
average annual risk of the current portfolio is 11.8% and the average annual
return is 7.21%; including inflation, it is geared to produce 10.21%. One proposed portfolio (A1) would produce a
projected annual return of 10.5% and a risk level of 10.79%, which would be a
significant decrease in volatility. A
second proposed portfolio (B1) would produce about 10.5% with a risk level of
9.82%, which is very low risk (bonds typically have a risk of about 6%, stocks
15-18%). Cambridge Associates
recommended that the University consider increased alternative investments and
a little less in bonds and stocks. The
Board of Regents has agreed that the A1 portfolio is the near-term goal and
that the B1 portfolio is the long-term goal, to be achieved by the spring of
2005.
The
biggest changes are in private equity and real estate, Professor Konstan
said. Private universities have a lot of
their endowment money in real estate and private investments; did Cambridge
Associates consider whether the University should go farther in that direction
with the endowment, and perhaps own buildings downtown? The endowments at Yale and Harvard are $15
and $18 billion, Mr. Mason commented, they are heavily invested in real estate
and private equity, and they also invest in hedge funds.
Ms.
Weinberg asked what form the alternative investments would take. Would the University take title to buildings
or invest in limited partnerships? Many
universities take title to buildings, Mr. Mason said; the
Is
the University's relationship with Cambridge Associates short-term or
long-term, Ms. Samuel asked? The
University has had them on a retainer as a consultant for 25 years, Mr. Mason
said, to provide a semi-annual report to the Board of Regents. They hired them for additional time to do the
focused portfolio study and hire them occasionally for other small projects as
well.
How
much bigger does the endowment have to be to be in
direct asset management, Professor Konstan asked? Are the Big Ten endowments large enough to
collectively go into asset management?
The Big Ten is probably large enough, Mr. Mason said.
Does
Cambridge Associates do a contingency analysis, Professor Roe asked? Like what happens to the portfolio if
Professor
Campbell thanked Mr. Mason for his presentation and said the Committee would
like to hear from him again in the future.
Mr. Mason said he would be glad to join the Committee whenever it
wished.
2. A Personnel Matter
Professor
Campbell explained that one Committee member has missed three consecutive
meetings, which by Senate rules means the seat has been vacated. A committee may, however, vote to reinstate
the individual. He has spoken with the
Committee member, who has expressed a wish to remain on the Committee and
indicated he will attend meetings in the future. He asked for a vote of reinstatement; the
Committee so voted.
3. The Financial Structure of the
University
Professor
Campbell next noted a chart containing a depiction of the former and current (Incentives
for Managed Growth--IMG) financial structure of the University: The "conceptual model" identifies
sources of revenue and how they are distributed within the institution. The question, he said, is whether the
structure could be significantly better or worse. There are several groups looking at this
issue and it clearly falls within the charge of this Committee. The other groups include the Twin Cities
Deans' Council, the Academic Health Center Finance and Planning Committee
(chaired by Professor Feeney), and the Budget Advisory Committee (which is
chaired by the Provost and includes Associate Vice President Pfutzenreuter,
finance officers, deans, and two faculty, and the charge to the group includes,
as an option, a comprehensive review of Incentives for Managed Growth).
The
chart was prepared by Mr. Pfutzenreuter and answers questions from the
30,000-foot level about the University's financial model. He suggested that the Committee might discuss
the chart and then decide what the Committee can do. It has several options:
-- become
educated about the model (invite people to discuss it and ask questions), which
serves the University through the Committee's probing and distribution of its
minutes.
-- begin
to do more detailed analyses in order to have a deeper understanding of what is
going on and make recommendations that might dovetail with those from the other
groups that are also looking at these issues.
-- invite
the heads of those other groups to learn what they are doing (i.e., Mr.
Pfutzenreuter and Provost Maziar, Dean Rosenstone, and Professor Feeney).
Professor
Roe said the chart is useful but that the Committee needs more detail to
understand the process. Data by college
might be too detailed, but there should be information that allows one to trace
revenues to that level. Mr.
Pfutzenreuter said such an analysis is prepared every year for the Board of
Regents.
This
chart was produced several years ago to show how dollars flowed before and
after the change to IMG, and especially tuition and ICR funds, Mr.
Pfutzenreuter explained. There is need
to produce another version that incorporates the Institutional Revenue Sharing
(IRS) tax, the Enterprise tax, the University fee, to show where they
flow. He said he could add those
elements and bring the chart to the next meeting. The IRS tax is a lot like tuition money in
the earlier budgeting system: the money
flows into the O&M funds and is then allocated to units, not to one
particular activity, with other green money.
The University Fee is an allocation directly to certain activities and
those funds are not lost site of in a central pool. That is not done with the IRS funds.
In
response to a question about the acronyms, Mr. Pfutzenreuter clarified that IMG
changed the way the University allocates revenue, with tuition now going
directly to the units that generates it, rather than into central coffers and
then reallocated by the administration to the units. Indirect cost recovery funds were also
allocated (in part) to the units that generated them. At the same time, however, there are central
costs that need to be paid so the IRS was imposed. The
Professor
Konstan said he would like to see a regression analysis of tuition and external
research funds to see if there has been any difference in the distribution of
money with the change to the IMG system.
"We don't know what the University's financial model really
is," he said. The model is known,
Mr. Pfutzenreuter said; the outcomes of the decisions are not. They know the outcomes, Professor Konstan
said; if the decision process could be reverse-engineered to figure out what
the actual process had been, the Committee would both know whether IMG has
changed anything and what policies have been implemented by the process. (For example, he conjectured that one might
find out that IMG is shifting funds towards colleges with large enrollments, or
one might find that it is shifting funds away from those colleges.) He said he did not know how productive the
Committee could be on this matter; it depends on its ability to get the data.
Mr.
Pfutzenreuter said they know the base budgets and the decisions that are
made. When the President puts together
the budget, he knows what must be paid in order to get to a net figure. What the University does NOT have is the
compact allocations post-budget. If one
wants the sum of the cuts and post-budget allocations, that information must
come after the budget has been set.
More important, Professor Konstan said, than knowing why a decision was
made is having college statistics (enrollment, research expenditure, etc.),
because there may be an unconscious model in place that affects the flow of
funds--or it may be that IMG has NOT changed anything and that people are
unhappy largely because there simply are fewer funds in the University.
Professor
Campbell said that there is definitely an adjustment in the endgame of the
budget--he has been consulted on the decisions--based on notions of who has
been hurt or helped. The administration
tries to balance out those effects. It
is part of the process and it must be, he said.
But he agreed with Professor Konstan that a regression analysis would be
a very good idea. A lot of the allocations
have been for facilities, technology, and the cost of compensation, Mr.
Pfutzenreuter said. The rest of the
allocations are relatively minor.
Once
the static picture has been obtained, Professor Roe said, the numbers that
Professor Konstan asked for would be needed to see changes over time, major
trends, and how significant the variance is.
Ms.
VanVoorhis asked if the other groups are looking at these same issues;
Professor Campbell said the Budget Advisory Committee is meeting for the first
time this week; he did not know what the other groups are doing.
There
are other questions, Professor Campbell told the Committee. One related one is about subsidies. One perception is that some colleges are
subsidizing others as a result of the way the formulae work out. That depends on what one looks at, Professor
Feeney said, such as the benefits pool, ICR, and so on. The question no one understands is whether
the system is revenue-neutral at the end of the day. Professor Campbell said he was not sure what
"revenue-neutral" means. IMG
was intended to be revenue-neutral when it was first established, so units
would be funded at the same level as they were before, but then IMG would allow
the units to manage their future better and to do more than they could in the
past to control events.
Professor
Feeney agreed. The issue from the
viewpoint of the
Tuition
went to the units but their O&M support was reduced by about the same
amount, Professor Campbell observed.
The
basic mythology about IMG is that if a college did not have a high percentage
of revenue from tuition, it would lose, but at the same time if a college had a
high percentage of its revenue from tuition, it will lose if students go away,
Professor Konstan said. Some units face
low risk and low reward, others have more risk but also potentially more
dollars. So everyone dislikes the
system. The problem is costs on the
margin: It costs less to generate a
dollar in tuition or research than the dollar earned, but everyone knows that
average costs of both teaching and research are more than what they generate in
revenue. So it LOOKS like one can
increase revenue on the margin but then one loses it on the average--and it is
the average which is long term. Units
that manage growth cannot sustain it on the new incentive revenue alone, and
therefore must look to the central administration to allocate some of the IRS
and state funds back to them. Mr.
Pfutzenreuter said that was a fair summary.
With
respect to unhappiness with the financial system, Professor Campbell said, with
substantial cuts from the legislature, EVERYBODY loses, and that complicates
evaluation of the system. And there are
certain things for which it is difficult to see the revenue stream (e.g.,
opening new buildings, increases in utility costs--there is no revenue stream
associated with them and the legislature will NOT fund them), including the
compact pool and academic priorities.
The $100 million provided by the IRS is how those items are paid
for--things that have no revenue stream cause the need for the IRS. That leads to what used to be called
retrenchment and reallocation (R&R)--some programs were started while
others were cut, to support growth in priority areas. He said he did not want to return to the days
of R&R as the way to change programs, with a specific percentage cut followed
by the opportunity to get money back by arguing for a fancy program that got
the attention of the administration.
It
seems that a lot of what is happening, as noted in the Budget Advisory Task
Force report of a couple of years ago, is the underfunding of common goods, Mr.
Fitzgerald said. There are still
institutional costs that must be paid for from somewhere. That problem has never been adequately dealt
with; the University has put band-aids on to address it. There was a lack of interest in reducing
operating budgets to fund common goods, Mr. Pfutzenreuter said, and that idea
was in the original IMG report.
Common
goods are underfunded, and always so when there are cutbacks, but private goods
in the colleges are also underfunded, Professor Konstan said. He said he was not sure whether common goods
would be better funded if the University received a large infusion of
additional funds. The problem is that
the University is cursed to now be in a time of no inflation: If there were higher inflation, to leave a
budget the same would mean a cut. In
this period it takes bolder action--and one does not see presidents and deans
making such actions. Instead the taxes
are increased across the board and units struggle to make do. Mr. Pfutzenreuter said that this year there
were targeted cuts; not everything was formulaic. There will be more such cuts
next year. The units facing those cuts
have already been informed.
Professor
Feeney said he was concerned that all understand the system and that all
participate in the discussion about it so they know how the game is
played. In the AHC, revenue-generating
units are negatively affected by the institutional taxes. Right now, education and research endeavors
are underfunded, but as soon as they try to work out additional support, they
have to pay more in taxes. But research
space, for example, is also the most expensive space the University operates,
Mr. Pfutzenreuter pointed out. The question a unit must get to, Professor
Feeney said, is how much space it needs.
The system must get to the point where it does not tax on revenues but
units also do not use as much space and thus save costs. Taxation means that some units will never get
their heads above water. He sat on the
Budget Advisory Committee last year and learned that there is the
Professor
Roe said there is a similar environment for most colleges. The question is what allocation mechanism to
use so that the opportunity costs are about the same for all of them. The Committee needs symmetric information,
and there will be mistakes, but over time they can be reduced.
Most
University expenses are space and staff, Professor Konstan said. In his view, the taxes on expenses or on
revenues are both wrong. In bad times,
units will cut expenses and retain revenues (if there is a tax on expenses), and
then will see taxes go up to cover for the reduction in revenues because units
are keeping expenses down. They will
similarly be discouraged from certain lightly revenue-raising opportunities if
the taxes are based primarily on revenue.
One could do a balance between the two.
What the Committee does not know is how effective central allocations
are in making up for the problems. Most
feel it is not doing well but that is probably because everyone has been cut.
If one could do an analysis of
representative years before and after IMG, Professor Konstan continued, one
could see if the trends are going in different directions or if perverse
incentives are leading to perverse behavior.
The Committee should probably look from the present to the future rather
than to the past, Professor Campbell commented.
One question about IMG is this, Professor Konstan said: In the old system, did increased enrollments
mean more dollars to a unit? Did research? The answer to that question needs to be
brought to light. And if different
opportunity costs were exacerbated or moved in the right direction, Professor
Roe added.
Space is the problem, Mr. Pfutzenreuter
said. It was in the RCM original plan,
Professor Konstan pointed out. One
cannot know what IMG is doing without space costs, Mr. Pfutzenreuter
maintained. And one must attribute higher
costs to research space, Ms. Weinberg added.
That is a complicated problem, Professor Roe agreed, but it must not be
allowed to derail the process.
Professor Campbell said it would be
useful for the Committee to have more information; what it can get will
determine in part what it does next. He
invited Committee members to send him emails with more thoughts and suggestions;
he would work with Fitz to move the process along and try to determine if the
Committee could do more than just learn.
An open dialogue will help, Professor
Feeney said, and it could help the administration solve the problems it
faces. He said that the deans have a
budget problem and have different revenue streams; no matter how one pushes the
levers, there will be differential effects on units. It would help to talk about the problems and
it may be that there will be a better solution if the model is refined. It may be that space is a key. All want more of it, and want it better
equipped; maybe units need to decide how much they really need. The situation will not get better; tuition
increases are raising the costs so they are getting to be not too far from
non-state institutions and the University could be at risk in enrollments. He said he was concerned that if the University
increases tuition, enrollment may actually drop. That will not happen yet, Professor Campbell
said, but demographics are not in the University's favor; units living on
tuition income could be at risk. Instead
of living off tuition gains, they may have to live off efficiency gains,
Professor Roe commented.
Professor Campbell adjourned the
meeting at
Gary
Engstrand