The excellence achieved by the University of Virginia rests on the secure foundation of its endowment, which totaled $962 million as of June 30, 1997. The mandate for the University, and every endowed institution, in managing its endowment is to distribute its wealth equally to current and future generations, in perpetuity. The University must balance the needs of the current University community and provide growth in the underlying assets so that the endowment will provide the same level of support in inflation-adjusted dollars to the University in the future.

Balancing these two goals is not a simple task. The maximum amount that can be distributed from the endowment for current spending without adversely affecting future generations of students equals the rate of return on endowment investments less inflation. The problem, however, is that both investment returns and the inflation rate fluctuate, sometimes wildly. Adhering to a policy of adjusting endowment spending each year to equal the real, inflation-adjusted return on assets would create an unreliable stream of income. In this scenario, programs supported by the endowment would, when real returns were negative, receive no support.

So, while spending should equal the real, inflation- adjusted return on assets, this is a long-term target, and not a policy that can be used to set the rate each year. To protect the current generation of programs, the competing objective of providing a predicable and stable stream of income must be considered.

The finance committee of the Board of Visitors has determined that an investment mix of 75 percent stocks and 25 percent bonds strikes a good balance between the prospects for stability and growth. Capital market history suggests that, over the long-term, this mix will produce a real, inflation-adjusted average annual return between 4 and 5 percent. The spending policy set by the board adopts the notion that this long-term expected real return is the sustainable spending rate, and expects distributions from the endowment to fall between 4 and 5 percent of the previous year's ending market value. To provide predictability, the board has set the growth rate in distributions at 4 percent per year, but will consider making an adjustment if the spending rate produced by the 4 percent increase falls outside a range of 3.5 and 5.5 percent of the previous year's ending market value.

A second, slightly higher spending rate, targeted to fall within a 5.5 and 6.5 percent range, is also supported by the endowment. Endowment assets that are eligible for income supplements by the Commonwealth and those endowment assets that can be used, at least in part, to support faculty salary increases are considered "Class B" shares. While over the long term, the higher spending rate may result in a deterioration of the principal value in real terms, the board has taken into consideration the Commonwealth's contribution, which boosts returns significantly, and the need to raise faculty salaries.

Faculty Salary Initiative

This year, the Board of Visitors identified the endowment as one of the major sources of funding for the faculty salary initiative. In response to this initiative, more than $278 million, or 30 percent of endowment assets, became eligible to receive the higher "Class B" spending rate.

Supporting two spending rates for an endowment has always been inconsistent with the notion that there is a single, sustainable rate of spending. This inconsistency was easier to overlook prior to the faculty salary initiative, when only 15 percent of endowment assets qualified for what may be an unsustainable rate, than now, when nearly 45 percent of the endowment is eligible to receive the higher rate.

In supporting the higher spending rate, is the board satisfying the needs of the current generation at the expense of future generations? The answer is yes and no. The board has determined that 5 percent, over the long-term, is the maximum sustainable rate. Therefore, if the rate were to remain at six percent, then the growth in assets and distributions might not keep pace with inflation. However, over the shorter term, (twenty years being relatively short term in the life of the endowment), the real return on the endowment has in fact been closer to 9 percent, allowing for some flexibility.

The board determined this year that the need to raise faculty salaries was so important to the long-term health of the University that the higher spending rate for those assets eligible for this use was justified, and the risk of adversely impacting future generations tempered by the endowment's recent performance.

The board has not abandoned the view that, over the long term, the sustainable spending rate falls between 4 and 5 percent. Spending on endowment assets covered under this initiative will gradually be brought down to the lower, sustainable rate, not through decreases in distributions, but by keeping the increase in distributions to 4 percent per year.