I am pleased to report that the University of Michigan remains in excellent financial health. This year’s positive financial performance is heartening even though it was due, in part, to successful cost cutting and reduced programming in the University’s general fund to absorb continued reductions in base state appropriations. In addition, our long-term investment strategy and The Michigan Difference fundraising campaign are providing the wherewithal to make important investments in the facilities, programs, and people necessary to maintain academic excellence and define what it means to be one of the truly great public research universities in the world.
As a testament to our outstanding fiscal stewardship, Standard & Poor’s upgraded the University to its highest credit rating (AAA) this past year even as we continued to face a challenging state economy. Receiving this upgrade and continuing to maintain Moody’s Investors Services highest credit rating (Aaa) are important indicators of the University’s strong financial health and outlook. In fact, the University is one of only three public universities in the country to maintain these highest possible ratings.
In summary, the University’s total net assets (assets less liabilities) grew by $1.1 billion this year to $8.8 billion. This increase is a result of many factors including: rewarding capital markets, which added $642 million to the endowment net of distributions for operations; generous donations of $197 million for capital and endowment purposes; the Hospitals and Health Centers achieving a positive operating margin, which resulted in a $71 million surplus for reinvestment in physical plant; as well as successful cost-containment activities and higher than expected investment income on working capital and gifts for operations. I will discuss these and other important contributors to the University’s overall financial health in the following sections to provide context to the accompanying financial statements.
The University’s base state appropriations declined again in FY 2005, setting a new precedent for a total decrease of $49 million, or 12 percent, over the last two years. While the University has historically adhered to a tight linkage between the growth in state support and our ability to restrain tuition growth, as noted in the chart at the right, we broke that relationship in fiscal years 2004 and 2005 by significantly restraining tuition increases in hopes that the state funding picture would improve. Although the University’s base state appropriations decreased 10 percent in FY 2004 and another 2 percent in FY 2005, the corresponding increase in tuition rates for resident undergraduates was restrained at 6.5 percent and 2.8 percent, respectively.
To achieve this aggressive tuition restraint while also experiencing historic reductions in base state appropriations, the University successfully restructured its general fund budget and reduced the cost base by over $37 million in FY 2004 and another $20 million in FY 2005 through a wide variety of initiatives. However, this combination of diminished state support and restrained tuition increases cannot continue without jeopardizing the University’s ability to provide the high-quality education that people have come to expect from Michigan.
As we look ahead to another year of likely cuts in base state appropriations, the cumulative impact of these reductions puts the University at a crossroads which will define Michigan’s future strength. To preserve the quality of a Michigan education, the University’s budget for FY 2006 includes a 12.3 percent tuition increase for resident undergraduates and a 6 percent increase for nonresident undergraduates on the Ann Arbor campus, with an 11.9 percent tuition increase for the Dearborn and Flint campuses. Even with this increase, the University’s tuition increases over the last five years are among the lowest in the Big Ten and in the state of Michigan. At the same time, we recognize the need to make education accessible and the University significantly increased centrally budgeted financial aid by 28 percent in the FY 2006 budget to preserve access for our most vulnerable students. The University’s commitment to an affordable education is evident in our continued pledge to cover the demonstrated financial need of all of our resident undergraduate students.
Although the last three years demonstrate a clear trend away from dependence on the state appropriation, state support remains a cornerstone of the University’s strength. The current level of state support received by the University equates to the revenue stream which would be generated from an additional endowment of approximately $7 billion.
The University realized meaningful growth in its endowment primarily as a result of generous donations and strong investment performance, which generated a return of 19 percent in FY 2005. This investment return is consistent with the aim of the University’s long-term diversified investment strategy to generate a level of return sufficient to provide dependable support for operations, while at the same time protect and grow the corpus in real terms. The University’s endowment spending rule smooths the impact of volatile capital markets by providing for annual distributions of 5 percent of the average three-year market value of the endowment. This spending rule, along with the growth of the endowment, allowed for distributions to support operations of $168 million in FY 2005, for a total of $762 million over the past five years.
The table below shows the endowment’s investment performance and results of the long-term strategy which has produced both extraordinary returns in the good years and limited the loss of capital in the more challenging years.
| INVESTMENT PERFORMANCE | Return for twelve-month period ended June 30, 2005 | Annualized three-year return | Annualized five-year return |
| Long-Term Porfolio | 19.1% | 14.9% | 6.5% |
| U-M’s Benchmark | 14.1% | 10.6% | 2.8% |
| S&P 500/Lehman Aggregate Bond Index (80/20 ratio) | 6.5% | 8.0% | -0.2% |
The 19 percent return in FY 2005 follows a 21 percent return in FY 2004 and is again high by historical standards. The University’s 6.5 percent annualized five-year return, while well above benchmarks designed to reflect the endowment’s diversified investment strategy, clearly reflects the volatility of capital markets over time. It also reflects the difficult challenge of maintaining the 5 percent spending rule for endowment distributions in support of operations while still protecting the corpus in real terms. Over the same five-year period, the return of the broad equity market was a negative 2.4 percent, as measured by the S&P 500 stock index.
The Health System, which integrates the Hospitals and Health Centers, Medical School, and M-CARE (the University’s HMO) under the direction of the Executive Vice President for Medical Affairs Dr. Robert Kelch, had an excellent year financially and continues to receive national recognition for its academic and clinical excellence.
I reported last year that in FY 2004 the Hospitals and Health Centers exceeded its 3 percent operating margin budget target ($35 million), resulting in the best operating results in over five years. The approved budget and business plan for FY 2005 aimed higher with a 4 percent operating margin ($52 million). I am pleased to now be able to report that the Hospitals and Health Centers exceeded the $52 million operating margin target by $19 million and achieved a 5 percent operating margin on $1.3 billion in revenues in FY 2005. The operating margin funds will be devoted to critical facilities and programs that will enhance patient care, research, and education as outlined in the ten-year strategic capital investment plan for the Hospitals and Health Centers. Even with the challenging healthcare environment, the Hospitals and Health Centers will again be targeting a 4 percent operating margin on budgeted revenues of $1.4 billion for FY 2006 to be achieved by continuing to attract more patients, contain costs, and focus on quality and patient safety.
The many honors and awards received by the Health System this past year are detailed on the U-M Health System page in the Highlights section of this site.
Revenue diversification has long been an important strategy for U-M to achieve financial stability in the face of unpredictable economic cycles—in the 1960s almost 80 percent of the University’s general fund revenues came from state appropriations, compared to the projected 26 percent in the FY 2006 general fund budget. The current mix of revenues can be seen on the chart below, which shows the FY 2005 operating revenue sources with and without the Health System and other clinical activities.
Significant cost pressures continue in a variety of areas, including the competition to attract and retain the University’s world-class faculty, increases in health benefit costs for current and retired employees, higher energy prices, and increased costs of new regulations and information technology security. Over the past year, the University benefited from many successful cost-containment efforts that were crucial to offsetting these growing pressures and meeting the budget needs of the University.
Effectively leveraging web technology throughout the University was a cornerstone of our FY 2005 cost-containment efforts. Today students, prospective students, faculty, staff, retirees, parents, and donors can do business with the University via web technology 24 hours a day, in a manner that is more convenient, accurate, and easier to use, and which results in significant savings to the University.
Our cost-containment accomplishments over the last year also included major changes to health benefit programs. The University completed a restructuring of employee and employer premium-sharing in our health insurance offerings in January 2005, based on recommendations from a University-wide committee, resulting in annualized savings of $19 million. As important, through a variety of cost-control efforts, plan design changes, and employee incentive programs, the total medical and prescription drug benefit rates increased less than 5 percent in 2005, compared to a national trend of 12 to 14 percent for a similar portfolio of health plans.
Several ongoing cost-containment programs in the procurement area continue to generate significant savings. Our strategic procurement program provides faster service at lower transaction costs and lower unit pricing through master contracts with our largest commodity suppliers for services ranging from office and medical supplies, to temporary labor services, to DNA for research. The University achieved over $10 million in reduced supply costs in FY 2005 through the use of pre-negotiated managed contracts for high-volume commodities. Our regular competitive bidding process for all items not included in strategic procurement contracts yielded over $13 million in reduced expenses in FY 2005 compared to the previous year for the same goods and services.
In addition, we again took advantage of the favorable interest rate environment by refinancing callable fixed-rate debt, saving $5 million for the general fund and housing operations over the next 13 years.
By focusing on a wide range of operational opportunities, the University not only saves money, but we also continue to instill a business-like atmosphere across campus resulting in new ideas and opportunities each year.
This year, we completed a new comprehensive master plan for the Health System and updated master plans for the central, north, and south campuses to integrate emerging academic, clinical, and residential life initiative priorities into the overall framework for future development. In addition, President Coleman’s task force on integrating student residential and academic life is providing guidance for major renovations and enhancements within many of the 19 residence halls, which currently range in age from 40 to 90 years old, as well as enhanced dining facilities and additional housing for undergraduates to meet current demand.
The University continues to expand its state-of-the-art clinical, teaching, and research facilities to meet growing academic, research, and clinical needs. For example, the Cardiovascular Center project, under construction adjacent to the hospitals, addresses the need for the focused treatment of cardiovascular disease which is the number one cause of death in the United States. Construction also continues on the Biomedical Science Research Building which will accommodate interdisciplinary research projects linking engineering and medicine. The Undergraduate Science Building and the Computer Science and Engineering Building will create exciting learning spaces for excellence in the education of undergraduate and graduate students.
Several major projects which are just underway or in planning are discussed later in this report including the Charles R. Walgreen, Jr. Drama Center, which will house the Arthur Miller Theatre; the C.S. Mott Children’s Hospital and Women’s Hospital Replacement Project; and the Stephen M. Ross School of Business Facilities Enhancement Project.
Investing meaningful amounts in the existing physical infrastructure, regardless of the economic environment, is one of our core financial principles. This practice leads to a manageable deferred-maintenance program and helps avoid major system failures. Over the last decade, U-M has invested an average of $271 million per year for renovation and replacement of buildings and related infrastructure. This year was no exception as the University completed more than 390 projects across campus, an investment of more than $360 million.
Even before the national spotlight was turned on corporate financial scandals, the University began an effort to ensure that all employees are aware of their role in the fiscal well-being of the University. Building on our efforts to more clearly define financial and stewardship responsibilities, we also began implementing recommendations from our comprehensive study of Sarbanes-Oxley Act best practices with respect to internal controls, financial integrity and transparency, and business ethics. So far, these efforts have generated a revised comprehensive charter for the Regents’ Finance, Audit and Investment Committee, new financial policies and increased disclosure for conflict of interest, and the initiation of a comprehensive internal control review process in conjunction with the Office of University Audits.
The continued financial health and resilience of the University is due in large part to the University’s 31,000 dedicated and innovative faculty and staff, who have kept their focus on the University’s core missions and continued to build on U-M’s strong foundation and long tradition of excellence, regardless of the challenges facing them.
Once again, it is satisfying to receive an unqualified opinion from the University’s external financial auditors (PDF). This opinion, signifies that the financial statements present fairly the financial position of the University. The Management Responsibility for Financial Statements section (PDF) is my certification of management’s responsibility for the preparation, integrity, and fair presentation of the University’s financial statements.
With this letter as a backdrop, I want to encourage you to read Management’s Discussion and Analysis (PDF.) It tells a story of financial strength, prudent financial policy, and the ability to sustain the highest level of excellence in continuing to fulfill the University’s mission for many decades to come.
Timothy P. Slottow
Executive Vice President and
Chief Financial Office