This week Commonfund released the 2017 update to the Higher Education Price Index® (HEPI). It includes three important changes that investors should take note of:
The 2017 HEPI inflation rate was 3.7 percent – the highest increase since 2008 (5.0 percent)
Seven of the eight HEPI components showed positive increases, with just Supplies and Materials registering a slight decrease of 0.5 percent as compared to the prior year.
Fringe Benefits increased 5.9 percent, the most since before the Great Financial Crisis.
The other big increase was in Utilities, reflecting higher energy costs since the sub-$30 per barrel low in the price of crude oil in February 2016. This measure is by far the most volatile component of HEPI and thus carries a smaller weighting in the total calculation.
Conversely, Fringe Benefits is one of the more stable components, as can be seen in the chart below showing the annual rate of change for each of the last five years for each component.
Notably, Fringe Benefits seem to follow a cycle, with the last few years representing a new upswing after a down period following the Great Financial Crisis.
An important difference between HEPI and CPI is that HEPI captures changes in costs whereas CPI captures changes in prices. In this case, Fringe Benefits represent costs to the institutions that are increasing overall. For example, health care costs have increased dramatically in recent years, due to a combination of higher prices and higher utilization of medical care. It is our belief that the underlying cause is an aging workforce at these institutions – a demographic shift that is also underway in society more broadly – which may become more evident in the coming quarters in a variety of broader employment cost statistics.
Costs for Higher Education are Accelerating Higher
With salary costs representing more than 70 percent of HEPI and benefits costs accounting for an additional 13 percent, the movement in these two components will be key factors in setting the overall direction of educational costs in the future. Faculty salary increases appear to be stabilizing around 2.5 percent, while administrative and clerical salaries are accelerating at closer to 3.0 percent. In both cases these readings are running slightly above consumer inflation. However, the further acceleration in Fringe Benefit costs from an already high 4.1 percent in 2016 to 5.9 percent in 2017 is significant. This could place additional strains on educational budgets at a time when many institutions could be hit with adverse consequences from the pending tax law changes. The HEPI data may also be an early sign that labor costs are beginning to accelerate in the economy.
Implications for Boards and Investment Committees
We believe there are important implications for boards and investment committees at educational institutions, including:
Budget and strategy considerations – Faster rising costs impact long- and short-term plans and should factor into everything from acceptance rates to planned expenditures on the physical plant, and more. Changes in HEPI should be incorporated into strategic plans.
Higher return targets – In order to maintain purchasing power over time, portfolio return targets account for annual spending (typically in the five percent range) plus inflation. An annual operating cost increase of 3.7 percent raises annualized return needs from around seven percent to almost nine percent. This is non-trivial and may require many committees to revisit their investment policy and appetite for risk.
Spending levels – As we discussed in a recent post, spending policy is an important item to review regularly. In light of the rise in HEPI and the late stage of the business cycle, investment committees should revisit spending policy now.