The news that the value of the Harvard endowment declined by 5.1 percent in fiscal year 2016, ended last June 30, refocused attention on how the Corporation determines what funds will be distributed to the University its schools. That determination is critical because the annual distribution now makes up 35 percent of University operating revenues—and more than half the operating revenues of the Radcliffe Institute, the Divinity School, and the Faculty of Arts and Sciences (FAS).

A primer on how the distribution is determined appears here. It begins with a brief look at the choices the Corporation faces, followed by a summary of the policy it has chosen, and an example in practice.

### The Strategic Choice

The Corporation, like *any* fiduciary overseeing an endowment or other financial assets meant both to exist in perpetuity and to fund current operations of an underlying institution, is caught between two poles:

- protecting the value of those assets for the long term; and
- enabling the operating institution to budget and manage its work on a shorter time horizon.

A simple rule for *protecting the assets* might be, for example, to declare that each fiscal year, 5 percent of the value of the assets (as of a set prior valuation date, or projected future valuation) may be distributed. Such a fixed rule would be very responsive to fluctuating market values. The distribution would soar when investment markets zoomed higher, making financial officers’ lives easy (think of that 32.2 percent annual return on Harvard’s endowment investments in fiscal 2000, or the 23 percent return in fiscal 2007). But it could lead to retrenchments—possibly severe ones, including emergency layoffs and other unwanted disruptions—in the adverse years that follow bountiful ones, or in case of catastrophic losses (following the boom years just cited, the negative 2.7 percent return in fiscal 2001, or the negative 27.3 percent return in fiscal 2009).

The rule has an automatic effect, importantly protecting the endowment’s potential value (and future recovery of value) after adverse investment results. It is easy to see how grant-making foundations could operate this way, but more difficult to imagine it being the best strategy for an *operating* entity—like a university, with fixed building expenses and lots of people on the payroll—that depends significantly on endowment funding.

A simple rule for *predictable budgeting* might be, for example, to declare that the endowment distribution would increase by some percentage each year: a fixed percentage, or some proxy for inflation (in universities’ case, the Higher Education Price Index, or HEPI, is the usual proxy). The idea is to establish a path for near-term and multiyear budgeting and the associated financial planning, while accommodating some inflation factor to maintain the real purchasing power associated with the funds disbursed. To guard against excessive effects on the value of the underlying financial assets, it would be typical to delimit the acceptable distribution within any single year to some payout band: a proportion of the endowment’s market value, perhaps 4 percent to 6.25 percent, meant to guard against excessive hoarding if market returns are very strong over a sustained period, or the risk of depleting the principal if the opposite occurs. (Princeton, which has the highest endowment per student enrolled, follows this sort of rule.)

Note that the critical issue, from a fiduciary body’s perspective, is the *value* of the endowment over time, balanced against operating needs, *not* the rate of investment return on invested assets in any given year.

### The Corporation’s Modus Operandi

Facing volatile financial markets, the need to preserve long-term purchasing power, and operating requirements for spendable revenue, the decisionmakers—in Harvard’s case, the Corporation—typically seek a balancing formula: weighting budgetary-continuity (some continuity with the current and recent distributions) and market-value considerations in some way. Quoting from the endowment footnote in the University’s most recent annual financial report, Harvard’s general approach is as follows:

The University’s endowment distribution policies are designed to preserve the value of the endowment in real terms (after inflation) and generate a predictable stream of available income. Each fall, the Corporation approves the endowment distribution for the following fiscal year. The endowment distribution is based on presumptive guidance from a formula that is intended to provide budgetary stability by smoothing the impact of annual investment gains and losses. The formula’s inputs reflect expectations about long-term returns and inflation rates.

In practice, Harvard assigns a *70 percent weighting* to the prior fiscal year’s distribution, and a *30 percent weighting* to the current/projected market value of the endowment. In any given year, that formula serves to buffer operations from extreme swings in endowment value. Over a several-year period, if investment returns have a very strong tendency (up or down), that effect is smoothed out, too, in successive iterations of the distribution-weighted part of the formula.

Peers using similar formulas appear to employ weightings ranging from 80 percent/20 percent to 60 percent/40 percent.

### Applying the Formula: A Simplified Example

First, a caveat: from the Corporation’s perspective, what matters is the distribution per equivalent share of the endowment each year. But of course multiple factors affect the endowment’s value: the rate of investment return; the funds distributed for operations; additional funds distributed for one-time purposes (so called-decapitalizations); funds temporarily returned for investment alongside endowment assets (*re*capitalizations); and gifts received. Although the total varies from year to year, of late, decapitalizations have averaged $200 million or so. And during The Harvard Campaign, gifts for endowment—to support financial aid, professorships, and so on—have risen to even larger sums annually.

This example puts those incidental monies aside, and focuses on a simplified unit of the endowment. It further simplifies the arithmetic by assuming a level-dollar distribution each year (here, $5 on a $100 unit of the endowment), rather than adjusting for the *exact* outcome from the prior periods.

In the fall of each year, the Corporation sets the annual distribution from the endowment for the *following* fiscal year. Thus, when Harvard Management Company (HMC) reported results for the fiscal year ended *June 30, 2016*, in September, *fiscal 2017* was already well under way; using those data, the Corporation determined the distribution for *fiscal 2018*, which runs from July 1, 2017, through the following June 30.

*In a year of investment returns greater than the distribution:*

At the start, a unit of the endowment is worth $100. The distribution during the year is 5 percent ($5), and HMC reports an investment return of 10 percent, yielding a market value of $104.50 ($100 minus $5 equals $95; the 10 percent investment return results in a value of 1.1 times $95 equals $104.50).

Step 1.Distribution: Current period sum ($5.00), adjusted for assumed HEPI inflation of 3 percent ($5.00 times 1.03) equals $5.15; that sum is then weighted at 70 percent (times 0.70), yielding a sum of $3.61.Step 2.Market value: Project the starting market value of $104.50 forward one year, using the long-term return assumption of 8 percent and accounting for the current period distribution ($104.50 minus $5.00 equals $99.50) times 1.08 yields a value of $107.46. Multiply that projected market value by the targeted distribution rate (5 percent or 0.05) equals $5.37; that sum is then weighted at 30 percent (times 0.30), yielding a sum of $1.61.Step 3.Combine the two sums ($3.61 plus $1.61), yielding a result of $5.22.Step 4. Divide the result by the prior distribution ($5.22 divided by $5.00), yielding a 4 percent increase in the dollars distributed to the schools, per unit of endowment, in the next fiscal year.In this happy example, since the endowment value rose 5 percent after the operating distribution, driven by the 10 percent investment return on assets, the operating budgets’ flow of funds from that source would go up 4 percent: a smoothed result that provides some protection against less favorable returns in the future.

Conversely, in *a year of weak or negative investment returns, when the value of the endowment declines*, the arithmetic works out this way:

At the start, a unit of the endowment is worth $100. The distribution during the year is 5 percent ($5), and HMC reports an investment return of negative 5 percent, yielding a market value of $90.25 ($100 minus $5 equals $95; the negative 5 percent investment return results in a value of 0.95 times $95 equals $90.25).

Step 1.Distribution: Prior period sum ($5.00), adjusted for assumed HEPI inflation of 3 percent ($5.00 times 1.03) equals $5.15; that sum is then weighted at 70 percent (times 0.70), yielding a sum of $3.61.Step 2. Market value: Project the starting market value of $90.25 forward one year, using the long-term return assumption of 8 percent and accounting for the current period distribution ($90.25 minus $5.00 equals $85.25) times 1.08 yields a value of $92.07. Multiply that projected market value by the targeted distribution rate (5 percent or 0.05) equals $4.60; that sum is then weighted at 30 percent (times 0.30), yielding a sum of $1.38.Step 3. Combine the two sums ($3.61 plus $1.38), yielding a result of $4.99.Step 4. Divide the result by the prior distribution ($4.99 divided by $5.00), yielding a 0 percent change in the dollars distributed to the schools, per unit of endowment, in the next fiscal year.In this less happy example, since the endowment value fell 10 percent after the operating distribution, driven equally by the negative investment return on assets and the result of sending funds to the schools, the operating budgets’ flow of funds from that source would fail to increase in the next period: a smoothed result that provides some near-term budgetary protection against the current unfavorable returns.

Note that even that buffered result could feel very painful for deans if it followed a year in which the endowment distribution had risen, because the percentage-point change in the funds they receive for each endowment unit would loom large.

In fact, that is the situation Harvard’s schools now face: after the dollars distributed per unit increased 6 percent in fiscal 2016, they are budgeted to increase 4 percent in the current year—and then, perhaps, reflecting the negative investment return and decline in endowment value recorded in fiscal 2016, just reported—to be held level in fiscal 2018, beginning next July 1. For operating units like Radcliffe, the Divinity School, and FAS—which relied on endowment distributions for 89 percent, 70 percent, and 51 percent of operating revenues, respectively, in fiscal 2015 (the latest report), to pay for salaries and benefits, facilities, and (excepting Radcliffe) financial aid—the trajectory is unsettling at best.