The Economics of Endowed Chairs

Over the many years of my career, I have served on several committees that had to deal with donations for allegedly endowed chairs in the university. The economic illiteracy of those who are on these committees is disturbing.

Here is the situation, as I see it:

If the university wants a fully endowed chair and wants to attract a noted scholar to fill the chair on an ongoing basis, they need to receive a donation that will generate an annual income of between $100,000 and $200,000, depending on the supply and demand conditions of the discipline. To keep the numbers easy, suppose the university can attract a noted scholar and provide some minor research funds for only $100,000 (impossible in business, engineering, or economics, but perhaps within reach in some other fields). 

If this chair is to be fully endowed, in perpetuity, then allowances must be made for expected future inflation. It is extremely unlikely that $100,000 would attract anyone, even in sociology from York University, in 2050. Hence, the endowment must draw no more than 2% (maybe no more than 2.5%) per year from the initial donation, and must reinvest whatever is left over to allow the fund to grow in anticipation of future inflation. In economics jargon, the chair should depend only on the real interest rate, not the nominal interest rate.

Furthermore, if the funding is provided initally during a period when interest rates appear to be less than the expected rate of inflation, as seems to be the case these days, even more will be required if the chair is to be fully endowed.

With these conditions, in mind, fully endowing a chair would require at a minimum $5 million, for the most modest of chairs. Anything less will mean that the chair will be dependent on the university for partial funding and/or that the holder of the chair will be expected to do additional fund-raising.

And yet I have seen several examples of endowed chairs that simply do not seem to understand these simple economics. One chair was funded with a grant of $500,000, to be matched by the university itself; what's worse, the donor was promising only $50,000 a year for ten years. So (over my objections) the department concerned hired someone, spent the money, and then became dependent on the university to fund the position thereafter. One might think this is a shrewd strategy to follow, but of course the department then was forced to cut a position elsewhere once the funding for the chair was exhausted. That's not an endowment; that's temporary funding.

In the most recent example, outside funding of $2million has tentatively been offered to fund a chair at Huron College (see this and this). At today's interest rates, that amount would fund no more than $20,000 - $40,000 of the money required for the chair. The remaining amount would have to come from the college's general funds.

I guess it is possible to partially endow a chair (as seems typical: see this). Just donate a chunk of money, specify a name, and specify the discipline and sub-discipline. But that is a partial endowment, leaving the university on the hook for the rest of the funds. 

Update: Eva points out in private correspondence that with benefits and other costs, she thinks there is no way to fully fund a chair for less than $200,000, and probably more like $250,000 per year. She is likely correct, and if so, with a real rate of interest at 2% - 2.5%, then fully endowing a chair would require $10m, not $5m, and certainly much more than $2m.

Comments

[KipEsquire]

And yet this is one of the simplest formulas in all of finance: The Gordon Growth Model.

Sad.

[Bla]

Who educates the educators?

[EclectEcon]

Kip: I also had in mind the Fisher Equation about nominal vs. real interest rates [for those unfamiliar with it, the nominal or stated rate of interest is equal (roughly) to the real rate of interest plus the expected rate of inflation]. This equation should help explain why, in times of higher inflation rates, managers of endowments should count on endowment income of only 3% or so and then reinvest the rest of any year's income to provide for future, expected inflation.
Bla: Economists' work is never done. As Kip says, "Sad".

[Tyler]

Any clown with a basic calculator and a internet connection can figure this one out. A conservative inflation adjustment would be something like 2.25%. Canada 7-years are currently at about 4.25%. I don't think the international Fisher relation needs to be taught to convey the concept.
N = Perpetual
FV = $0
PMT = $100,000
INT = (4.25%-2.25%)

CPT PV = $100,000/0.02 = $5,000,000

[Larsen E Whipsnade]

Interesting blog, but it doesn't say, anywhere, who the host author is. Any idea, anyone?