ANALYSIS OF FINANCIAL RESULTS

I. Introduction

The traditional university financial report has been largely an accounting document which focuses on a detailed review of income, expense, and investment performance for the year under consideration rather than a planning document which addresses the major financial issues which the institution faces. In order to provide more comprehensive and useful information. Harvard began several years ago to include in the annual Financial Report an Analysis of Financial Results which seeks to achieve three important purposes: to summarize the financial results for the year; to identify and discuss the significant factors which these results reflect; and, most important, to select one or more major financial issues and opportunities which face the University and to discuss the University's planned actions in the related area within the broad context of the major administrative, financial, and educational initiatives being undertaken by the University.

Under this format, the Financial Report for 1978 summarized the trends in Harvard's income over a forty-year period and reviewed the changing reliance on income from the four major sources: tuition, endowment, current use gifts, and sponsored research. The Report for 1979 focused on the effects which inflation has upon the endowment and out-lined the reasons why private universities need continually to increase their capital bases if they expect both to maintain financial strength and to assure the future flexibility which is so critically important to their success. In 1980, the Report described the University's financial structure and explained the primary planning and control systems which Harvard uses to promote financial effectiveness within its several departments. That Report pointed out that, while the University's management system continues to be based on Harvard's traditions of departmental responsibility and financial conservatism, revisions to that system are made continuously to assure that it adapts to the changing scale, scope, and nature of the University's activities: recognizes the increasing complexity of the University community and of the society which it serves; and reflects the development and availability of new methods of management, new technologies, and new techniques.

During 1981, Harvard gave considerable attention to the revision and reorganization of several areas in the financial administration, including budget planning and research management. The Report for this year focuses on these two activities both as important changes in and of themselves and also as representative examples of the opportunities which Harvard has to further improve its management.

H. Summary of Financial Results for the Year

Income

Income earned during the year totaled $446.6 million. Income components are displayed graphically in Exhibit I, while Table 1 compares the amounts of income from the various sources used by the University during selected years in the past decade. TABLE 1 Summary of University Income (In millions of dollars)   1971  1976  1980  1981  Rate of Change 1980-81  Rate of Change 1971-81 (compound) Endowment income  $ 42.3  $ 57.0  $ 76.6  $82.1  7.2%  6.9% Current gifts  33.3  38.1  62.7  72.6  15.8%  8.1% Student income: Tuition and fees  38.3  59.8  91.1  104.6  14.8%  10.6% Student income: Board and lodging  9.1  16.2  23.5  27.6  17.4%  11.7% Federal research-direct  49.3  52.5  73.1  76.9  5.2%  4.5% Federal research-indirect  8.6  15.0  25.0  29.1  16.4%  13.0% Other  13.1  31.1  44.9  53.7  19.6%  15.2% Total  $194.0  $269.7  $393.9  $446.6  13.4%  8.7%

During 1981, $6.97 per unit was distributed to participants in the University's general investments. Departments utilized $82.1 million in investment income, an increase of 7.3% over the level in 1980. The increase in income from endowment funds, while sizable, did not keep pace with the rate of expense growth within the University community. As a result, endowment income represented only 18.4% of University income during 1981, a decrease from 19.5% during the prior year. The importance of this trend and the University's actions and plans in the area of endowment management are discussed below under the caption "Capital Activities."

Gifts for current use and other receipts for special purposes used during the year represented 16.3% of the University income, an increase from 15.9% in 1980. The amount utilized during the year, $72.6 million, was 15.8% over the amount used during the prior year. This level of growth exceeded the rate of inflation and reflects both increased level of current use gifts and substantial increases in support of University programs of restricted nature from other sources such as research agreements with industry, grants from foundations, and support from public organizations other than the federal government.

Tuition and other fees increased by 14.8% to $104.6 million. As the number of students increased by less than 1.0%, the increase in tuition and fees represents a real increase in the cost of attending Harvard College and the various professional schools of the University. Tuition continues to provide an increasing share of income to compensate for lower rates of growth in other income sources. Tuition how represents 23.4% of income.

Income from fees charged to students for board and lodging increased by 17.4% to $27.6 million to reflect the relatively higher growth rate in the expenses such as building maintenance and operation which these fees must cover. During the year, a number of preliminary plans were developed for major renovations to the University's housing facilities, particularly the undergraduate residential houses. These facilities, the majority of which were constructed between 1920 and 1940, are in need of substantial maintenance. The specific projects to be undertaken and the source of their financing will be major topics for discussion during 1982.

Receipts from the federal government under grants and contracts which support the University's educational and research programs exceeded $100.0 million for the first time and grew to $106.0 million an increase of 8.1%. Income covering direct expenses--those items such as salaries, benefits, equipment, supplies, trainee stipends, travel, and like items which are attributed to individual research programs--increased by 5.1%, a rate substantially less than inflation. Income covering indirect expenses, which represent reimbursements to the University for costs such as general and departmental administration, library use, operation and maintenance of facilities, and depreciation, none of which can be directly associated with single research projects but which must be aggregated and distributed pro rata to all projects, increased by 16.4% to $29.1 million. Total receipts from the government constituted 23.7% of University expenditures, a decrease from 24.9% during the prior year.

The relatively large increase in indirect costs reflects the combined effects of increases in the annual costs of building operations, the addition of the Biochemistry Building to the University's plant, added costs associated with more accurate facilities depreciation and several renovations to the plant, improved methods of cost allocation which divide the costs of space more accurately between teaching and research programs and which assign relatively high energy costs to the laboratories which generate those costs, and recovery during 1981 of indirect costs incurred in prior years but not recovered at that time. Indirect costs represent an average overhead of 37.8% on all direct costs. However, the manner in which federal research funds are awarded and managed requires that indirect costs be spread over only certain direct costs. As a result, indirect cost rates are frequently higher than this average. It is important to note that no federal research program permits full recovery of indirect costs. For example, the government does not consider interest to be a cost and individual federal agencies may not permit the University to charge the indirect cost rate which has been negotiated with the government for the period in question.

Receipts from other sources represented 12.0% of University income, an increase from 10.6% one year earlier. This category of income increased by 28.2% to $53.7 million. This large increase reflects substantial growth in the University's housing, conference, and publications programs as well as additional space rental.

Expenses

Expenses for the year, which totaled $446.3 million, are displayed graphically in Exhibit 2 and compared in Table 2 with expenses in selected years over the past decade. TABLE 2 Summary of University Expenses (in millions of dollars)   1971  1976  1980  1981  Rate of Change 1980-81  Rate of Change 1971-81 (compound) Salaries and wages  $ 98.6  $ 130.1  $ 178.8  $ 199.0  11.3%  7.3% Employee benefits  13.8  18.4  31.8  35.1  10.4%  9.8% Scholarships  20.4  24.7  31.1  34.3  10.3%  5.3% Equipment and supplies  32.0  44.4  78.6  93.6  19.1%  11.8% Other  32.0  44.4  78.6  93.6  19.1%  11.8% Total  $195.4  $268.8  $393.5  $446.3  13.4%  8.3%

Salaries, wages, and employee benefits paid by the University to its faculty and staff during 1981 were $234.1 million, an increase of 11.2% over the prior year. Taken together, these items constituted 52.4% of total University expenses for the year, a slight reduction from 53.5% of expenses one year earlier. This change reflects the higher rates of increase in expense categories other than salaries and wages within the University community and displays the difficulty which Harvard, along with other leading universities, has had in raising salaries at rates comparable to inflation. Smee employment during the year was approximately constant, the increase in salaries and wages represented an increase in average salary levels. Salary increase levels to continuing staff members were at slightly higher levels since University-wide averages are reduced by the replacement of relatively senior staff who retire or resign with persons who are more junior and whose salaries are at a lower level.

Total expenses for employee benefits grew at a rate of 10.3% to $35.1 million. The most significant increases in this category were those incurred for the University's various health care programs. The cost of employee benefits for the year was at a level equal to 17.6% of salaries and wages.

Scholarships and other awards to students increased by 10.4% to a level of $34.4 million and constituted 7.7% of University expenses. This total includes only scholarship and fellowship awards made by Harvard. Excluded are similar awards estimated to total over $3.5 million which are made directly to students by other organizations. During the year the University granted $17.2 million in new loans to students and provided $12.5 million to students in the form of term-time employment at Harvard in various positions, including teaching fellowships. Additional loans of approximately $20.0 million are estimated to have been awarded directly to students by banks.

The total financial aid in the form of scholarships, fellowships, term-time employment, and student loans provided to students by the University was $64.1 million, an increase of 13.9% over the prior year. Total student aid awarded by the University continued to represent almost half of the total charges by the University to its students for tuition, fees, room and board. While the University was able to maintain financial aid during the year at levels which provided purchasing power essentially equal to the prior year, the future stability of this program is in question.

During the year, the federal government began a series of changes to the various national student aid programs, including both individual grants, veterans benefits, social security benefits and guaranteed student loans. These changes will not affect Harvard students significantly until 1983 but the future effects are expected to be significant both in terms of reduced availability of grants and reduced access to the guaranteed loan market. Loans are important not only to those who must borrow to defer the cost of their college education to the years when they will earn sufficient income to support the cost but also to those who require temporary liquidity to permit them to meet current costs of higher education without resorting to the sale of assets. Precise analysis of the effect which these changes will have cannot be made at this time since the legislation relating to the changes has not been completed and the related regulations have not been issued. However, it is clear that changes will be made, that the effects will be significant, and that the strength of Harvard's internally financed student aid program will ensure that the effects will be felt to a smaller degree by Harvard students than will typically be the case at other institutions. The limited availability of guaranteed student loans is likely to be the most significant factor.

During the past decade, tuition and student fees increased at a compound rate of 10.6% while scholarship and fellowship aid provided to students by Harvard increased at a compound rate of 5.3%. To support the costs of their education, students are being asked increasingly to rely on government support or on their own resources either currently, or in the deferred terms when loans are used.

Expenditures for equipment and supplies increased by 15.3% to $84.4 million. A large component of this increase represents the annualization in 1981 of the energy price increases which occurred in stages during 1980. The balance of the increase represents the continued effect of inflation on the markets for the various items required by the University in its normal operations. The category headed "Other Expenses," which includes a large variety of items such as telephone service, travel, production of publications, consultant fees, temporary help, and various other purchased services, increased by 19.1% to $93.6 million. This relatively large increase represents significant volume growth in several aspects of the University's real estate program as well as additional conference activities.

During the year, expenses incurred by the ten faculties grew by 14.2% to a level of $351.8 million. These departments account for approximately four-fifths of the University's activity. A further $30.1 million, or somewhat less than one-tenth of University activity, is incurred in the other academic departments, research institutes, museums, and similar organizations for which separate budgets are maintained. Expenses incurred within the service departments of the University, which bill the faculties, other academic departments, or individuals for their products and services, increased by 16.4%, primarily as a result of increased utility costs.

Expenses of the Central Administration grew at 9.8% during the year, a rate substantially less than that experienced by the University as a whole. This total includes both the costs of the offices included in the Central Administration as well as $2.9 million in expenses to provide support to a number of the schools and departments. The costs of the Central Administration are financed from a number of sources, including unrestricted endowment income, indirect cost revenues received under research programs, assignment of investment management costs as a reduction to gross investment income, and an assessments to the various departments. The departmental assessment pays only one-fifth of the total cost of the Central Administration. If all costs of the Central Administration other than investment management and cost involved in the support of other departments were borne solely by the academic departments, then that cost would represent an overhead of 7.0% on the activities of those departments.

Capital Activities

Total general investment income received during the year was $113.1 million, an increase of 11.2% over the prior year. Income received totaled $9.52 per general investment unit, an increase of 9.2% from the level of $8.72 per unit during the prior year. The value of a general investment unit appreciated by 4.0% from $135.10 to $140.50. Total return from capital appreciation and current income was $14.92 per unit, or 11.0% of average unit value. Of the income earned in 1981, $7.18 per unit, or approximately three-quarters of the total, will be distributed to participating funds during 1982. The balance will be added to the stabilization reserves which are maintained for each fund to assure that sufficient income is available to meet the unit distribution rate which is determined in advance.

The establishment of policies covering the investment of endowment assets and the allocation of investment return received from income and appreciation between the two competing demands of current use and reinvestment are centrally important decisions for Harvard, as well as for other endowed institutions. In addressing these decisions, the University faces two basic problems. First, it must work to provide annual income to the activities which the endowment supports in sufficient quantities to minimize the effects of inflation in the short term. Second, it must seek to assure that the endowment will generate a flow of annual income in future years which is sufficient to maintain purchasing power and to assure that current programs receive the same degree of support from endowment as did their predecessors in generations past and as will their successors in generations to come.

In 1974, Harvard adopted a consistent plan for distributing income from the endowment. This plan, which reflected the economic conditions and predictions prevailing at that time, was designed to permit the distribution of endowment income to increase indefinitely at an annual rate of 4.0%. During the seven years since this policy was adopted, significant levels of inflation and lower than expected rates of long-term growth in capital values have reduced the purchasing power of endowment income. This problem is not unique to Harvard but is faced by all similar institutions and, in fact, Harvard's performance has been superior to that of most other institutions. During this same period, however, interest rates have been at generally high levels and the current income earned by the endowment has been at a higher level than expected. The success of this income distribution policy and the effects which inflation has upon the endowment are discussed in detail in the Financial Report for 1979.

The occurrence of these partially offsetting situations--capital growth rates substantially lower than inflation but current income at a high level--has caused the University to refine the policy governing the rate at which endowment income distribution is increased. The annual rate of increase in distribution has been lowered from 4.0% to 3.0% and sufficient undistributed income is being capitalized each year to provide an additional growth factor of 1.0% through an addition to capital. These two actions maintain the planned rate of growth and offset, at least partially, the fact that capital value have not grown at rates equal to inflation. However, these policies are unable to address the central problem; endowment distributions growing at 4.0% per year are not keeping pace with the current rate of inflation.

Endowment management policies can be adjusted in the short term or intermediate term so as to increase endowment capital value at the expense of current income or to increase current spending at the expense of asset growth. Particularly in times when inflation and current rates of return are both at high levels, there are pressures to address the erosion in the value of endowment income which inflation causes by distributing a larger fraction of the high earnings which result from high interest rates. If high rates of inflation and of current income prove to be short-term phenomena of similar duration, then such action might be justified. However, if high rates of current return endure for only a short period while high inflation rates continue into the longer term, then a decision to utilize more income currently will reduce the opportunity for reinvestment and will limit the University's ability to maintain both endowment value and future endowment income.

When interest rates are high, and when a relatively large fraction of the total return earned by the endowment from both income and capital appreciation is provided in the form of current income, then the value of the endowment can be maintained only through a conservative distribution policy which retains a fraction of current income to build the capital base. Failure to follow such a policy would assist current operations, but only at the expense of the University's ability to maintain those same endowment-dependent activities in the future.

Harvard's planning for the management of its endowment--in similar fashion to the planning of most other universities--is based on the maintenance of market value of the endowment and on the assumption that the rate at which income is distributed from that endowment cannot consistently exceed a level of approximately 4.0% to 5.0% of market value without reducing the value of the endowment. A rate of distribution higher than this level in the absence of continuous, significant capital appreciation can be maintained only if the rate of return earned by the assets in which the endowment is invested grows continuously. While the rate of return provided by equity and debt investments has increased somewhat during the past two decades reflecting, in part, the embedding of increased inflation in investor expectations, such increases cannot be expected to continue indefinitely, nor can they be expected to be at rates equal to inflation. Therefore, a balanced policy must be maintained towards distribution and reinvestment.

Gifts for capital received during the year were $51.6 million and gifts for current use were $39.3 million, a total of $90.9 million, 19.3% above the amount received during the prior year. The significant increase in the level of gifts, particularly gifts, for capital, reflects the results achieved under the Harvard Campaign. In addition to gifts for capital, endowment was increased by the addition of $14.7 million from the stabilization reserves referred to above, together with an additional $11.2 million which represents the net effect of several capitalization and decapitalization activities. At year end, the market value of the University's endowment was $1,622.7 million, an increase of 8.8%. The general investment portfolio was invested approximately 62.0% in equities and related instruments and approximately 38.0% in cash and fixed-income securities.

During 1981, $6.97 per unit was distributed to participants in the University's general investments. Departments utilized $82.1 million in investment income, an increase of 7.3% over the level in 1980. The increase in income from endowment funds, while sizable, did not keep pace with the rate of expense growth within the University community. As a result, endowment income represented only 18.4% of University income during 1981, a decrease from 19.5% during the prior year. The importance of this trend and the University's actions and plans in the area of endowment management are discussed below under the caption "Capital Activities."

Gifts for current use and other receipts for special purposes used during the year represented 16.3% of the University income, an increase from 15.9% in 1980. The amount utilized during the year, $72.6 million, was 15.8% over the amount used during the prior year. This level of growth exceeded the rate of inflation and reflects both increased level of current use gifts and substantial increases in support of University programs of restricted nature from other sources such as research agreements with industry, grants from foundations, and support from public organizations other than the federal government.

Tuition and other fees increased by 14.8% to $104.6 million. As the number of students increased by less than 1.0%, the increase in tuition and fees represents a real increase in the cost of attending Harvard College and the various professional schools of the University. Tuition continues to provide an increasing share of income to compensate for lower rates of growth in other income sources. Tuition how represents 23.4% of income.

Income from fees charged to students for board and lodging increased by 17.4% to $27.6 million to reflect the relatively higher growth rate in the expenses such as building maintenance and operation which these fees must cover. During the year, a number of preliminary plans were developed for major renovations to the University's housing facilities, particularly the undergraduate residential houses. These facilities, the majority of which were constructed between 1920 and 1940, are in need of substantial maintenance. The specific projects to be undertaken and the source of their financing will be major topics for discussion during 1982.

Receipts from the federal government under grants and contracts which support the University's educational and research programs exceeded $100.0 million for the first time and grew to $106.0 million an increase of 8.1%. Income covering direct expenses--those items such as salaries, benefits, equipment, supplies, trainee stipends, travel, and like items which are attributed to individual research programs--increased by 5.1%, a rate substantially less than inflation. Income covering indirect expenses, which represent reimbursements to the University for costs such as general and departmental administration, library use, operation and maintenance of facilities, and depreciation, none of which can be directly associated with single research projects but which must be aggregated and distributed pro rata to all projects, increased by 16.4% to $29.1 million. Total receipts from the government constituted 23.7% of University expenditures, a decrease from 24.9% during the prior year.

The relatively large increase in indirect costs reflects the combined effects of increases in the annual costs of building operations, the addition of the Biochemistry Building to the University's plant, added costs associated with more accurate facilities depreciation and several renovations to the plant, improved methods of cost allocation which divide the costs of space more accurately between teaching and research programs and which assign relatively high energy costs to the laboratories which generate those costs, and recovery during 1981 of indirect costs incurred in prior years but not recovered at that time. Indirect costs represent an average overhead of 37.8% on all direct costs. However, the manner in which federal research funds are awarded and managed requires that indirect costs be spread over only certain direct costs. As a result, indirect cost rates are frequently higher than this average. It is important to note that no federal research program permits full recovery of indirect costs. For example, the government does not consider interest to be a cost and individual federal agencies may not permit the University to charge the indirect cost rate which has been negotiated with the government for the period in question.

Receipts from other sources represented 12.0% of University income, an increase from 10.6% one year earlier. This category of income increased by 28.2% to $53.7 million. This large increase reflects substantial growth in the University's housing, conference, and publications programs as well as additional space rental.

Expenses

Expenses for the year, which totaled $446.3 million, are displayed graphically in Exhibit 2 and compared in Table 2 with expenses in selected years over the past decade. TABLE 2 Summary of University Expenses (in millions of dollars)   1971  1976  1980  1981  Rate of Change 1980-81  Rate of Change 1971-81 (compound) Salaries and wages  $ 98.6  $ 130.1  $ 178.8  $ 199.0  11.3%  7.3% Employee benefits  13.8  18.4  31.8  35.1  10.4%  9.8% Scholarships  20.4  24.7  31.1  34.3  10.3%  5.3% Equipment and supplies  32.0  44.4  78.6  93.6  19.1%  11.8% Other  32.0  44.4  78.6  93.6  19.1%  11.8% Total  $195.4  $268.8  $393.5  $446.3  13.4%  8.3%

Salaries, wages, and employee benefits paid by the University to its faculty and staff during 1981 were $234.1 million, an increase of 11.2% over the prior year. Taken together, these items constituted 52.4% of total University expenses for the year, a slight reduction from 53.5% of expenses one year earlier. This change reflects the higher rates of increase in expense categories other than salaries and wages within the University community and displays the difficulty which Harvard, along with other leading universities, has had in raising salaries at rates comparable to inflation. Smee employment during the year was approximately constant, the increase in salaries and wages represented an increase in average salary levels. Salary increase levels to continuing staff members were at slightly higher levels since University-wide averages are reduced by the replacement of relatively senior staff who retire or resign with persons who are more junior and whose salaries are at a lower level.

Total expenses for employee benefits grew at a rate of 10.3% to $35.1 million. The most significant increases in this category were those incurred for the University's various health care programs. The cost of employee benefits for the year was at a level equal to 17.6% of salaries and wages.

Scholarships and other awards to students increased by 10.4% to a level of $34.4 million and constituted 7.7% of University expenses. This total includes only scholarship and fellowship awards made by Harvard. Excluded are similar awards estimated to total over $3.5 million which are made directly to students by other organizations. During the year the University granted $17.2 million in new loans to students and provided $12.5 million to students in the form of term-time employment at Harvard in various positions, including teaching fellowships. Additional loans of approximately $20.0 million are estimated to have been awarded directly to students by banks.

The total financial aid in the form of scholarships, fellowships, term-time employment, and student loans provided to students by the University was $64.1 million, an increase of 13.9% over the prior year. Total student aid awarded by the University continued to represent almost half of the total charges by the University to its students for tuition, fees, room and board. While the University was able to maintain financial aid during the year at levels which provided purchasing power essentially equal to the prior year, the future stability of this program is in question.

During the year, the federal government began a series of changes to the various national student aid programs, including both individual grants, veterans benefits, social security benefits and guaranteed student loans. These changes will not affect Harvard students significantly until 1983 but the future effects are expected to be significant both in terms of reduced availability of grants and reduced access to the guaranteed loan market. Loans are important not only to those who must borrow to defer the cost of their college education to the years when they will earn sufficient income to support the cost but also to those who require temporary liquidity to permit them to meet current costs of higher education without resorting to the sale of assets. Precise analysis of the effect which these changes will have cannot be made at this time since the legislation relating to the changes has not been completed and the related regulations have not been issued. However, it is clear that changes will be made, that the effects will be significant, and that the strength of Harvard's internally financed student aid program will ensure that the effects will be felt to a smaller degree by Harvard students than will typically be the case at other institutions. The limited availability of guaranteed student loans is likely to be the most significant factor.

During the past decade, tuition and student fees increased at a compound rate of 10.6% while scholarship and fellowship aid provided to students by Harvard increased at a compound rate of 5.3%. To support the costs of their education, students are being asked increasingly to rely on government support or on their own resources either currently, or in the deferred terms when loans are used.

Expenditures for equipment and supplies increased by 15.3% to $84.4 million. A large component of this increase represents the annualization in 1981 of the energy price increases which occurred in stages during 1980. The balance of the increase represents the continued effect of inflation on the markets for the various items required by the University in its normal operations. The category headed "Other Expenses," which includes a large variety of items such as telephone service, travel, production of publications, consultant fees, temporary help, and various other purchased services, increased by 19.1% to $93.6 million. This relatively large increase represents significant volume growth in several aspects of the University's real estate program as well as additional conference activities.

During the year, expenses incurred by the ten faculties grew by 14.2% to a level of $351.8 million. These departments account for approximately four-fifths of the University's activity. A further $30.1 million, or somewhat less than one-tenth of University activity, is incurred in the other academic departments, research institutes, museums, and similar organizations for which separate budgets are maintained. Expenses incurred within the service departments of the University, which bill the faculties, other academic departments, or individuals for their products and services, increased by 16.4%, primarily as a result of increased utility costs.

Expenses of the Central Administration grew at 9.8% during the year, a rate substantially less than that experienced by the University as a whole. This total includes both the costs of the offices included in the Central Administration as well as $2.9 million in expenses to provide support to a number of the schools and departments. The costs of the Central Administration are financed from a number of sources, including unrestricted endowment income, indirect cost revenues received under research programs, assignment of investment management costs as a reduction to gross investment income, and an assessments to the various departments. The departmental assessment pays only one-fifth of the total cost of the Central Administration. If all costs of the Central Administration other than investment management and cost involved in the support of other departments were borne solely by the academic departments, then that cost would represent an overhead of 7.0% on the activities of those departments.

Capital Activities

Total general investment income received during the year was $113.1 million, an increase of 11.2% over the prior year. Income received totaled $9.52 per general investment unit, an increase of 9.2% from the level of $8.72 per unit during the prior year. The value of a general investment unit appreciated by 4.0% from $135.10 to $140.50. Total return from capital appreciation and current income was $14.92 per unit, or 11.0% of average unit value. Of the income earned in 1981, $7.18 per unit, or approximately three-quarters of the total, will be distributed to participating funds during 1982. The balance will be added to the stabilization reserves which are maintained for each fund to assure that sufficient income is available to meet the unit distribution rate which is determined in advance.

The establishment of policies covering the investment of endowment assets and the allocation of investment return received from income and appreciation between the two competing demands of current use and reinvestment are centrally important decisions for Harvard, as well as for other endowed institutions. In addressing these decisions, the University faces two basic problems. First, it must work to provide annual income to the activities which the endowment supports in sufficient quantities to minimize the effects of inflation in the short term. Second, it must seek to assure that the endowment will generate a flow of annual income in future years which is sufficient to maintain purchasing power and to assure that current programs receive the same degree of support from endowment as did their predecessors in generations past and as will their successors in generations to come.

In 1974, Harvard adopted a consistent plan for distributing income from the endowment. This plan, which reflected the economic conditions and predictions prevailing at that time, was designed to permit the distribution of endowment income to increase indefinitely at an annual rate of 4.0%. During the seven years since this policy was adopted, significant levels of inflation and lower than expected rates of long-term growth in capital values have reduced the purchasing power of endowment income. This problem is not unique to Harvard but is faced by all similar institutions and, in fact, Harvard's performance has been superior to that of most other institutions. During this same period, however, interest rates have been at generally high levels and the current income earned by the endowment has been at a higher level than expected. The success of this income distribution policy and the effects which inflation has upon the endowment are discussed in detail in the Financial Report for 1979.

The occurrence of these partially offsetting situations--capital growth rates substantially lower than inflation but current income at a high level--has caused the University to refine the policy governing the rate at which endowment income distribution is increased. The annual rate of increase in distribution has been lowered from 4.0% to 3.0% and sufficient undistributed income is being capitalized each year to provide an additional growth factor of 1.0% through an addition to capital. These two actions maintain the planned rate of growth and offset, at least partially, the fact that capital value have not grown at rates equal to inflation. However, these policies are unable to address the central problem; endowment distributions growing at 4.0% per year are not keeping pace with the current rate of inflation.

Endowment management policies can be adjusted in the short term or intermediate term so as to increase endowment capital value at the expense of current income or to increase current spending at the expense of asset growth. Particularly in times when inflation and current rates of return are both at high levels, there are pressures to address the erosion in the value of endowment income which inflation causes by distributing a larger fraction of the high earnings which result from high interest rates. If high rates of inflation and of current income prove to be short-term phenomena of similar duration, then such action might be justified. However, if high rates of current return endure for only a short period while high inflation rates continue into the longer term, then a decision to utilize more income currently will reduce the opportunity for reinvestment and will limit the University's ability to maintain both endowment value and future endowment income.

When interest rates are high, and when a relatively large fraction of the total return earned by the endowment from both income and capital appreciation is provided in the form of current income, then the value of the endowment can be maintained only through a conservative distribution policy which retains a fraction of current income to build the capital base. Failure to follow such a policy would assist current operations, but only at the expense of the University's ability to maintain those same endowment-dependent activities in the future.

Harvard's planning for the management of its endowment--in similar fashion to the planning of most other universities--is based on the maintenance of market value of the endowment and on the assumption that the rate at which income is distributed from that endowment cannot consistently exceed a level of approximately 4.0% to 5.0% of market value without reducing the value of the endowment. A rate of distribution higher than this level in the absence of continuous, significant capital appreciation can be maintained only if the rate of return earned by the assets in which the endowment is invested grows continuously. While the rate of return provided by equity and debt investments has increased somewhat during the past two decades reflecting, in part, the embedding of increased inflation in investor expectations, such increases cannot be expected to continue indefinitely, nor can they be expected to be at rates equal to inflation. Therefore, a balanced policy must be maintained towards distribution and reinvestment.

Gifts for capital received during the year were $51.6 million and gifts for current use were $39.3 million, a total of $90.9 million, 19.3% above the amount received during the prior year. The significant increase in the level of gifts, particularly gifts, for capital, reflects the results achieved under the Harvard Campaign. In addition to gifts for capital, endowment was increased by the addition of $14.7 million from the stabilization reserves referred to above, together with an additional $11.2 million which represents the net effect of several capitalization and decapitalization activities. At year end, the market value of the University's endowment was $1,622.7 million, an increase of 8.8%. The general investment portfolio was invested approximately 62.0% in equities and related instruments and approximately 38.0% in cash and fixed-income securities.

Salaries, wages, and employee benefits paid by the University to its faculty and staff during 1981 were $234.1 million, an increase of 11.2% over the prior year. Taken together, these items constituted 52.4% of total University expenses for the year, a slight reduction from 53.5% of expenses one year earlier. This change reflects the higher rates of increase in expense categories other than salaries and wages within the University community and displays the difficulty which Harvard, along with other leading universities, has had in raising salaries at rates comparable to inflation. Smee employment during the year was approximately constant, the increase in salaries and wages represented an increase in average salary levels. Salary increase levels to continuing staff members were at slightly higher levels since University-wide averages are reduced by the replacement of relatively senior staff who retire or resign with persons who are more junior and whose salaries are at a lower level.

Total expenses for employee benefits grew at a rate of 10.3% to $35.1 million. The most significant increases in this category were those incurred for the University's various health care programs. The cost of employee benefits for the year was at a level equal to 17.6% of salaries and wages.

Scholarships and other awards to students increased by 10.4% to a level of $34.4 million and constituted 7.7% of University expenses. This total includes only scholarship and fellowship awards made by Harvard. Excluded are similar awards estimated to total over $3.5 million which are made directly to students by other organizations. During the year the University granted $17.2 million in new loans to students and provided $12.5 million to students in the form of term-time employment at Harvard in various positions, including teaching fellowships. Additional loans of approximately $20.0 million are estimated to have been awarded directly to students by banks.

The total financial aid in the form of scholarships, fellowships, term-time employment, and student loans provided to students by the University was $64.1 million, an increase of 13.9% over the prior year. Total student aid awarded by the University continued to represent almost half of the total charges by the University to its students for tuition, fees, room and board. While the University was able to maintain financial aid during the year at levels which provided purchasing power essentially equal to the prior year, the future stability of this program is in question.

During the year, the federal government began a series of changes to the various national student aid programs, including both individual grants, veterans benefits, social security benefits and guaranteed student loans. These changes will not affect Harvard students significantly until 1983 but the future effects are expected to be significant both in terms of reduced availability of grants and reduced access to the guaranteed loan market. Loans are important not only to those who must borrow to defer the cost of their college education to the years when they will earn sufficient income to support the cost but also to those who require temporary liquidity to permit them to meet current costs of higher education without resorting to the sale of assets. Precise analysis of the effect which these changes will have cannot be made at this time since the legislation relating to the changes has not been completed and the related regulations have not been issued. However, it is clear that changes will be made, that the effects will be significant, and that the strength of Harvard's internally financed student aid program will ensure that the effects will be felt to a smaller degree by Harvard students than will typically be the case at other institutions. The limited availability of guaranteed student loans is likely to be the most significant factor.

During the past decade, tuition and student fees increased at a compound rate of 10.6% while scholarship and fellowship aid provided to students by Harvard increased at a compound rate of 5.3%. To support the costs of their education, students are being asked increasingly to rely on government support or on their own resources either currently, or in the deferred terms when loans are used.

Expenditures for equipment and supplies increased by 15.3% to $84.4 million. A large component of this increase represents the annualization in 1981 of the energy price increases which occurred in stages during 1980. The balance of the increase represents the continued effect of inflation on the markets for the various items required by the University in its normal operations. The category headed "Other Expenses," which includes a large variety of items such as telephone service, travel, production of publications, consultant fees, temporary help, and various other purchased services, increased by 19.1% to $93.6 million. This relatively large increase represents significant volume growth in several aspects of the University's real estate program as well as additional conference activities.

During the year, expenses incurred by the ten faculties grew by 14.2% to a level of $351.8 million. These departments account for approximately four-fifths of the University's activity. A further $30.1 million, or somewhat less than one-tenth of University activity, is incurred in the other academic departments, research institutes, museums, and similar organizations for which separate budgets are maintained. Expenses incurred within the service departments of the University, which bill the faculties, other academic departments, or individuals for their products and services, increased by 16.4%, primarily as a result of increased utility costs.

Expenses of the Central Administration grew at 9.8% during the year, a rate substantially less than that experienced by the University as a whole. This total includes both the costs of the offices included in the Central Administration as well as $2.9 million in expenses to provide support to a number of the schools and departments. The costs of the Central Administration are financed from a number of sources, including unrestricted endowment income, indirect cost revenues received under research programs, assignment of investment management costs as a reduction to gross investment income, and an assessments to the various departments. The departmental assessment pays only one-fifth of the total cost of the Central Administration. If all costs of the Central Administration other than investment management and cost involved in the support of other departments were borne solely by the academic departments, then that cost would represent an overhead of 7.0% on the activities of those departments.

Capital Activities

Total general investment income received during the year was $113.1 million, an increase of 11.2% over the prior year. Income received totaled $9.52 per general investment unit, an increase of 9.2% from the level of $8.72 per unit during the prior year. The value of a general investment unit appreciated by 4.0% from $135.10 to $140.50. Total return from capital appreciation and current income was $14.92 per unit, or 11.0% of average unit value. Of the income earned in 1981, $7.18 per unit, or approximately three-quarters of the total, will be distributed to participating funds during 1982. The balance will be added to the stabilization reserves which are maintained for each fund to assure that sufficient income is available to meet the unit distribution rate which is determined in advance.

The establishment of policies covering the investment of endowment assets and the allocation of investment return received from income and appreciation between the two competing demands of current use and reinvestment are centrally important decisions for Harvard, as well as for other endowed institutions. In addressing these decisions, the University faces two basic problems. First, it must work to provide annual income to the activities which the endowment supports in sufficient quantities to minimize the effects of inflation in the short term. Second, it must seek to assure that the endowment will generate a flow of annual income in future years which is sufficient to maintain purchasing power and to assure that current programs receive the same degree of support from endowment as did their predecessors in generations past and as will their successors in generations to come.

In 1974, Harvard adopted a consistent plan for distributing income from the endowment. This plan, which reflected the economic conditions and predictions prevailing at that time, was designed to permit the distribution of endowment income to increase indefinitely at an annual rate of 4.0%. During the seven years since this policy was adopted, significant levels of inflation and lower than expected rates of long-term growth in capital values have reduced the purchasing power of endowment income. This problem is not unique to Harvard but is faced by all similar institutions and, in fact, Harvard's performance has been superior to that of most other institutions. During this same period, however, interest rates have been at generally high levels and the current income earned by the endowment has been at a higher level than expected. The success of this income distribution policy and the effects which inflation has upon the endowment are discussed in detail in the Financial Report for 1979.

The occurrence of these partially offsetting situations--capital growth rates substantially lower than inflation but current income at a high level--has caused the University to refine the policy governing the rate at which endowment income distribution is increased. The annual rate of increase in distribution has been lowered from 4.0% to 3.0% and sufficient undistributed income is being capitalized each year to provide an additional growth factor of 1.0% through an addition to capital. These two actions maintain the planned rate of growth and offset, at least partially, the fact that capital value have not grown at rates equal to inflation. However, these policies are unable to address the central problem; endowment distributions growing at 4.0% per year are not keeping pace with the current rate of inflation.

Endowment management policies can be adjusted in the short term or intermediate term so as to increase endowment capital value at the expense of current income or to increase current spending at the expense of asset growth. Particularly in times when inflation and current rates of return are both at high levels, there are pressures to address the erosion in the value of endowment income which inflation causes by distributing a larger fraction of the high earnings which result from high interest rates. If high rates of inflation and of current income prove to be short-term phenomena of similar duration, then such action might be justified. However, if high rates of current return endure for only a short period while high inflation rates continue into the longer term, then a decision to utilize more income currently will reduce the opportunity for reinvestment and will limit the University's ability to maintain both endowment value and future endowment income.

When interest rates are high, and when a relatively large fraction of the total return earned by the endowment from both income and capital appreciation is provided in the form of current income, then the value of the endowment can be maintained only through a conservative distribution policy which retains a fraction of current income to build the capital base. Failure to follow such a policy would assist current operations, but only at the expense of the University's ability to maintain those same endowment-dependent activities in the future.

Harvard's planning for the management of its endowment--in similar fashion to the planning of most other universities--is based on the maintenance of market value of the endowment and on the assumption that the rate at which income is distributed from that endowment cannot consistently exceed a level of approximately 4.0% to 5.0% of market value without reducing the value of the endowment. A rate of distribution higher than this level in the absence of continuous, significant capital appreciation can be maintained only if the rate of return earned by the assets in which the endowment is invested grows continuously. While the rate of return provided by equity and debt investments has increased somewhat during the past two decades reflecting, in part, the embedding of increased inflation in investor expectations, such increases cannot be expected to continue indefinitely, nor can they be expected to be at rates equal to inflation. Therefore, a balanced policy must be maintained towards distribution and reinvestment.

Gifts for capital received during the year were $51.6 million and gifts for current use were $39.3 million, a total of $90.9 million, 19.3% above the amount received during the prior year. The significant increase in the level of gifts, particularly gifts, for capital, reflects the results achieved under the Harvard Campaign. In addition to gifts for capital, endowment was increased by the addition of $14.7 million from the stabilization reserves referred to above, together with an additional $11.2 million which represents the net effect of several capitalization and decapitalization activities. At year end, the market value of the University's endowment was $1,622.7 million, an increase of 8.8%. The general investment portfolio was invested approximately 62.0% in equities and related instruments and approximately 38.0% in cash and fixed-income securities.