Three Impacts of Proposed Tax Policy Changes for Endowments

What Is Happening to Tax Policies?

Recently — as part of a plan to extend the 2017 tax cuts — the US House of Representatives proposed significant increases to tax rates on large US university endowments.¹

For instance, private colleges and universities with at least 500 students and endowments exceeding $2 million per student would pay a much higher rate of 21% (up from 1.4%) on net investment income. Colleges with endowments below $2 million but more than $1.25 million per student would pay 14%, and those with endowments less than $1.25 million to $750,000 would pay 7%.

We need to wait to see whether the bill is modified or proceeds in its current form. But any shift could require endowments to rethink return expectations, risk tolerances, and liquidity needs to maximize after-tax returns.

Three Key Implications of Proposed Tax Changes

Based on our work with other tax-aware investors like insurance companies and high net worth investors, we see three potential implications to endowments’ asset allocation and investment strategy.

1. Lower Expected Returns Could Change Target Asset Allocations

The new taxes would take a sizable bite from the returns that drive annual spending and real return levels of long-term endowment portfolios. This may require staff and boards to adjust annual spending downward, accept lower real returns to endowment growth, or take on more risk to drive a higher return to achieve similar after-tax returns.

Because only the largest, most well-endowed organizations could handle a reduction in endowment, many institutions could move toward more growth-oriented assets — equities, credit, and alternatives like hedge funds, private equity, and private credit.

While alternatives might be out of favor in the short run given their reduced liquidity, they could be beneficial over the longer term as institutions adjust. Thoughtful use of active strategies such as stock selection or tactical asset allocation is another way endowments could seek incrementally higher returns.

2. Liquidity Could Be More Important to Cover Potential Near-term Gaps in Funding

At least in the short run, a sudden increase in the tax rate could exacerbate funding issues stemming from budget cuts related to federal government grant reductions. Institutions might be forced to respond by selling the more liquid segments of their portfolios. Or, if they can afford to — and can find buyers at the right price — they might sell the less illiquid parts. In fact, the Harvard and Yale endowments already have announced plans to sell portions of their private equity portfolio.²

3. Investments Will Need to Become Tax-aware, Including Explicit Tax-aware Strategies for Managing Capital Gains

Tax-efficient investments such as municipal bonds, and tax-efficient vehicles such as ETFs, would likely benefit under the proposed tax changes. All else equal, investment options that have lower turnover will be favored (e.g., lower turnover than active managers in equities and credit).

Illiquid alternatives like private equity and real estate defer capital gains and might also benefit, although their reduced liquidity might be negatively perceived in the short term. Lastly, more sophisticated tax-loss harvesting could include explicit tax-manager strategies that use derivatives or structured products to manage exposure without triggering gains.

Drawing Insights From Our Tax-aware Experience

Today’s technological platforms and data can support building tax awareness across a wide range of asset classes and investment styles. Our Systematic Equity Beta team relies heavily on optimization to manage tax considerations efficiently.

This “tax-loss harvesting” approach can be used to offset taxable capital gains either within the equity portfolio or from other investments such as private equity or hedge funds. Taking advantage of natural market volatility, portfolio managers regularly rebalance recognized tax losses from securities that have declined. Reducing taxes paid improves the after-tax return of the portfolio.

Harvesting losses can add value over the years as the tax savings compound. By deferring paying taxes now, the money stays invested and grows at the rate of the portfolio’s return. Since a typical tax-managed portfolio harvests losses and defers gains over the years, the net unrealized gains of the portfolio grow over time.

In the 30-plus years State Street Global Advisors has been managing tax-aware assets, we have helped clients with a wide range of challenges, including:

• Tax efficiently moving client portfolios from one benchmark to another.
• Presenting trade-off options between predicted tracking error and tax impact for cash redemptions.
• Tilting toward or away from factors such as dividend yield, while also managing risk and gains/losses.
• Targeting client directed gain/loss outcomes over various time periods.
• Implementing portfolio-specific restrictions and constraints, including avoiding stocks based on credit ratings, market cap, industry, etc.

Preparing for a New Tax Reality

As the policy landscape crystallizes, the tax implications for university endowments will come into greater focus. Importantly, tax-aware investing is not new — we’ve been implementing tax-loss harvesting techniques, and helping clients implement these techniques, since 1994.

Of course, this is just one dimension of a myriad of issues that endowments could face if tax policy changes. In addition to overall return expectations, spending adjustments, and liquidity concerns, new tax policy could impact how university endowments segment their asset allocation as part of the shift to tax-aware investing and could change the types of vehicles that are most appropriate.

We’ll continue to monitor the policy discourse as the situation evolves. To stay current, don’t miss our latest policy insights.