Senate Scrutiny for Endowments

In the world of tax legislation, hedge funds are the hot topic. The same could be said for the world of university endowment portfolios. Both were scrutinized in a hearing on Wednesday as the Senate Committee on Finance set its sights on the insurance and reinsurance industries, offshore tax havens and, of course, the high-yield but potentially volatile financial products.

Hedge funds have been controversial, in part, because of the low tax rates reserved for their managers, but they've netted some impressive gains -- as well as recent losses -- for investors, prominent among them university endowments. Stagnating state and federal support for higher education and the ever-increasing price tag have only intensified calls for closer scrutiny of endowments, and specifically, questions about why universities don't withdraw more from their holdings to boost their financial aid offerings or even, in some cases, cover tuition entirely.

And so, while most of the participants' energy focused on tax havens in Bermuda and deferring taxes for insurers, they squeezed in some discussion of colleges' and universities' investments in considering policies that could potentially regulate their foreign holdings, tax endowments or even require a certain payout level each year to direct returns toward real operating or financial aid costs.

The hearing, called "Offshore Tax Issues: Reinsurance and Hedge Funds," explored ways to recoup lost tax revenue and close what members of the committee believe to be loopholes in the code. True to the spirit of its title, the pair of panels had a total of seven members, only two of whom spoke about university endowments. Both expressed concern about the typical level of payouts compared with above-average returns in recent years, and some education groups worried that their emphasis signaled the direction of the committee in drafting an expected higher education tax bill in the latter half of next month.

An aide to the office of the ranking Republican, Sen. Charles Grassley of Iowa, said in an interview late Wednesday that whatever legislation the committee drafts next month will not tackle university endowments, but that the issues related to them could be considered at a later date.

With taxes on their minds, senators at the morning session questioned panelists about the practice of investing in hedge funds through "blockers," offshore corporations set up by universities and other nonprofit organizations, to avoid paying "unrelated business income tax" on the revenue they receive from such funds. Known as UBIT, the tax was originally intended to keep both for-profit and nonprofit investors in such managed funds on the same playing field, but a House bill now making the rounds, H.R. 3501, would have the effect of allowing universities and other entities to forgo the complex legal maneuvers and invest -- legally and sans tax -- in hedge funds at home.

But the issue that garnered the most attention, both from senators and critics in the higher education establishment, was the question of how much universities should dip into their endowments each year to offset rising tuition costs.

"Senators, what would your constituents say if gasoline cost $9.15 a gallon? Or if the price of milk was over $15? That is how much those items would cost if their price had gone up at the same rate that tuition has since 1980," said Lynne Munson, an adjunct fellow at the Center for College Affordability and Productivity, which supports increased transparency at universities.

Munson argued in her testimony that the public is not benefiting enough from "massive" higher education endowments, noting returns that averaged in the double digits (referencing data from the National Association of College and University Business Officers), but "miserly" payouts, averaging 4.2 percent. She outlined the concentration of wealth in a minority of top colleges -- both public and private -- with 62 institutions boasting endowments of over $1 billion, up from 39 in 2004.

But private foundations -- which tend to have smaller endowments -- still pay out more, she said, averaging 7 percent in 2005, 2 percent above the legal requirement.

Munson's solution is twofold: to mandate that colleges make available statistics about their endowments and, if that does not produce results, to mandate a minimum payout, similar to that currently required of nonprofit organizations. "Possibly the most significant challenge for policy makers will be to make sure that any newly directed monies actually go toward aid or tuition reduction and don't become part of a shell game," she concluded.

But while Munson focused on the far end of the spectrum, higher education groups stress that the vast majority of endowments are not nearly as large. "It’s not just about Harvard, Princeton, Stanford and Yale. There are a lot of institutions, some of them not as well known, that have endowments that could be caught up in some sort of federal legislation," said Terry W. Hartle, the senior vice president for government and public affairs at the American Council on Education. "I am not sure it’s in anyone’s interest for the federal government to tell Holy Cross, Yeshiva and Texas Christian University how to spend their money."

The crux of the argument by those lobbying the Finance Committee -- such as the Ad Hoc Tax Group, which represents some members of the Association of American Universities -- is that colleges can't necessarily project how much of their endowments they will spend in any given year. That depends on economic conditions, the size of the return, stipulations placed on donations and any number of other factors.

"Endowments are very complex, they are technical and they are essential to the financial stability of the institutions," Hartle said. "The payout rate is a fairly complicated question because an endowment is not a single account at institutions; it’s usually a combination of hundreds of specific accounts, many of which are restricted for specific purposes."

Most important, perhaps, is the idea that endowments must essentially exist forever -- that many donors expect their gifts to benefit the university indefinitely. And with the ever-changing tides of the markets, fund managers may lean toward investing in assets with strong growth potential and allowing compound interest to work its magic rather than worrying about precise payout amounts that could in some cases negatively affect the institution's future assets.

"[I]f you talk about payouts, most university endowments ... already as a matter of policy have a target payout rate of between [4.75] percent and 5 percent.... But these are targeted payout rates that are based on the returns, and what concerns us about a mandatory payout is, of course we have been in a period of ... tremendous growth in returns on equity investments. But most of these funds we have to manage in perpetuity," said A. Scott Sudduth, assistant vice president for federal governmental relations for the University of California and co-chairman of the Ad Hoc Tax Group.

Instead of placing an additional legal burden on endowments, Sudduth suggested applying tax incentives for donors "to give the money for student financial assistance [instead of] libraries or athletics."

But even the tax status of endowment earnings wasn't entirely off the table. Sen. Jim Bunning (R-Ky.) asked explicitly why, given high compounded growth over two decades, "are we allowing our endowments to remain tax-free?"

The other panelist who spoke on the issue, Jane G. Gravelle, a senior specialist in economic policy at the Congressional Research Service, noted that educational endowments totaled at least $340 billion last year, with an overall return of 15.3 percent, or $52 billion -- "earnings that are generally tax-exempt."

Assuming that taxes aren't immediately going to be levied against Harvard, Princeton, Stanford and Yale, however, Gravelle did offer another policy option: restricting investment in offshore funds, which, in the case of hedge funds, would lead to more revenue from the UBIT (presuming H.R. 3501 did not make it out of committee).

Even if the proposed solutions on endowments don't make it into legislation this session, as the Grassley aide said in the interview that they would not, the tilt of the committee's Democratic and Republican members was clear, both from their questions and the concerns of their chosen panelists ("They basically heard from a Congressional employee and from an op-ed columnist," as Hartle put it).

"The taxpayers subsidize university endowments in two ways. One, the taxpayer’s donation to the endowment is tax deductible. Two, the endowment itself isn’t taxed. So big tax breaks make the big endowments possible, and taxpayers at large pay for those tax breaks," Grassley said in a statement. "Since tax breaks for charitable donations are supposed to contribute to the public good, it’s fair to ask whether the tax breaks that lead to big university endowments are serving the public. That’s especially true when low- and middle-income working families are struggling to pay college tuition.”