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.