In our paper, Economic Budgeting for Endowment-Dependent Universities, we develop a framework to analyze a university’s financial position using an intertemporal budgeting approach. The essence of our approach is to forecast university operating revenues and costs over the infinite future, to calculate the present value of those operating obligations, and then to compare the value of the obligations to the value of the university’s wealth.

It is useful to understand our approach in contrast to the traditional approach to university budgeting, which typically focuses on one or two years at a time and uses generally accepted accounting principles (GAAP). For example, the Harvard Faculty of Arts and Sciences (FAS) adds together several sources of “operating revenue,” (such as tuition fees and federal sponsored programs) then subtracts various items that are deemed “operating expenses,” (such as salaries and benefits) to arrive at a net GAAP budget surplus or deficit. According to this measure, Harvard FAS consistently generates enough revenue to cover its expenses each year.

However, the GAAP surplus/deficit is misleading from the perspective of an economist interested in the university’s intertemporal budget constraint, because it mixes financial flows with the real-side revenues and expenses that reflect the physical economics of the university. For example, distributions from the endowment and proceeds from new debt issuance are both treated as forms of revenue. However, these sources of revenue simply transfer a pool of fixed resources from the future to the present — higher endowment spending today leads to lower endowment spending in the future, and debt issuance today requires debt repayment in the future. There is no distinction in the budget between these sources of revenue and other sources which improve the university’s long-run financial position, such as increased tuition income.

In contrast to the conventional budgeting method, our intertemporal approach fully separates real and financial flows. The real operating economics of the university are captured in the present value of the net expenditures, which have nothing to do with debt issuance, interest expense, or endowment payouts. And financial resources are fully captured by the current value of the endowment in excess of debt obligations. The difference between the present value of operating obligations and wealth is the structural deficit of the university.

This framing makes it clear that the size of the endowment must be compared with the sequence of obligations that the endowment is expected to support. It removes the temptation to think that financial engineering of various sorts can solve fundamental economic problems, and instead focuses attention on the real-side decisions that university leadership must make—decisions about revenue generation (e.g., policies regarding tuition-setting), operating costs such as headcount, salaries, and benefits, and the path of capital expenditures. And it makes transparent how alternative assumptions about each of these affects financial sustainability. In so doing, it can highlight the most important drivers of intertemporal budget balance, and clarify the policies that are likely to be most effective in achieving budget balance.

We illustrate our approach using data from the Harvard FAS as of June 30, 2023. As with any discounted cash flow analysis, our approach requires a set of assumptions about growth rates and discount rates. For our baseline analysis, we use the FAS multi-year financial plan for fiscal years 2024 through 2028, which projects line-item spending and revenues in granular detail. For years that extend beyond the FAS planning horizon, we assume an inflation rate of 2% and real growth in compensation, maintenance costs, and net tuition of 1%. To discount these cashflows, we use a real discount rate of 5%. This value is consistent with the assumption that Harvard’s endowment is able to earn a 5% real rate of return in expectation.

Of course, universities face significant uncertainty in forecasting revenues and costs far out into the future. And there is no guarantee that a 5% expected rate of return on the endowment can be achieved without taking undue levels of risk. A key strength of our framework is that it allows us to conduct various sensitivity analyses to illustrate how changes in cash flows and endowment returns affect the long-term financial health for the FAS.

Under our base case assumptions, the present value of all revenues sum to $16.07 billion and the present value of all operating costs and capital expenditures total $44.51 billion. Taking the difference between these two figures, the FAS has present-value obligations of $28.44 billion to fund its future stream of planned consumption. In terms of the wealth that the FAS has to support this consumption, the FAS share of Harvard’s endowment stands at $17.84 billion. After adjusting this value for existing debt that the FAS owes and expected future philanthropy, the total wealth of the FAS is estimated to be $21.9 billion.

With present-value obligations of $28.44 billion and total wealth of $21.9 billion, the FAS faces an estimated present-value shortfall of $6.54 billion, which corresponds to an annualized structural deficit of $327 million. In other words, to achieve long-run structural budget balance, the FAS would have to generate an additional $327 million per year in real terms through some combination of revenue increases or cost cutting measures. This figure can be compared to FY 2023 total operating costs of $1.56 billion to get a sense of magnitude; one might thus say that in our base case, the FAS has a structural budget deficit of 21%.

In our sensitivity analysis, we change the expected real rate of return on the endowment from 5% to 4%. This makes a dramatic difference to our results: the present value of the budget shortfall jumps from $6.54 billion to $13.15 billion, and the corresponding annualized structural deficit goes from $327 million to $526 million: over one third of the $1.56 billion currently budgeted for annual spending. This strong sensitivity to endowment returns reflects the fact that 51% of FAS operating revenues in 2023 came from the endowment.

Our framework also helps to identify the levers that university leadership might use to restore financial balance. For example, if compensation grows at only 0.5% in real terms as opposed to the base-case value of 1.0%, the present value of the budget shortfall shrinks by $2.2 billion, and the annualized structural deficit shrinks by $112 million.

In conclusion, we believe that an economic approach to university budgeting which compares the present value of operating obligations to the present value of wealth can help inform university leaders’ decision making. Our approach focuses attention on long-run strategic solutions to financial problems and makes clear the effects of financial market conditions on an endowment-dependent university’s financial position.