2020-21 Operating Budget and Parameters

To: Members of the University Community
From: Steve McAllister
Subject: Financial Planning for the University's 2020-21 Operating Budget
Date: April 24, 2020

Executive Summary:

• While this crisis is different from others, W&L has a long history of managing through periods of uncertainty and financial challenge and emerging from each a stronger institution. We enter this period with the benefit of being as financially strong as at any point in our history and with the knowledge, that as an institution, our goal is to return to residential education of the highest quality as soon as is practical.

• The financial impact of COVID-19 is two-fold: the first is the loss of revenues in operations while still maintaining the infrastructure and cost structure that those revenues underwrite, and the second is the decline in investment markets, which impacts endowment payout and philanthropy, at least over the short to intermediate period.

• Revenues in the current year will be lower than previous projections by approximately $6.5 million. Revenue forecasts for 2020-21, assuming that students will be able to return to campus for the fall, will be 4% less than those budgeted in the current year and $12.5 million less than forecasts made just this past February for the 2020-21 year.

• Expense budgets will require adjusting. With compensation being the largest budgetary expense, actions that will need to be taken for 2020-21 include a salary freeze, reduction in the university's match on retirement contributions and heightened scrutiny of position replacements. W&L does not anticipate layoffs or furloughs of employees if students return to campus in the fall. Departmental budgets and the annual capital budget will also be reduced to reflect the lower revenue environment.

• The Trustee Reserve Fund, which was established in 2000 and served the university well through the Great Recession, will be tapped for over $16 million of support to underwrite operations through 2021-22.

• We should view this period as a temporary setback recognizing that the university has a strong Strategic Plan and confidence in the ability to have a very successful capital campaign that will continue to advance Washington and Lee as one of the premier small liberal arts universities in the nation.

Background and Analysis

I write today to share information on the planning process and factors that have been considered as we have developed the university's 2020-21 Operating Budget. Some of this material has been shared with you in my earlier correspondence about the financial impact of COVID-19 on the university. In this memo, I expand upon that earlier document to provide you with a more complete picture and context of the environment that W&L is navigating.

While I recognize that there continues to be uncertainty surrounding the timeframe for the university to resume operations at near-normal levels, I write with optimism that the university will move through this environment and emerge in a position to thrive and grow in its ability to serve students and provide the rich curricular and co-curricular offerings that make W&L one of the great liberal arts institutions in America. This optimism is grounded in three underlying tenets. First is the incredible history of the university. Over 271 years, W&L has witnessed and been subjected to many crises, many much worse than this one. If we have anything to learn from this history, it is that the university finds its way through each crisis and emerges a stronger institution. The resilience of the university should not be underestimated as we work our way through this pandemic. The second is that as an institution, we know who we are, and we are good at what we do. Our primary focus in the decisions made during the last six weeks has been how we navigate this environment on a temporary basis so that we can return to being a great residential university. All of our planning is focused on making it possible to return to residential education as soon as practical. The third is that our underlying financial condition entering this crisis was stronger than at any other time in the university's history. While the endowment has been impacted by significant market volatility, over the long term, it will recover and continue to provide the financial resource support that few schools in the country can rival.

But it cannot be dismissed that this crisis has had a financial impact on the university, and the budget has to adjust accordingly. Outlined below are the assumptions that have been used as we built out the budget for 2020-21. This budget has been reviewed and approved by the Finance Committee of the Board of Trustees. To be clear, it is built around an underlying assumption that students will be able to return to the campus in fall 2020. University leadership is keenly aware that this may not prove possible and has begun to consider other scenarios. If the duration of the public health crisis necessitates a different scenario, we will certainly face additional financial implications, and the budget will have to adjust. In such a circumstance, we will engage with the community to share the impact and ways that we will manage through it.

Impact of COVID-19 on the Current Year

Before providing an outline of the budget parameters for 2020-21, it is important that we be transparent about the financial impact of the health crisis on the current fiscal year. There are three areas where we believe we will experience material impact. The first, and most apparent, relates to the pro rata share of refunds that we provided students for their room and board plans. Those refunds totaled nearly $5.5 million, and while there is an offset for the reduction in the costs of inputs (most notably food costs in Dining Services), the effect is a loss of net revenues in excess of $4.5 million. The second area of impact is on giving. Unfortunately, significant financial contractions are often followed by a reduction in philanthropy over the short-term. With the lateness in the year, we predict the Annual Fund may fall short of the public goal by 5% to 10%. Finally, a number of enterprises will also reflect a decline in net revenues from the crisis. These include the University Store and Catering operations. While limited activity on campus and reductions in travel will reduce some expenses over the balance of the year, we anticipate that the university will experience a $7.6 million operating deficit for 2019-20. This deficit will be underwritten by the Trustee Reserve Fund, taking its balance down to $10.2 million as of June 30, 2020.

2020-21 Revenues

Under the assumption that students will be able to return in the fall, net tuition and fees are predicated on the following:

1. We will achieve our enrollment goals for 2020-21 with 467 entering first-year students and 120 entering 1L students;
2. There will be a reduction in the number of students who will participate in Study Abroad;
3. Retention will not be significantly impacted as a result of the public health crisis; and
4. The financial aid budget will grow by an additional $500,000 to address financial hardship concerns that emerge from the COVID-19 crisis.

These criteria are very similar to those that we anticipated and experienced following the 2008-09 financial crisis. We will be monitoring all of these assumptions over the summer months, but thus far, what information we do know is holding up relative to these assumptions. Overall net student fees are expected to grow 4.3% over the current year's budgeted level to $75.6 million. Unfortunately, this is the only area within the revenue budget for which we anticipate growth in 2020-21.

Investment income is impacted by an assumed 20% decline in W&L's internal endowment return over the last six months of the 2019-20 fiscal year. Equity indices were down more than 30% over their early year highs in the month of March, and as we have seen this week, extreme market volatility continues to be a challenge to investors, with no clear indication of whether the market has reached the trough or whether the trough is yet to be found. Returns in 2020-21 are assumed to be flat for much of next year, when we anticipate returns will begin to rebound. This assumption is based on the average length of a bear market following the Great Depression. With the legal requirement to preserve endowment corpus over time and for endowments to manage payout to preserve intergenerational equity, W&L has established and maintained for more than 25 years a payout policy that is structured to preserve these two important objectives. Following this long-established payout policy, the 5% payout policy cap will be utilized for 2020-21. This results in a predicted decline in endowment payout of $9.8 million from the level that we were anticipating for the 2020-21 year at the February Board meeting. This assumption will be examined regularly through the balance of this fiscal year as we move closer to the valuation of the endowment at June 30, which will dictate payout in 2020-21. Trusts Held by Others and short-term investment earnings are also negatively impacted, although the L.P. Evans distribution holds up reasonably well based on the Coca-Cola dividend that serves as the majority of the basis of that distribution. Overall, investment payout and distributions from trusts are expected to be $53.8 million in 2020-21, a drop of $7.8 million from the current year.

Annual Giving is expected to hold at expected current year results with no increases. The Annual Fund is assumed at slightly less than $9.9 million, while giving to support Student Aid holds steady at $1.6 million. It is worth noting that in 2008-09, we saw the Annual Fund decline by just 5% from its prior year result, and the fund fully recovered to a new record high in 2009-10. Our assumptions in the current year and beyond are more conservative, reflecting limited time to take proactive steps in the current year to "rally" the fund and the reality of the national headwinds that unrestricted annual giving has been experiencing in recent years.

With reductions in departmental operating budgets and weaker economic activity as a whole, auxiliary operations are diminished, with Catering, the University Store and the Copy Center each seeing reduced revenues from the 2019-20 budgeted levels. These activities are budgeted at just under $6 million in revenue, a drop of 7.3% from the current year budget.

Overall, we expect revenues to be down by $12.5 million from our projected levels in February and $5.75 million below the current year budget, a decline of nearly 4% year-over-year budgets. The following charts reflect the budgeted revenues for 2019-20 and 2020-21 for comparison purposes.

2020-21 Expenses

With such a decline in revenues, it is only natural that adjustments to the expense side have to be made. Unfortunately, with such a magnitude of change, we must examine and focus reduction efforts on our largest expense area: compensation. On this front, there is a three-prong approach to reducing growth. The first is a salary freeze for 2020-21. The second is heightened scrutiny of position replacements. For the purposes of the budget, we anticipate that 29 positions will not be replaced over the next two years. Six of these are faculty positions, with 12 administrative positions and 11 staff positions representing the balance. This is based on an attrition rate that is projected to be one-half the normal level, meaning that one out of every two positions that become open on the administrative and staff side are not likely to be replaced. It is important to note that staff and administrative employees who would normally be scheduled to work between June 1 and June 30 will continue to receive pay through this fiscal year. Assuming that students are able to return to campus in the fall, we do not anticipate layoffs or furloughs as a strategy for reducing costs. The third prong is the decision to reduce the maximum university retirement contribution match from 5% to 2.5% (the automatic 5% contribution for eligible employees will remain as is). The combination of these three elements translate to a reduction in compensation from the February model by $4.1 million. At $103.4 million, this is less than budgeted in 2019-20. While the actual severity of the downturn will need to factor into future budgets, under our current planning model, we are hopeful to restore the retirement contribution level to 10% and to provide salary increases no later than the 2022-23 year.

While we are working through the actual reductions in departmental budgets, we are targeting a minimum reduction of $1.369 million. This is an overall reduction of 4% from the 2019-20 budget levels with the largest reductions in areas that can be considered discretionary. About two-thirds of departmental operating budgets are rather fixed (utilities, property insurance, software licenses, etc.) at least in the short-to-intermediate-term, which limits the ability to make more meaningful reductions in this portion of the budget. With the planned targeted reductions, departmental budgets are estimated at $33 million for 2020-21.

The Annual Capital Projects budget has been adjusted to remove any capital projects that are enhancements while retaining all projects related to life cycle replacements or required maintenance. This allows the university to ensure that facilities and systems do not deteriorate in meaningful ways as a result of the financial challenge- a lesson learned from the response to the 2008-09 Great Recession. This has allowed for a reduction in the capital budget by $584,000, to $4.55 million.

Finally, we anticipate that we will experience a better rate on our variable rate debt for the foreseeable future. As a result, we have lowered the expected rate for that element of our debt payments in 2020-21. With this crisis, we believe that an opportunity for an advanced refunding may emerge when markets stabilize. We took advantage of a similar refunding opportunity earlier this year when we advance refunded the 2013 bonds, yielding over $6 million in present value savings over the remaining life of those bonds while generating annual interest savings of $463,000 per year. We will continue to monitor markets closely, and should we be able to take advantage of another such opportunity, we will do so. Even with the adjustment for variable rate debt interest costs, and factoring in the impact of the 2019 advance refunding savings, we anticipate our debt service to be $14.4 million in 2020-21.

Overall, we expect expenses to be down by $6.1 million from our projected levels in February and $2.37 million below the current year budget, a decline of 1.5% from 2019-20. The following charts reflect the budgeted expenses for 2019-20 and 2020-21 for comparison purposes. It is worth noting that even with the adjustments in compensation, it actually does grow modestly as a percentage of the overall budget.

As noted above in aggregate, this expenditure budget is $6.1 million less than planned in February. The delta between the reduction in revenues and reduction in expenses will need to be covered through a drawdown of the Trustee Reserve Fund. We anticipate a $7.14 million draw on the fund in 2020-21, taking its balance to $3.04 million as of June 30, 2021. Currently, we anticipate another draw of the Trustee Reserve Fund in 2021-22 to help us through this period. We expect to return to operating surpluses when operations return to a more normal cycle, and we will then begin to replenish the Trustee Reserve Fund so that we are well-positioned when the next financial crisis occurs.

Concluding Thoughts

I fully recognize that the university faces a challenging financial environment over the short-term. Some of the drivers of this can be directly tracked to the need to provide virtual instruction for a period of time while supporting an infrastructure of costs that has lost its underlying revenue source. Beyond this, we face the impact of a volatile investment market that will lower endowment payout and likely have an impact on philanthropy for some time. But I view these as relatively short-term impacts and ones that can be partially mitigated with a return to residential education at the university.

While each of us will need to make sacrifices over this period to help improve the budget situation and allow us to maintain our commitments to employees, I see a promising future. We will realize the advances that our strategic plan will bring to the university and execute a successful capital campaign that will strengthen the financial resources that allow W&L to provide an exceptional residential educational experience for our students. I look forward to communicating in the coming weeks as we understand better what the fall will allow, and I value the willingness of the community to face this crisis as a collective.