Dean Outlines FAS’s Financial Straits

Dean Michael D. Smith outlined for the Faculty of Arts and Sciences the severe challenges—as much as a $200-million shortfall in revenue—looming in the next year as the endowment declines in value.

A standing-room-only crowd of professors filled the Faculty of Arts and Sciences (FAS) meeting on November 18, attracted by the sole, starkly worded item on the docketed agenda: "Dean M. Smith will lead a discussion of the impact of the worldwide economic downturn" on the faculty. The dean, Michael D. Smith, a computer scientist, methodically led his colleagues through the arithmetic of "unprecedented losses" in the endowment and a prospective "period of greater financial constraint," as first described by President Drew Faust in her November 10 message to the community. As further detailed in a report on Smith's own message of the same day, in the fiscal year ended last June 30, FAS's endowment funds were valued at $15.7 billion (of Harvard's $36.9 billion total), and income distributions from those assets accounted for nearly 52 percent of FAS's revenue in that year (34.5 percent for the University as a whole).

That reliance on endowment financing has since grown substantially. In the current fiscal year, Smith indicated, income distributions from the endowment account for about $650 million in FAS revenues, nearly 60 percent of the budget. And preliminary planning for fiscal year 2010, beginning next July 1, had assumed a further $100-million increase in endowment-income distributions to FAS, for a total of $750 million.

Instead, Smith said, FAS found itself facing a much more adverse environment. He cited rule-of-thumb estimates from financial rating services, and endowment results recently reported by other institutions, to indicate that "unprecedented losses" suggested a decline in value of 30 percent, and he adopted that as an illustrative guideline for FAS's future planning. If a decline of that magnitude actually occurred, FAS's endowment would then be worth $11 billion, a $5-billion reduction. If the Corporation were then to hew to its long-term distribution goal of approximately 5 percent of value annually (see explanation), FAS would receive $550 million in endowment-income distributions for fiscal year 2010—fully $200 million less than it planned, and $100 million less than it is actually using in the current year. Moreover, Smith said, even if FAS were to receive the full $750 million it was anticipating, its core budget (the College, the Graduate School of Arts and Sciences, and the faculty members themselves) would have run a $20-million deficit next year, without factoring in any new programs or enhancements.

(Several unknowns surround this $200-million figure. Given the extremely volatile financial markets, the exact value of the endowment is not now known—or at least not disclosed; Harvard Management Company reports its results at the end of each fiscal year—and market conditions may improve. FAS has not yet disclosed its actual fiscal year 2008 results nor its current and planned budgets, so the relative magnitude of the prospective shortfall cannot be calculated externally. And, crucially, it is up to the Corporation to determine exactly what endowment distributions and budgets it will authorize; that decision is usually made around Thanksgiving, but the indications are that this year, it is deferring the decision pending information from the schools and the central administration about what savings they might effect, and about the ultimate likely value of the endowment. Faust, who normally presides at faculty meetings, perhaps offering a Corporation perspective, was absent from this one, because she had to attend National Book Award events; her most recent scholarly work is a finalist.)

Smith put the current situation in some perspective. From 1971 through 2008, he noted, the endowment had declined in value only during four years: 1974, when investment returns were a negative 12 percent, and slightly negative returns (as he called them, "hiccups") in 1984, 2001, and 2002. In the current circumstances, he said, it was prudent for FAS to plan for those truly "unprecedented losses" by setting priorities; if the losses turned out to be less severe, items identified for elimination or reduction could be restored.

FAS has begun working to control administrative costs, Smith said. President Faust had directed all schools to cut their budgeted spending for this fiscal year by a percentage point (about $10 million for FAS, he said), with the year already nearly half over. His goal was to eliminate costs, not to defer them to the future; accordingly, all open positions were being scrutinized, with strong indications that they would not be filled. But such savings paled compared to a prospective $200-million shortfall in FAS's revenues next year.

So, Smith said, the faculty had to help prioritize programs, "not something we typically do," particularly because "everything we do on campus has merit." This could not be a top-down exercise, he said. Rather, the faculty members themselves would have to lead it. He urged them to categorize everything they did in three buckets: a very few highest priorities in which further investment had to continue; a slightly larger bucket of core activities, where the aim would be to minimize cost-cutting; and everything else, where the cost-reduction would have to focus.

In addition, he said, planning would have to continue for a capital campaign, more urgently than ever. With all that, the faculty would have to proceed as "business continues"—educating students, conducting research, meeting deadlines—but with an admonition he bluntly described as the new common mission: "save cash."

In the ensuing concerned but businesslike discussion, Smith was asked whether he had become more pessimistic about the situation in recent days. He said no, but that he was "continuing to understand how hard it is going to be to make these changes." He was asked to explain sources of growth in FAS's budget during the past several years; Smith responded that faculty expansion, new buildings, and new programs were the driving factors—but he urged that faculty members focus on FAS's present situation and prospects in identifying cost-cutting priorities, rather than returning to past circumstances. He was urged to protect library acquisition funds, and to reassure junior faculty members (those on the tenure track, he said, would remain so, as scheduled). Would faculty searches now under way be stopped? No, he said; but if the pool of applicants seemed unpromising, or if the position no longer seemed absolutely essential, he urged departments to reconsider pursuing the search.

Several questions focused on Harvard's planning for and construction in Allston, and Smith repeatedly said of spending there (as elsewhere), "everything is on the table." One interest concerned the annual half-percent administrative assessment on all endowments, the so-called "strategic infrastructure fund," that reimburses central administrative spending on Allston (see explanation); in fiscal year 2008, that totaled $168 million, with FAS contributing the largest single share. A questioner noted that the assessment had been levied when the endowment was appreciating, earlier in the decade, and that circumstances had clearly changed. (If the Corporation were to decide to scale back Allston work, and to temporarily reduce or suspend the assessment, that would have the effect of boosting FAS's endowment by several tens of millions of dollars annually; that would not necessarily augment spendable funds by the same amount.) Another question focused on deferring duplicate facilities, such as an engineering clean room in Cambridge and a planned one in Allston; Smith said the administration and the council of deans were addressing such projects and overlapping investments case by case.

One faculty member asked whether even in diminished circumstances, Harvard might not use its relative strength to invest in new hiring and programs, when the costs of such actions had declined. Smith said he, too, aimed for FAS to emerge stronger than it is now, but that it had to be able to sustain its activities. With the endowment likely diminished, other sources of revenue (higher tuition; a larger enrollment; sponsored-research grants; current-use giving) were unlikely, in the near term, to pick up the slack. (And in fact, he might have added, financial-aid costs will likely grow, perhaps sharply.) So the funds for investments in programs and people, if any, would have to come from savings. "We can't move forward with an expense structure that is completely out of line with our income structure," Smith said. In fact, he added, some newly endowed funds, from recent gifts, were actually now "under water"—worth less than the initial gift amount—and so could not be used for any spending at all.

In an environment where all of the faculty's activities are on the table for review, Smith stressed, the worst possible solution was an across-the-board, percentage-based reduction in costs: a formula for doing everything the faculty now does, but less well. With the faculty's close involvement, he said, a better solution was possible, but, "It has to come from you."

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