John Harvard's Journal
During recent years, when returns on endowment assets have been much stronger than the ﬁnancial markets in general, the performance-based pay system used by Harvard Management Company (HMC) to compensate its investment professionals has annually produced a few outsized paychecks (see “Outperformance Pays,” March-April 2003, page 58). But the $17.5-million peak realized by one investment manager for ﬁscal year 2002 paled in comparison to the $35.1 million and $34.1 million earnings for the top two HMC staff members in ﬁscal year 2003, ended last June 30. The data, released January 22, attracted more than routine attention, and prompted unusual responses from University offcials.
During ﬁscal year 2003, the foreign ﬁxed-income portfolio returned 52.4 percent, versus 18 percent for the market benchmark; manager Maurice Samuels received $35.1 million in total compensation. David R. Mittelman’s domestic ﬁxed-income portfolio earned 31.1 percent, 13.8 percentage points more than its benchmark; he earned $34.1 million. (Mittleman was the top earner the prior year, when Samuels ranked third. A Barron’s proﬁle published February 2 called the duo “two of the best ﬁxed-income managers in the business.”) Other members of the foreign and domestic ﬁxed-income teams, Elizabeth A. Randall and Shawn Martin, received $7.6 million and $6.5 million, respectively. Jeffrey B. Larson, who oversees foreign-equity and emerging-markets investments, earned $17.3 million, slightly less than in the prior year, when he was the second most highly compensated HMC manager.
According to University data, Samuels and Mittleman directed investments that during the year yielded Harvard more than $700 million in “value added” (returns in excess of the market benchmarks). The return on assets overall was 12.5 percent, raising the value of the endowment to a record $19.3 billion. That performance more than tripled the median return on comparable institutions’ investments, and exceeded the market benchmarks used to measure HMC results by 4.2 percentage points—some $800 million (see “Rebounding Returns,”
November-December 2003, page 59). In releasing the compensation ﬁgures, HMC president Jack R. Meyer reported that for the ﬁve years from 1999 through 2003, the ﬁve investment managers’ portfolios have generated $2.5 billion in above-market returns for the endowment. That sum approaches the $2.65 billion raised by the University Campaign from 1994 to 1999.
Large as those returns are, “Not surprisingly, these compensation ﬁgures have attracted signiﬁcant attention and comment,” as University Treasurer and chairman of the HMC board D. Ronald Daniel put it in a letter made available to alumni on the same day as Meyer’s news release. Arguing the case that HMC’s current pay system stimulates superior investment results at “an overall cost considerably lower than the expense that would be entailed…through external hedge fund management” yielding equivalent returns, Daniel acknowledged the potential for occasional bonus ﬁgures of “extraordinary magnitude.”
HMC portfolio managers, the letter explained, earn base salaries of less than $400,000; a “neutral bonus” of about $100,000 for meeting their benchmarks; and, thereafter, an incentive bonus, positive or negative, for performance relative to the benchmarks. The latter part of the formula, which produces “extraordinary earnings” linked to “extraordinary performance relative to benchmarks,” also makes bonus sums contingent—subject to “clawback” in case of future underperformance. Meyer, in an interview, ampliﬁed that bonuses are a percentage of value-added performance, varying by portfolio and weighted by each manager’s contribution to the results.
In an interview, Daniel said that bonuses at the current level were never contemplated when the compensation formula was set up in 1990-1991. “We never expected this level of exceptional [investment] performance,” he said. “As the economists say, it should revert to the mean,” he continued. “For Harvard’s sake, we hope it doesn’t.”
Meanwhile, “We’re aware that it creates an awkward situation for the University,” Daniel said of the resulting paydays. “We’re not immune to the fact that it’s upsetting to some signiﬁcant number of people.”
The compensation system has “served the University well when viewed from a ﬁnancial perspective,” the letter noted, so the HMC board, “believing in [its] merits,” appears unlikely to alter it. But the board “has taken the opportunity to reexamine the current compensation system” (during meetings in September and December, according to Meyer, which delayed the release of the compensation data beyond the normal date in late November). Within the prevailing system, Daniel wrote, the board “expects to institute changes that would constrain the maximum annual compensation of individual managers.” When interviewed, he described speciﬁc changes as a work in progress, to be determined in future HMC board meetings.
Another perspective was tendered by a group of alumni. In a letter e-mailed to President (and HMC board member) Lawrence H. Summers dated November 25, William A. Strauss ’69, M.P.P.-J.D. ’73, and six of his College classmates, contemplating their thirty-ﬁfth reunion gift, took note of the $100 million (plus) paid to the most highly compensated HMC personnel in ﬁscal years 2001 and 2002—years when the endowment outperformed the market, but declined in absolute value. That became the point of departure for a sweeping overview of University aims and ﬁnances, far beyond occasional past criticisms about HMC pay.
While saluting the strength of HMC’s investment performance over time, the correspondents wrote, “If Harvard can afford to pay over $50 million per year to a small number of ﬁnancial managers, and if it does so because the endowment has recently experienced excellent growth, it is clear that Harvard can afford to reduce more than $50 million per year from the ever-increasing cost burden on current students and debt burdens on recent graduates.”
Comparing HMC’s reported senior compensation for those two years to other metrics (“half of the annual tuition and living expenses paid by all students at the College,” for example), the correspondents called the investment pay packages “inappropriate, indefensible, and corrosive to the values of the University.” The compensation system, they wrote, offered an “unwelcome object lesson for the current generation of students” and could only be the result of “a market distortion, especially in a university context.” They called on the University to freeze tuition, eliminate the loan component of ﬁnancial aid, and forgive loan balances for graduates empliyed in public serverice or the arts, at an aggregate cost equal to the compensation of senior HMC professionals. Further, the advocated higher distributions from the endowment to begin reversing the growth in the cost of attending elite schools in recent decades.
Thereafter, the group forwarded its letter to news outlets, including the Boston Globe and the Crimson. Steve Bailey, AMP '94, a Globe business columnist, then interviewed Jack Meyer and was able to calculate, based on published endowment results for fiscal year 2003, that compensation for the most successful portfolio managers would be as much as $30 million to $40 million—news that broke on the front page of the paper on December 11. HMC's January 22 release validated those estimates.
On the same day, vice president for government, community, and public affairs Alan J. Stone sent a letter to Srauss. Writing at the request of President Summers, he acknowledged the November correspondence; shared the correspondents' "commitment to need-blind admissions and need-based aid for Harvard's graduates"; linked strong endowment returns to the University's ability to sustain financial aid and reduce College graduate's debt; and referred to Treasurer Daniel's simultaneous letter on all matters pertaining to compensation at HMC.
In a subsequent interview, Strauss—a cofounder and director of the Capitol Steps, the political satire group, who has also been coauthor of several books on issues confronting the current generation–took strong exception to those responses. "No one should require a $35-million bonus to give his best efforts to Harvard," he said.
The larger point, Strauss maintained, is that "Harvard presents itself as a philanthropy." Payments of $107.5 million for fiscal year 2003 (the five portfolio managers' compensation, plus Meyer's $6.9 million) equal about 4 percent of total University spending, he pointed out, and about one-eight of the sum distributed from the endowment to support all academic operations.
Restating arguments his group had raised before, he said the compensation system “is not a good example for Harvard students.” Alluding to the correspondents’ views of motivation and employee incentives, he renewed their suggestion From the pages of the Harvard Alumni Bulletin and Harvard Magazine that no employee earn more than the University’s president (about $450,000, plus beneﬁts). In their November 25 letter, the class of 1969 members wrote, “We reject any suggestion that this limit on ﬁnancial manager pay would in any way jeopardize the future performance of the endowment Even if that were true, which we seriously doubt, we believe the that the actions we recommend will advance the interests of the Harvard community far more than any additional increment in a University wealth that , by any measure, is already very ample.
Accordingly, in the wake of the January 22 disclosure and letters from Harvard officials, Strauss and the other correspondents reiterated their call for a community forum on investment manager compensation.
There, for the moment, the matter rests. The University essentially stands by HMC's compensation system for investment professionals. If their performance holds up, the endowment will grow further during the current fiscal year, and significant paychecks will ensue: Meyer's news release disclosed that bonus payments carried forward into 2004 for himself and the five highest-earning professionals last year total $44.8 million—subject to "clawback" if returns trail the relevant portfolio benchmarks. And because HMC is required to disclose certain compensation data annually, those payments, if earned, will be reported next Thanksgiving. Were HMC spun off, disclosures would not have to be made, but Harvard would pay a heavy price, Meyer maintains. Based on experience with externally managed portions of the endowment and the investment fees charged by hedge funds whose strategies most closely approach HMC’s internal funds, he said, “Fees will go up, returns will go down, and we will underperform our peers, because of our size.” The current system, which he introduced when he became HMC’s president, has proven itself in economic terms. The resulting release of managers’ pay to comply with tax-reporting requirements “is certainly our least favorite time of the year.” Daniel’s letter noted that “Other universities, which rely on external investment managers…do not face comparable scrutiny.” Strauss said that if other universities are paying comparable fees to external money managers, their alumni ought to object.
Indeed, the discussion begun at Harvard may resonate. Leading institutions from MIT to Stanford to Yale have implemented cuts in staffing and expenses, or announced their intent to do so. Harvard had been buffered, in part because of relatively strong returns on the endowment. But even here, as the University has noted, absolute returns were negative in ﬁscal years 2001 and 2002, so the recent gains have recouped only part of the loss in the endowment’s actual purchasing power since 2000.
As a result, belts are being tightened in Cambridge and Boston, too. Harvard College Library has been reducing staff. The central administration has set a goal of level or reduced administrative expenses in the year beginning July 1 (see “Barer-Bones Budgets,” November-December 2003, page 58). Harvard Business School intends no increase “for spending on campus operations,” according to the most recent annual letter from chief ﬁnancial o∞cer Richard P. Melnick. Given surging employee beneﬁts and building costs, those budgets suggest reductions in the work force.
Thus, in a very real sense, the issues buffeting the larger society since the economy cooled at the end of the twentieth century—concerns over jobs and the distribution of economic rewards—have found an echo at twenty-ﬁrst-century Harvard.