Photographer: Michael Fein/Bloomberg
Photographer: Michael Fein/Bloomberg

It's the time of year when top-tier universities update us on the state of their endowments, and it hasn't taken long for misinformed commentary to emerge. Jordan Weissmann writes at the Atlantic that universities have too much money and should be forced to spend down their savings. This is a bad idea that would defeat the entire purpose of having an endowment and undermine the staying power of our best educational institutions.

Endowments at nonprofits aren't rainy day funds or cash piles, but another source of revenue. Universities bring in money by charging tuition to students, getting grants from the government, licensing patents to private companies and donations. All of this covers about 60 percent to 70 percent of their budgets, however. The rest comes from their endowments. Schools such as Harvard, Yale and Stanford use this revenue to reduce the burden on students and provide better resources for their scholars. They could temporarily increase their spending or cut tuition by eating into the principal of their endowments, as Weissmann wants, but this would come at the cost of future students and scholars. (Schools with smaller endowments are much less generous with financial aid and research grants to begin with.)

The basic idea of a nonprofit endowment is that you start with a certain amount of money, invest it in a mixture of assets that generate positive returns, reinvest some of that income and consume the rest to cover your daily operations. This creates tradeoffs for endowment managers and university administrators. Consume as much as possible out of current income, or reinvest to increase future earnings? Fund a large share of your budget through the endowment, or insulate yourself from market swings? Pursue a cautious investment strategy that minimizes the risk of large losses, or try to grow as much possible during bull markets with leverage?

Most schools are relatively conservative with their spending commitments (between 4 percent and 5 percent of a rolling average of endowment assets) and aggressive with their investment strategies. They also use endowment earnings to fund large proportions of their total budgets. Once you net out financial aid, the fees paid by Yale's students cover less than a tenth of the university's budget, while the endowment brings in about four times as much. (Just for disclosure purposes, I'm a Yale alumnus.) That's great for students, but it creates challenges when the endowment loses money. Harvard is a case study of what can go wrong with this strategy.

It's reasonable to expect old schools with wealthy alumni to cover as much of their expenses as possible with endowment earnings rather than government subsidies and tuition fees. But that only works if endowment portfolios are conservatively managed and university budgets are small relative to the size of the endowment. Significantly higher levels of endowment spending might feel good for a few years but it would come at the expense of universities' long-term ability to provide quality education to a broad swath of students.

(Matthew C. Klein is a writer for Bloomberg View. Follow him on Twitter.)