President Hennessy addresses the state of the university and the economy

Good afternoon and welcome. It is good to see so many of you here today. This past year—particularly these past six months—has been extremely challenging for us all. At the same time, the university has made significant progress on a number of fronts.

Today, I will briefly review some of the accomplishments of the past year and then focus in detail on the university’s financial situation in the changed economic climate.

I know the state of the global economy is on everyone’s minds, so I have asked several colleagues to join me today to share their insights. After my remarks I will turn the podium over to John Shoven, who will moderate a panel that includes John Taylor, Darrell Duffie and Kathryn Hall. I hope the panel may be able to shed some light on how we got here, and more important, what is to come in the world’s financial markets.

Highlights of the Past Year

These past months it has become clear that this is a critical juncture in history. Turmoil in the global economy has disrupted the financial plans of nations, businesses, institutions and individuals. Every industry—from banking to manufacturing to higher education—has had to adjust to a new reality and reconsider future directions.

Although the economic crisis has forced us to rethink the university’s finances and significantly restructure the budget, I remain confident about the future. This is not the first test we have faced as an institution.

Stanford University has survived and thrived two major earthquakes, a crisis over academic freedom, the Great Depression—which prompted the trustees to increase enrollment by admitting more women—the protests of the 1960s, severe reductions in federal research support, world oil shortages, double-digit inflation, and a merger and an acquisition.

Through repeated trials, we have become stronger while holding true to our values. And we have learned that times of challenge can also be times of opportunity.

I realize that it has been a very difficult six months, and it is likely that our budget challenges will continue for a while. But in times such as these, it is important not to lose sight of why we are here, of the academic mission.

Education has the power to transform lives and to change the world for the better. And our research mission has never been more important to the future of our world and the people who inhabit it.

This fall there was an historic election in the United States. The number and scale of the problems our new president inherited are unprecedented. But in his February 24 speech to Congress, President Obama was clear: “The answers to our problems don’t lie beyond our reach. They exist in our laboratories and our universities; in our fields and our factories; in the imaginations of our entrepreneurs.”

We know that supporting our faculty and students is key to our continuing excellence. As Gerhard Casper explained in his address to the Academic Council more than a dozen years ago: “At a university, all of us are support staff—secretary or president, lab technician or provost, groundskeeper or dean—because all of us are here for only one reason: to support our faculty and students in their work of teaching, learning and research. It is an honorable and a vital role.”

Together, we have built an undergraduate program that is second to none. We see evidence of the excellence of the Stanford undergraduate experience each year, in how well our students do in competitions for prestigious fellowships and in what they choose to do with their talents. This year, for example, two Stanford seniors were awarded Marshall Scholarships, and a recent alumna was awarded a Rhodes Scholarship.

Stanford is also known for excellence outside of the classroom, a fact wonderfully demonstrated last summer. In the three weeks prior to the 2008 Olympics, members of the Stanford Symphony Orchestra, the Stanford Chamber Chorale, Stanford Taiko and the Stanford Choral Union traveled to China and gave 13 performances in a “Musical Journey to the Olympics,” which included a performance in the Great Hall of the People. Soon after, 48 members of the Stanford family—the largest number from any university—competed in the Beijing Olympics, winning eight gold medals, 13 silvers and four bronzes.

Given the volatile economy and our enhanced financial aid program for lower- and middle-income families, the Office of Undergraduate Admission was prepared for a slight increase in the number of applications this year, but the response was truly stunning. Twenty percent more students applied to Stanford this year than last year.

Because the pool was so large—an unprecedented 30,428 applicants—only 7.6 percent could be admitted, the lowest admit rate and most competitive year in Stanford’s history. As I discovered last week when I welcomed the prospective members of the Class of 2013 to campus, they are amazingly talented individuals with incredible enthusiasm and high ambitions.

Not unexpectedly, the economic situation has put a strain on some students’ families, and requests for financial aid have increased.

When Stanford expanded the program last year, eliminating both tuition and room and board charges for students from families with less than $60,000 in annual income and eliminating tuition charges for students from families making less than $100,000, the provost and I realized that it was an ambitious new plan, designed to eliminate any doubts about affordability for lower- and middle-income families.

Of course, we designed the new program under very different financial circumstances, and we now face challenges in funding it. But, we should be steadfast in our commitment to this program, especially when so many Stanford families are facing personal financial challenges.

Our graduate students are also increasingly vulnerable. Although it is likely that the federal stimulus package will provide some short-term increase in research funding, the long-term funding situation for at least some disciplines, as well as interdisciplinary work, is likely to remain challenging. The Stanford Interdisciplinary Graduate Fellowship program was designed to provide support for outstanding multidisciplinary scholars, and continued progress on raising endowment for these fellowships, as well as fellowships in the individual schools, will be critical to enhancing our graduate student funding.

While we focus on building new endowment to support graduate fellowships in the long term, we also need to find ways to provide immediate support for today’s students.

The quality of our faculty, already extraordinary, continues to increase; they are leaders in innovation, scholarship and research across the broad set of disciplines represented at Stanford. This year five colleagues were elected to the National Academy of Engineering, five to the National Academy of Sciences, six to the American Philosophical Society and 12 to the American Academy of Arts and Sciences.

Although we are not big supporters of the U.S. News & World Report undergraduate ranking methodology, the rankings for graduate programs are more narrowly based on peer ratings, and until the next round of the National Academies reviews are released, the U.S. News rankings are one of the best approximations we have of excellence of our graduate programs. By that measure, Stanford has never been stronger.

All six of our schools that are ranked score in the top 10 and five of the six rank in the top three. Among the 11 ranked departments in the sciences, social sciences and humanities, all 11 are in the top five and seven are ranked or tied for first. This is an amazing accomplishment: No other university matches this combination of breadth and excellence.

Maintaining the quality of our faculty and positioning Stanford to be a leader in important new areas remain priorities. While our faculty recruiting will necessarily be somewhat limited in the next few years, we will not stand still; instead we must use the resources we have strategically and with a focus on excellence.

The Stanford Challenge: Ensuring Innovation in a Volatile Economy

We are now in the second half of The Stanford Challenge, and as I have traveled and visited with our alumni at Leading Matters events around the world, many have asked me about our ambitious course. Some have even asked if I regret having launched the campaign. While I certainly had hoped for a more cooperative economy, I do not regret pursuing this opportunity.

Although we must rethink how we can achieve our objectives, we remain committed to them. Advances in knowledge will be crucial to solving today’s problems, and educated and thoughtful leadership will be more important than ever. Who will address society’s complex challenges and produce tomorrow’s leaders, if not the research universities of the world?

This past year, our university-wide initiatives in human health, the environment and sustainability, and international affairs have made promising advances. The energy problem, a key part of our environmental initiative, is of enormous complexity and requires a long research horizon, making the university a perfect place to pursue solutions.

In January, we launched the Precourt Institute for Energy, thanks to the vision and generosity of alumnus Jay Precourt and his family, alumni Tom Steyer and Kat Taylor who have created the TomKat Center for Sustainable Energy, and other donors. Together with other recent energy research programs, such as the Global Climate and Energy Project, we will, in a period of about seven years, have multiplied the amount of research funding focused on the energy challenge by about a factor of 10.

We also have made significant progress in the area of stem cell technology, a key focus of our human health initiative. We have recruited one of the best set of faculty researchers in the world, and they have been very successful in obtaining funding—nearly $95 million—from the California Institute for Regenerative Medicine. Together with the new Lokey Building for Stem Cell Research and prospective improvements in federal funding, the potential for advances both in basic science and new therapies has never been brighter.

So how are we progressing on the fundraising goals of The Stanford Challenge?

The campaign is roughly halfway through its original five-year schedule, and we are closing in on the originally announced target. Much has changed, however, since we began in 2006.

First, while we expanded several major aspects of the campaign, we still have not met some of our important original goals. Second, the investment losses of the endowment and the increased demand for financial aid will require us to significantly expand our financial aid goals, just to stand still.

Thus, we will need to raise considerably more than our original goal to fulfill the needs we identified during the multiyear planning exercise that occurred before the campaign announcement.

While the last few years have been characterized by unprecedented success in development as well as remarkable gains in faculty and student excellence, the key question in this environment is: How can we continue to innovate, to drive discovery and to produce the next generation of leaders given the volatile economy?

As you know, in recent years Stanford has experienced remarkable growth in the endowment, thanks to the dedicated efforts of the Office of Development and the expertise of the Stanford Management Company. For the first time in the university’s history, investment income from the endowment became the largest source of revenue, at least for the current academic year. Unfortunately, that will not be true by next year, a point I will return to shortly.

Sponsored research is our second largest revenue source. Although sponsored research revenue has been nearly flat in the last few years, the combination of the stimulus package and a generally improved outlook for science funding hold some promise. For example, the SLAC National Accelerator Laboratory recently was awarded $68 million in stimulus money to fund research on the Linac Coherent Light Source and upgrade equipment and research facilities.

Tuition is our third major source of revenue, and a much more modest one. Given the economic climate, we will also need to keep tuition increases reasonable. As the provost reported to the Faculty Senate earlier this year, we have already seen an increase of $7 million in financial aid for next year, and we anticipate additional aid requests in 2010. And although we have generous and supportive alumni, as you might expect in this uncertain economy, expendable gifts and annual giving are likely to be down somewhat.

Building the endowment to be a major revenue source has long been a goal of the university. From Jane and Leland Stanford’s initial gift that established the endowment, it has grown to encompass about 6,000 individual gift funds. Invested together, they can provide a source of income independent of political vagaries, tuition increases or annual fundraising. Our investment portfolio is highly diversified.

In addition, we apply a smoothing formula to the endowment payout, thus reducing the volatility of the payout. Based on these steps, we thought we were well positioned to ride out normal fluctuations in the market. Indeed, as we progressed through last summer and it appeared that our endowment would be flat or very slightly down, we believed that our normal mechanisms would be adequate.

The situation, however, became radically worse as we entered the last three months of 2008. All assets—natural resources, real estate and private equity as well as public equities—experienced significant downturns in the last quarter of 2008; these losses continued in January and February of this year with a small recovery in March.

As the provost noted in an early communication to the campus community, we have been tracking endowment performance since 1964; 37 of those 45 years, it returned between 2 and 38 percent. In only eight years has the endowment produced a negative nominal return, and the lowest such downturn was -8 percent. Until the fall of 2008.

In the first few months of this fiscal year, we experienced an unprecedented 30 percent decline in the merged endowment pool. Although the economy may stabilize during the remainder of the fiscal year preventing further losses, we are projecting a total loss of 30 percent for the current fiscal year.

As the situation deteriorated in the late fall and early this year, the provost decided to seek a reduction in next year’s general funds budget of 15 percent, an amount we initially thought would be the maximum we would cut over two years. A 15 percent reduction requires deep cuts, and we know it will affect hundreds of dedicated employees, but we saw no alternative.

In addition to the role that the endowment and related investments play in supporting general funds, endowed funds are used across the university to support faculty salaries, financial aid for graduate and undergraduate students, and program expenses.

The endowment payout is set by the trustees every year at the February or April meeting. A tentative endowment payout is computed using the smoothing rule. But, the smoothing rule was never designed to deal with one-year downturns that are more than two standard deviations from the mean of the historical distributions.

If we were to set the endowment payout by blindly applying the smoothing rule, we would likely see more than five years of decreasing annual payouts and several additional years where the endowment would grow by less than inflation. This would lead to many years of successive budget cutting, continuing long after the economy had recovered.

As an additional perspective, consider what it would take for the endowment to recover to the peak value of mid-2008. We would need a 43 percent increase in the endowment from today’s reduced value, before accounting for inflation!

If we assume a 3 percent inflation rate—which is slightly less than our rate historically—an 8 percent return for the next five years and a 10 percent annual return after that, it will take more than 30 years for the endowment to recover to its peak value.

If we add the effect of incremental endowment gifts, starting at $150 million next year and increasing to $300 million three years later, it will take more than 15 years for it to return to the peak value. Although we believe that many of the reductions we are making will lower our operating costs, the endowment most likely will need to recover at least half of the value lost in the past year to adequately fund our teaching, research and financial aid programs.

This analysis makes it clear that we must reduce our draw on the endowment and realign expenses with the reduced value of the endowment as fast as possible.

Based on this, we proposed to the trustees to bring the endowment payout down faster than the smoothing formula would dictate. By decreasing the payout by 10 percent next fiscal year and 15 percent in FY 2011, we hope that the endowment payout will begin to recover in three to four years, versus more than five or six.

Of course, this will require additional sacrifices in the next few years, as payouts are aligned with the real value of the endowment.

Just as the reduction in general funds affected the schools and units in different ways, the reduction in endowment payout will also impact various parts of the university differentially. Some operating units that depend primarily on general funds will achieve almost all of their reductions for the coming academic year; in contrast, some academic units that rely heavily on endowment will likely see budget reductions for both next year and academic year 2010-2011.

Our success in fundraising has greatly added to the endowment in the last few years, and that complicates the payout issue.

Newer endowed funds have experienced a rapid decrease in value. As a result, hundreds of them are under water—that is, their current value is less than the value of the initial gift.

Due to legal restrictions as well as the value we place on the relationships with our donors, we have determined that we need their permission to spend portions of the initial corpus to maintain the funding for the program that the gift enabled. We are in the process of contacting our donors to seek such permission.

Lastly, the drop in the value of the merged endowment pool also affected our expendable funds, or the university’s cash. A commitment to protect these funds against investment losses has meant that the central reserve funds will be diminished by about $1 billion. This loss of reserves significantly reduces both general funds income and the discretionary funds available to the president.

This “perfect storm” has forced us to think differently about the university’s finances going forward. The loss of income will be felt over multiple years and have a significant impact on the way we do business, which is why the provost asked for your thoughts on ways to adjust the budget, utilize resources more efficiently and eliminate waste. Your response has been deeply gratifying. Throughout the university every unit set to work to help conserve our financial resources.

Earlier this year, hiring freezes were implemented for staff, faculty searches were cancelled or significantly reduced, and senior administrators voluntarily accepted salary reductions. Last month, we announced a salary freeze for staff and faculty for the coming fiscal year.

When we realized that layoffs would be unavoidable, we announced an enhanced severance plan for staff as well as enhancements to the Faculty Retirement Incentive Program. We are encouraging employees to take vacation in the year in which it is earned, and over the next few years, we are reducing the number of vacation hours that can accrue. In the next few years, we expect that both salary and benefits increases will need to be very modest.

Some of you have asked about ongoing construction. I can assure you that every capital project has been reviewed. We have delayed or canceled about $1.3 billion in projects. Halting ongoing projects in the middle of construction would waste money and be foolish. Likewise, we have an obligation to donors who have funded buildings to go forward as soon as we have identified all the needed funding. Ironically, we have found an inadvertent upside to the financial downturn: Construction costs have decreased substantially!

A related critical issue in this crisis has been the liquidity of the endowment.

Liquidity is a measure of how quickly an asset can be converted to cash without a significant discount in the price received for the asset. Assets such as publicly traded stocks and bonds are liquid, while assets such as holdings in a private held company or in real estate are considered illiquid.

Because a significant fraction of the endowment assets are in illiquid investments, endowment payout has had to be funded disproportionately by sales of liquid investments, primarily public equities. Such a concentrated sale further reduces liquidity and also distorts our asset allocation from its desired profile.

For these reasons, we raised $1 billion through a bond offering last week. As you may know, a number of our peers have pursued this course, including Harvard, Princeton, Duke, Vanderbilt and Notre Dame, raising in the range of $500 million to $1.5 billion each.

Fortunately, we do not have a pressing need to spend the proceeds of this debt, but we believe that the added liquidity will enhance the university’s financial stability and provide insurance against a need to raise funds at a time when the market might be less attractive.

As a measure of the strength of the university’s financial position, the demand for these bonds exceeded the size of the offering by seven times, and the average interest rate on a combination of five-, seven- and 10-year maturities was a low 4.27 percent—about 25 basis points better than our peers have achieved in other recent debt offerings. Of course, we will have to pay these funds back over the next decade, and for that reason, they will be held in a segregated account of highly liquid securities, unless a true emergency demands their use.

Concluding Remarks

Going forward, it is best to think about the process we are going through as a rebasing of our budget, rather than as a series of budget cuts that might be someday restored. A budget rebasing relies on the reduced value of the endowment and the resulting payout, yielding a budget with $300 million less than we received in this academic year.

In the years ahead, as the financial situation improves and our alumni and friends provide new gifts to the university, we will be able to increase the base budget and make strategic decisions about new opportunities and the best uses for the additional funds.

Last fall, our annual Reunion Homecoming Roundtable explored the question of leadership in the 21st century. At the close of the discussion, journalist and parent Tom Brokaw noted: “The best leaders that I have found have the ability to take the complexity of the world and get it focused on what you need to do. As a great leader, you have to make others great. You have to see that as your role. You have to be able to collaborate and connect … all of the folks here, all of the students coming out of Stanford, if they represent those characteristics of leadership … this world will be a better place.”

That remains our goal: to lead in research and to educate the next generation for leadership. I am confident that—through our collective efforts, talents and dedication—Stanford University will thrive and will remain a leader in this century and those ahead.

Thank you for your support, and thank you for your attention this afternoon.

Fortunately, some of our best and brightest people are economists. And given the continued severity of this global economic downturn, it seemed like a good idea to call upon them to discuss the issues.

Please join me in welcoming John Shoven, the Wallace R. Hawley Director of the Stanford Institute for Economic Policy Research, the Charles Schwab Professor of Economics and senior fellow, by courtesy, at the Hoover Institution. John will serve as moderator and will be joined by:

• John Taylor, the Mary and Robert Raymond Professor of Economics, senior fellow at the Hoover Institution and senior fellow, by courtesy, at the Stanford Institute for Economic Policy Research;
• Darrell Duffie, the Dean Witter Distinguished Professor in Finance and senior fellow, by courtesy, at the Stanford Institute for Economic Policy Research; and
• Kathryn Hall, MBA ’84, chief executive officer and chief investment officer, Hall Capital Partners.