How can this be enough to fund a scholarship in perpetuity?

Question

I am trying to understand how funding for scholarhips works. I received this email recently:

Some of you, and your colleagues, knew X, a long-time member of our Unit, who died recently. We have established a scholarship in her honour, seeking to support [something]. The Department at the University has funded this to the value of $10000.

We have also launched an appeal seeking to fund the scholarship in perpetuity. To do this, we need to raise an additional $20K. I would be grateful if you circulate the notice about the appeal, listed below, to your colleagues.

Presumably the scholarship is awarded annually. If so, how can $30000 be enough to keep it funded forever? Is the idea that the 30000 is kept in a bank and the scholarship is paid out of the interest? What happens then if the interest rate drops to zero?

Answer 1

The Trinity study looked at 'safe' withdrawal rates from retirement portfolios. They found it was safe to withdraw 4% of a portfolio consisting of stocks and bonds. I cannot immediately find exactly what specific investment allocations they used, but note that they found a portfolio consisting largely of stocks would allow for the withdrawal of 3% - 4% and still keep up with inflation.

In this case, if you are able to fund $30,000, the study claims it would be safe to withdraw $900 - $1200 a year (that is, pay out as scholarships) while allowing the scholarship to grow sufficiently to cover inflation, and that this should work in perpetuity.

My guess is that they invest such scholarship funds in a fairly aggressive portfolio. Most likely, they choose something along these lines: 70 - 80% stocks and 20 - 30% bonds. This is probably more risky than you'd want to take, but should give higher returns than a more conservative portfolio of perhaps 50 - 60% stocks, 40 - 50% bonds, over the long term. Just a regular, interest-bearing savings account isn't going to be enough. They almost never even keep up with inflation.

Yes, if the stock market or the bond market takes a hit, the investment will suffer. But over the long term, it should more than recover the lost capital. Such scholarships care far more about the very long term and can weather a few years of bad returns.

This is roughly similar to retirement planning. If you expect to be retired for, say, 10 years, you won't worry too much about pulling out your retirement funds. But it's quite possible to retire early (say, at 40) and plan for an infinite retirement. You just need a lot more money to do so. $3 million, invested appropriately, should allow you to pull out approximately $90,000 a year (adjusted upward for inflation) forever. I leave the specifics of how to come up with $3 million as an exercise for the reader. :)

As an aside, there's a Memorial and Traffic Safety Fund which (kindly and gently) solicited a $10,000 donation after my wife was killed in a motor vehicle accident. That would have provided annual donations in her name, in perpetuity. This shows you don't need $30,000 to set up a scholarship or a fund. I chose to go another way, but it was an option I seriously considered.

Edit: The Trinity study actually only looked at a 30 year withdrawal period. So long as the investment wasn't exhausted within 30 years, it was considered a success. The Trinity study has also been criticised when it comes to retirement. Nevertheless, there's some withdrawal rate at which point your investment is expected to last forever. It just may be slightly smaller than 3-4% per year.

Answer 2

Some historical and mathematical insights as a complement to existing answers.

History. I found it astonishing that already in Ancient Roman they investigated the issue of perpetuity of 30'000 (almost).

Columella writes in De re rustica (3, 3, 7–11.) in 1-st century AD about a perpetuity of 32480 sesterces principal under 6% p.a. resulting in 1950 sesterces annual payment.

And if the husbandman would enter this amount as a debt against his vineyards just as a moneylender does with a debtor, so that the owner may realize the aforementioned six per cent. interest on that total as a perpetual annuity, he should take in 1950 sesterces every year.
By this reckoning the return on seven iugerum, even according to the opinion of Graecinus, exceeds the interest on 32'480 sesterces.

Math. If we fix a scholarship at 1'000 a year, then it's clear that it could be paid out infinitely if we could achieve 3.33% p.a. on it. On the other side, with 0% we'll spend out the endowment in 30 years. Thus, having the interest rate between 0% and 3.33% p.a. we could vary the life of endowment between 30 years and infinity.

Just a few numbers in between: under 1%, it would be ~36 years, under 2% ~46 years, under 3% ~78 years (however, 1000$ in 78 years could be less than 10$ today).

Conclusion: to keep it perpetual either the fund's yield must be at the level of scholarship, or re-adjust the amount of scholarship depending on fund achievement, or redefine the notion of perpetuity (like 50 years is approximately infinite for our purpose).

Answer 3

What's the value of the scholarship, and is it administered by itself or by the university? If by itself, the financial return discussed above drives. If by the university, they create the tuition, so it gets more interesting.

If this is something that is administered and backstopped by the university, then keep in mind that while it may be named the "John Doe Memorial Scholarship" with $30000 in it's account under the endowment, the university overall is likely to cut some number of students' tuition in financial aid packages anyway. Let's say they substitute a generic tuition adjustment in past years with this happens-to-be-named "John Doe Memorial Scholarship" moving forward: the university can do this as long as they are not constrained in pricing power by laws and financial aid customs. There's the finance answer, and there's the fact that a university can create a "coupon" indefinitely (Similar in concept to the price discrimination where Proctor and Gamble can launch a new flavor of Tide at a high price to maintain the market position, and flood marketing channels with coupons)

Also the university might find it to be an inexpensive benefit to the faculty to create a ceremony around a valued, deceased professor; collecting funds from other professors or staff to partially pay for it at finance price or even a slight loss.