The economic risk conundrum: why IHE financial planners should prepare now, for future economic shocks.

Over the past two years, the combination of recession and falling stock prices has provided a painful reminder of higher education's vulnerability to economic shocks. It has also underscored the need for colleges and universities to incorporate the risk of economic downturns into their ongoing financial-planning processes.

Studies of human behavior show that people generally underestimate the degree of uncertainty--that is, risk--that they face. They tend to operate on the assumption of a steady-state environment and to downplay the potential for disruptive change. Unfortunately, institutions of higher education behave in much the same way. Their financial plans rarely include an explicit assessment of economic risk, even though adverse changes in macroeconomic variables (such as personal income, interest rates, and government support) have the capacity to inflict considerable hardship on the institution.

The recession of 2001 is a case in point. My informal discussions with an unscientific sample of business officers over the past year suggest that, heading into the recession of 2001, most institutions developed their budget on the basis of an assumed steady-state economy. Very few hedged their bets by developing an alternate plan to soften the impact of a recession. Although most institutions did set aside a small contingency fund (usually amounting to Less than 1 percent of expenses), few engaged in a systematic effort to identif7 areas of risk and to prepare a plan of action in the event these risks became reality.

This raises an obvious question: Since recessions occur at reasonably regular intervals and have such disruptive potential why is budget planning at colleges and universities so wedded to steady-state assumptions? Is it bureaucratic inertia? The Lack of technical tools? The politics of higher education budgeting?

ESTIMATING THE MAGNITUDE OF ECONOMIC RISK

There are models that can be used to incorporate economic risk into financial-planning processes in higher education. William Nordhaus, in 1990, developed an econometric model of economic risk based on historical patterns of change in inflation, gross national product, government spending, stockmarket prices, interest rates, and wages. ("Evaluating the Risks for Specific Institutions," Financial Planning Under Economic Uncertainty, Richard E. Anderson, and Joel W. Meyerson, eds, Jossey-Bass Inc., 1990). Nordhaus' analysis yields specific numerical estimates of the weight, volatility, and impact of risk factors. He finds that the frequency of economic shocks varies by type of institution. In the period covered by his analysis, major unfavorable shocks--those equal to or greater than 3 percent of the budget--occurred, on average, one year in five for research universities and one year in 10 for small colleges.

More recently, Craig Aase and Gary Krueger of Macalester College (MN) developed a model that was intended to develop a strategic plan to guide the school's budgetary decisions in a time of crisis or recession. Their article, "Build Your Boat Before the Hood: Contingency Planning in Higher Education," (Forum Futures, 2002) estimates the effect of several recession scenarios on Macalaster's budget. Each scenario was modeled on one of the nation's past three recessions. From their article:

   In the summer of 1997, Macalester did face a serious reduction
   of revenues when it received notice that a $4
   million revenue stream (out of a $40 million net operating
   budget) would terminate by year's end. Although
   successfully managed--fortunately this revenue stream
   had been used primarily for capital projects and had not
   been placed in the operating budget--the administration
   was forced to react to events on an ad hoc basis.
   The experience motivated the president and senior offciers
   of the college to develop a deliberative plan to
   guide Macalester's budgetary decisions in times of crisis
   or recessiosn, in a manner analagous to a rehearsed
   evacuation plan in the event of a fire. The planning effort
   was designed to complement an ongoing strategic
   planning process in that it would force members of the
   community to confront difficult budgetary choices and,
   ideally, establish dear priorities.

What practical value do the Nordhaus and Aase-Krueger models have? At Macalester, Aase and Krueger's work was an important contribution to budget planning. In an exercise described by Aase and Krueger as "planning for pain," the college's Long Range Planning committee--after reviewing Macalaster's vulnerability to a possible recession scenario--was charged with developing a contingency plan to cut 10 percent of expenditures ($4 million) from the college's operating budget. And contrary to the claim that such a plan is difficult to sell on campus, Aase and Krueger write, "The real value of such an exercise is that it helps to raise consciousness among faculty and staff who generally don't concern themselves with budgetary matters, thus laying the groundwork for making difficult choices while Still retaining the fabric or the college community.

INCORPORATING ECONOMIC RISK

There is one category of funds--endowment--in which colleges and universities attempt to minimize volatility. Endowment payouts are usually calculated as a percentage of a multiyear average market value. This payout rule tends to smooth (but not eliminate) market perturbations, thereby giving institutions time to adjust to the sharp fall in stock prices.

Yet the question is: How can colleges and universities reduce risk for sources of revenue other than endowment? One option is to follow Macalester's approach: Assess the risks and likely effect of economic dislocation, identify the required budget-reduction target, and develop a plan of specific spending reductions in the event of a recession.

A possible alternative to this approach is to establish a reserve fund that reflects an institution's exposure to and tolerance for risk. Nordhaus used a simple income-expense ratio, tracked over time, to measure the probability of major unfavorable shocks. The results of this analysis showed that, from 1954 to 1987, the chances of an unfavorable shock in any particular year were relatively small. For a university, the probability of a negative shock equal to 5 percent or more of the budget was approximately one in 20. Thus, a university could protect itself against a negative 5 percent shock by setting aside 1 percent of annual expenditures for five years.

A university that is more tolerant of risk might want to shield itself from a negative shock of up to 3 percent. In this case, Norhaus' figures indicate a negative-shock probability of .17 (of 20). That is, an institution seeking protection from a shock of up to negative 3 percent would have to pay an annual risk premium equal to 3.4 percent of its budget over five years.

There are, of course, several practical obstacles to funding risk reserves or "planning for pain."

* College and university budgeting processes are often so messy and so driven by constituency politics, they defeat any effort to establish a disciplined effort to minimize downside risk.

* Planning for cuts before hard times have arrived is especially difficult. While recessions may be inevitable, their timing is unpredictable. Creating a rainy-day fund or austerity plan for an event that could be five years away could be a difficult sell on campus.

* Third, planning for financial risk can only succeed with strong presidential leadership, as exemplified by the backing of Macalester President Michael McPherson. Other presidents, fearing the prospect of faculty resistance to anticipatory austerity might prefer to take their chances with the economy.

In the 1990s, when colleges and universities were awash in black ink, the creation of a prudent risk reserve would hardly have been felt on most campuses. But today, with endowment values still well below their 2001 values, student need rising, and faculty salary growth slowing, the creation of a risk reserve may not be politically feasible. Still, what better time to initiate plans for such action--when the pain of not having had a plan is still being acutely felt, and is not a distant memory? The hope is that the recovery from hard times (and its distance from the economic difficulties colleges and universities are experiencing now) does not lead to a spending binge that once again leaves institutions vulnerable to the inevitable, if unpredictable, economic shock.

Gerald B. Finch is the founder and managing principal of The Stillwater Group (www.stillwater.com), a higher-education consulting group that specializes in finance, strategy, end operations management.