Report | Chief Financial Officer
I am pleased to report that the University of Michigan remains in excellent financial health. The continued financial health and resilience of U-M is due in large part to the University’s 32,000 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, even as we face significant challenges.
Our disciplined budget approach, which balances current and emerging operating needs with cost saving opportunities, together with our diverse revenue, long-term investment strategy, positive operating margins at the Hospitals and Health Centers, and The Michigan Difference fundraising campaign all contributed to another strong year. These fundamentals are providing the University 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.
In summary, the University’s total net assets (assets less liabilities) grew by $1.6 billion this year to $11.5 billion. This increase is a result of many factors including: rewarding capital markets, which added $1.2 billion to the endowment net of distributions for operations; generous donations of $160 million for capital and endowment purposes; a positive margin at the Hospitals and Health Centers resulting in a $62 million surplus for reinvestment in physical plant; a gain on the sale of M-CARE of $160 million; as well as successful cost-containment activities 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.
Revenue Diversification
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 24 percent in the FY 2008 general fund budget. The current mix of revenues can be seen on the chart below, which shows the FY 2007 operating revenue sources with and without the Health System and other clinical activities.
The General Fund Operating Budget Challenge
While the last five years demonstrate a clear trend away from dependence on the state appropriation, support from the State of Michigan remains a cornerstone of the University’s strength. To put it in perspective, it would take an additional endowment of approximately $7 billion to generate a revenue stream which would equate to the current level of state support received by the University.
After four years of declining base appropriations, the State approved a 3 percent increase for FY 2007. However, continued economic difficulties led the State to approve a mid-year rescission and deferral of base appropriations in FY 2007 of $40 million. Since FY 2002, the University’s base appropriations from the State have decreased $44 million, or 11 percent. In contrast, if our state appropriations had grown at the level of the Consumer Price Index, our base appropriations would have been $100 million higher in FY 2007.
As we look ahead, our general fund operating budget remains challenging. The State’s uncertain financial circumstances and the University’s commitment to academic excellence and access require a careful balance between fiscal discipline and the need to invest in our future. In adopting the budget for FY 2008, the University faced an unusual position of finalizing the budget without knowing the level of appropriation from the State. The approved budget for FY 2008 includes a moderate increase in tuition rates of 7.4 percent for both resident and nonresident undergraduates and a 5 percent increase for most graduate programs, along with an increased investment in centrally awarded financial aid for undergraduates of 11.5 percent to preserve access for our most vulnerable students. This budget is based on an assumption of little change in base state appropriations and our success in limiting expenditure growth. The University’s deans, directors, faculty, and staff have been focused and diligent in reducing more than $21 million in recurring general fund expenditures for the coming year.
The graph below shows the historic inverse relation between changes in state appropriation and changes in undergraduate tuition.
Transforming Residential Life
To stay at the forefront, the University must continually find better ways to support residential life and its important intersection with the learning experience. The University is investing $286 million over ten years in a series of “Residential Life Initiatives.” Most notable is the construction of the North Quad Residential and Academic Complex. Targeted for completion in summer 2010, North Quad will combine sophisticated classroom and academic space for five information and communications-related programs with residence space for 460 students. The result will be an exciting and engaging environment in which academic and residential life will be integrated more fully.
Renovating and enhancing our 19 residence halls, which range in age from 40 to 90 years old, to better service the needs of our students is another important element of the University’s Residential Life Initiatives. This multi-year renovation program includes upgraded fire and life safety systems, improved technology infrastructure and other renovations focused on an improved living-learning experience. A comprehensive renewal and renovation of Mosher-Jordan Hall, the first U-M residence hall ever to undergo such a process, is currently underway, along with the creation of a Hill Dining Center which will enable the University to consolidate dining services for all of the Hill area residence halls. An extensive renovation of Stockwell Hall is scheduled to commence in spring 2008. The renovation process preserves existing historic areas and details, while creating new community environments by reconfiguring current spaces and completing significant infrastructure upgrades.
On North Campus, a renovation of Bursley Residence Hall was completed, which included infrastructure updates as well as the addition of the Blue Apple—a dining emporium that combines convenient hours and a variety of fresh foods with access to the internet and a place to socialize. This created a community gathering space that not only is convenient for Bursley residents, but is also accessible to students who live in Baits Houses and the Northwood Apartments. UM-Flint has begun the transformation of its commuter campus to include a residential component with the construction of its first residence hall, which is scheduled to open in fall 2008.
The Health System
The Health System, which integrates the Hospitals and Health Centers, Medical School, and Michigan Health Corporation 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. We take great pride in the fact that the Hospitals and Health Centers have experienced more than a decade of solid finances, while also improving the quality of the care we deliver to patients.
In FY 2007, the Hospitals and Health Centers achieved an operating margin of 3.9 percent ($62 million) on revenues of $1.6 billion. A positive operating margin is essential to fund critical facilities and programs that will enhance patient care for a growing patient population, as well as research and education. The new state-of-the-art Cardiovascular Center, which opened in FY 2007, addresses the need for the focused treatment of cardiovascular disease, the number one cause of death in the United States. Several major projects are also underway, including the C.S. Mott Children’s and Women’s Replacement Hospitals and the expansion of the Kellogg Eye Center, which will add clinical and research space to meet rising demand for services and better accommodate technology enhancements and clinical care innovations. Even with a challenging health care environment ahead, the Hospitals and Health Centers will target a 3 percent operating margin on budgeted revenues of $1.7 billion for FY 2008.
Twenty years after launching M-CARE to provide innovative and high-quality health plans to the community, the University completed the sale of M-CARE to Blue Cross Blue Shield of Michigan and its subsidiary, Blue Care Network of Michigan. Given the rapidly changing business climate in the insurance industry, this sale enables the Health System to focus on its critical missions of providing exceptional care to patients, educating tomorrow’s health care professionals and scientists, and conducting groundbreaking research. This transaction also allows the innovative, high-quality plans and programs that M-CARE has built to be incorporated into an organization that shares many similar values and approaches to health coverage.
The Endowment
The University realized meaningful growth in its endowment primarily as a result of generous donations and strong investment performance, which generated a return of 26 percent in FY 2007. This investment return is consistent with the goal 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 table above 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.
The 26 percent return in FY 2007 follows a 16 percent return in FY 2006 and is again high by historical standards. Relative to the performance of the capital markets, the Long Term Portfolio’s annualized five-year return is nearly 4 percentage points above the customized market benchmark designed to capture the University’s long-term diversified investment strategy and 7 percentage points over the undiversified benchmark consisting of major equity and fixed income indices in an 80/20 ratio. Over the same five-year period, the return of the S&P 500 stock index was 10.7 percent.
The University’s endowment spending rule smooths the impact of volatile capital markets by providing for annual distributions of 5 percent of the moving average fair value of the endowment. Effective July 1, 2006, the moving average period was extended from three years to four years, and it is being extended by one quarter each subsequent quarter until it reaches seven years. This change is expected to reduce distribution volatility, as well as better preserve and grow the endowment corpus over time. The spending rule, along with the growth of the endowment, allowed for distributions to support operations of $205 million in FY 2007, for a total of $874 million over the past five years.
Health Benefits
As employee and retiree benefits continue to represent a significant and rapidly escalating cost to U.S. employers, we have pursued a coordinated set of actions to manage the cost of our benefits. In addition to ongoing review of vendors and competitive pricing for our benefit plans, we are focusing increasing efforts on prescription drug costs. By encouraging the use of lower-cost generic medications, the U-M Prescription Drug Plan has achieved a 60 percent generic drug dispensing rate (GDR), representing an additional 3 percent gain over last year’s rate. Greater utilization of generic drugs reduces out-of-pocket expenses for plan members and aggregate plan costs for the University. Each percentage point increase in the GDR reduces drug plan expenditures by as much as $466,000 per year.
Wellness as a Cost Control Strategy
Extraordinary participation and interest in the health and wellness programs offered by the Michigan Healthy Community initiative—known as MHealthy—have encouraged us to pursue greater integration of evidence-based wellness programming into our benefit programs. We believe improving the public health through targeted disease management efforts and careful attention to nutrition, fitness, workplace safety, and other wellness and prevention efforts can slow the rate of health care cost increases. A five-year strategic plan will be implemented starting in this fiscal year to integrate and evaluate these efforts in concert with benefit plans and strategies. Our work will be grounded both in evidence-based principles of health behavior and the results of our current health initiatives. To date, these efforts have included programs to:
- Increase the daily physical activity level of the entire faculty and staff community through team challenges that have attracted over 10,000 participants;
- Create safer, more efficient work environments through targeted ergonomic audit, training, and investment in programs to reduce risk of injury and lost productivity; and
- Improve nutritional health by making food and beverage choices that meet or exceed University-developed nutritional guidelines more readily available to faculty and staff.
Within the University community, we are also testing bold concepts in the delivery of care that have potential for improving the public health. One such program is MHealthy: Focus on Diabetes, winner of the Driving Value in Health Care Award sponsored by health care leadership organizations including the National Business Coalition on Health, The Leapfrog Group, and Bridges to Excellence. This groundbreaking two-year pilot program eliminates or reduces the cost of selected medications for employees and dependents with diabetes to encourage the proper and sustained use of specific drugs that help prevent or reduce long-term complications. Another pilot program, Focus on Medicines, is an intervention for those individuals with the greatest challenges in terms of medication cost and safety. This program offers several levels of help to the 3,000 individuals covered under the U-M Prescription Drug Plan who take nine or more prescription medications. The program provides comprehensive medication reviews by clinical pharmacists in the College of Pharmacy designed to protect against unwanted drug interactions, enhance the effectiveness of drug therapies, and reduce costs through greater utilization of generic medications. Focus on Medicines is helping to improve health while reducing medication costs for both patients and the University.
Physical Plant
Even as we continue to address ongoing economic pressures from the State and escalating health care and energy costs, it is essential to invest in our future through strategic facility renovation and replacement. Our facilities play a critical role in meeting patient care needs;
accommodating current technologies; and supporting growing academic, research, and clinical needs. Over the last decade, U-M has invested an average of $312 million per year for renovation and replacement of buildings and related infrastructure. This year was no exception as the University completed more than 421 projects across campus, an investment of more than $507 million.
In addition to the commitment to the residential life and clinical facilities discussed earlier, many transformational facilities to support the University’s academic, research, and athletic functions have recently been completed or are currently under construction to meet these changing needs. In FY 2007, construction was completed on the School of Public Health’s Crossroads and Tower Building renovation and expansion and the new Joan and Sanford Weill Hall for the Gerald R. Ford School of Public Policy. Projects underway include a new facility for the Stephen M. Ross School of Business, and additions to the Electrical Engineering and Computer Science Solid State Electronic Laboratory and the Kelsey Museum. Our focus on the arts is demonstrated by the construction of the new Charles R. Walgreen, Jr. Drama Center and the Alumni Memorial Hall Museum of Art addition. These important projects were largely made possible through generous gifts from alumni and friends.
Through prudent financial management and additional revenue sources such as those from the Big Ten Network and donor contributions, the Athletic Department is making significant investments in their facilities. Renovation and enhancement of the Wilpon Baseball and Softball Complex is underway. Planned projects include a major renovation to our 80-year-old football stadium, a new indoor practice field for football, and new soccer fields.
Energy Efficiency as a Cost Control Strategy
A tremendous amount of work has been done, especially in recent years, to improve the efficiency of our building systems and implement energy conservation measures. In FY 2007, the University marked ten years of participation in the U.S. Environmental Protection Agency Energy Star Program. During this time, all general fund buildings were evaluated under this program, which resulted in more than 216 energy efficiency projects to upgrade mechanical and lighting systems to save energy, prevent pollution, and lower operating costs. Annual estimated energy cost savings from these projects total well over $4.6 million per year.
Participation in Google’s Climate Savers program for information technology is the latest in an ongoing series of measures the University has taken toward creating a more environmentally sustainable future. As part of this program, we will work to ensure that units throughout campus buy computers with energy efficiency in mind, and will educate the campus about how to reduce information technology energy consumption. Energy efficient computers could make a $1.8 million difference in electricity consumption each year.
To build upon these efforts, a campus-wide Energy and Environmental Initiative was launched in April 2007 to more fully engage building occupants so we can better align building systems to meet their needs and, in turn, contribute to conservation efforts. Other components of this initiative include compilation and distribution of an annual report on consumption trends, research activities, and operations efforts; increased efforts to purchase electricity produced from renewable sources; maintenance and expansion of alternative transportation options for students, staff, and faculty; strengthening procurement offerings to ensure green products are prominently promoted; and revision of construction and renovation guidelines to improve energy efficiency.
Financial Controls
Fueled by best practices from the Sarbanes-Oxley Act legislation, we have been working with units across campus to clearly define the risks and controls associated with our major financial processes. Although Sarbanes-Oxley focuses primarily on the need for controls to ensure accuracy of financial statements, the University is pursuing a broader vision for controls that also includes a focus on the effectiveness and efficiency of business processes. For example, during FY 2007 we implemented the first University-wide compliance hotline, added employment process controls to the annual certification now required by vice presidents and deans, and created new web-based report tools to support management oversight and review of key internal controls.
Conclusion
As a testament to our outstanding fiscal stewardship, the University maintains the highest credit ratings of both Standard & Poor’s (AAA) and Moody’s Investors Services (Aaa) even as we continue to face a challenging state economy. These ratings 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.
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 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 Officer