Report from the Chief Financial Officer
The University of Michigan continues to be in excellent financial health, largely due to the University’s 32,000 faculty and staff who remain keenly focused on the institution’s core missions. Our committed and innovative faculty and staff continue to build on U-M’s strong foundation and long tradition of excellence, even in the face of significant challenges.
The University’s disciplined and focused budget approach carefully balances our current and emerging operating needs with cost savings opportunities. This approach, combined with our diverse revenue streams, long-term investment strategy, positive operating margins at the Hospitals and Health Centers, and The Michigan Difference fundraising campaign, contribute to the University’s strong financial position. As a result, the University continues to have the wherewithal to make key investments in the facilities, programs, and people necessary to maintain academic excellence and define what it means to be one of the world’s best public research universities.
During FY 2008, the University implemented Governmental Accounting Standards Board (GASB) Statement No. 45, which requires recognition of the cost for postemployment benefits that will be paid in the future during employees’ active years of service. In previous years, the University recognized costs for nearly all postemployment benefits as they were paid. Implementation of this statement resulted in an increase in the University’s liabilities and a decrease in its net assets (assets less liabilities) of $1.4 billion. This impact, however, was offset by a $662 million growth in net assets before the implementation of GASB 45, which resulted from a variety of factors: positive investment income, which added $252 million to the endowment net of distributions for operations; generous grants, appropriations, and donations of $172 million for capital and endowment purposes; a positive margin at the Hospitals and Health Centers, resulting in a $22 million surplus for reinvestment in physical plant; as well as successful cost-containment activities and gifts for operations. Accordingly, in FY 2008 net assets decreased $742 million; however, the University’s financial position remains strong with net assets totaling $10.8 billion at June 30, 2008.
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, for example, almost 80 percent of the University’s general fund revenues came from state appropriations, compared to the projected 24 percent in the FY 2009 general fund budget. The current mix of revenue can be seen on the charts below, which show the FY 2008 operating revenue sources with and without the Health System and other clinical activities.
Operating Activities
Total Revenue: $4,983 Million
Operating Activities Excluding Health System and Other Clinical Activities
Total Revenue: $2,797 Million
The General Fund Operating Budget Challenge
The last several years demonstrate a clear trend away from dependence on state appropriations, but 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 that would equal the current level of state support received by the University.
In FY 2008, the University received $370 million in base appropriations from the state, a 1 percent decrease from the prior year, as well as $34 million to restore a FY 2007 rescission. Since FY 2002, the University’s base appropriations have decreased $46 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 $106 million higher in FY 2008.
Looking ahead, our general fund operating budget continues to be a challenge for the institution. Our commitment to academic excellence and access combined with the state’s uncertain financial circumstances requires a careful balance between cost containment and the need to invest in our future. In adopting the budget for FY 2009, we are anticipating a state appropriation of $374 million, an increase of 1 percent. Given the state’s constrained financial circumstances, this planned increase shows support for higher education, for which we are very grateful. This increase in funding is a clear indication that the state recognizes the crucial role that higher education in general and, more specifically, research universities can play in transforming our economy.
At the same time, however, this allocation will put our state appropriation at a level that is $42 million lower than the amount that was appropriated for FY 2002 and $114 million lower in inflation-adjusted dollars.
Through a combination of innovation, ingenuity, and hard work, we have been able to limit tuition increases. The approved Ann Arbor campus budget for FY 2009 includes a moderate increase in tuition rates of 5.6 percent for both resident and nonresident undergraduates and 5 percent for most graduate programs, along with an 11 percent increase in centrally awarded financial aid for undergraduates to preserve access for our most financially vulnerable students. The University’s deans, directors, faculty, and staff have been focused and diligent in reducing $20 million in recurring general fund expenditures from the Ann Arbor campus budget for the coming year. This is in addition to the $117 million of recurring cost reductions achieved in the general fund over the previous five years. The graph below shows the historic inverse relation between changes in state appropriation and changes in undergraduate tuition rates.
Percentage Change in Undergraduate Tuition Rate and State Appropriations
The Health System
The Health System, which integrates the Hospitals and Health Centers, Medical School, and Michigan Health Corporation under the direction of Executive Vice President for Medical Affairs Dr. Robert Kelch, had another 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 12 years of solid financial results, while also improving the quality of the care we deliver to patients.
In FY 2008, the Hospitals and Health Centers achieved an operating margin of 1.3 percent ($22 million) on revenues of $1.7 billion. This somewhat smaller-than-expected margin reflects the strains of a difficult economy, decreased reimbursements from government insurers, and a trend of longer inpatient stays. That said, the continued achievement of a positive operating margin will allow us to fund critical facilities and programs that will enhance patient care for a growing patient population, as well as research and education. Among them: a new facility for the C. S. Mott Children’s Hospital and Women’s Hospital, which will open in 2012, and the expansion of the Kellogg Eye Center and Brehm Diabetes Center, which will open in 2010. Even within existing facilities, capital projects such as a $43 million investment in advanced medical imaging technology and renovated space, and a major information technology initiative that is bringing us close to becoming a truly paperless health care delivery system, continue to expand our capacity to serve patients and ensure their safety. As we look to the future, this year’s purchase of a 32-acre parcel of land in Brighton, near our existing health center and other U-M health facilities in Livingston County, will pave the way for further growth to serve patients where they live.
Philanthropy directed toward the Health System continues to be very strong, and supports our clinical, biomedical research, and medical education missions in many ways. In FY 2008, major gifts included $22 million from A. Alfred Taubman for a new medical research institute named after the retail pioneer, as well as many other generous donations of all sizes.
The Endowment
The University realized meaningful growth in its endowment, primarily as a result of generous donations and strong investment performance. The University’s long-term diversified investment strategy is designed 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.
This long-term strategy’s 6 percent return in FY 2008 was strong relative to difficult financial markets and follows a 26 percent return in FY 2007. The Long Term Portfolio’s annualized five-year return of 17 percent was 5 percentage points above the custom market benchmark designed to capture the University’s long-term diversified investment strategy and nearly 10 percentage points over the undiversified benchmark consisting of major equity and fixed income indices in an 80/20 ratio. The return of the S&P 500 stock index was 7.6 percent over the same five year period.
Investment Performance
| Return for twelve–month period ended June 30, 2008 | Annualized three-year return | Annualized five-year return | |
|---|---|---|---|
| Long Term Portfolio | 6.4% | 15.8% | 17.5% |
| U-M’s Benchmark | -1.0% | 10.8% | 12.4% |
| Equity/Fixed Income Index (80/20) |
-8.0% | 5.6% | 7.6% |
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 University’s endowment spending rule smoothes 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 $227 million in FY 2008, for a total of $950 million over the past five years.
The payout from our more than 6,500 separate endowment funds enables us to serve a diverse population, ranging from patients in our health system to students. For example, approximately $2 billion, or 26 percent, of our $7.6 billion endowment is restricted for use by our health system, which serves the needs of 1.6 million patients each year. The portion available for University operations supports the education of more than 57,000 students. About 20 percent of our total endowment, or $1.5 billion, has been set aside for student aid, with nearly 80 percent of our undergraduate students who are Michigan residents receiving some form of institutional financial aid, which includes grants, work-study, and loans. Endowment income also provides key support to the University’s research efforts, which have made countless contributions to our global society in areas ranging from medicine and law to arts and science. The average effective annual spending rate from our endowment over the last 10 years, including spending rule payouts and withdrawals from funds functioning as endowment, was 6.5 percent.
Health Benefits | The National Challenge
Organizations across the country continue to grapple with the escalating costs of employee and retiree benefits, with large employers reporting annual rates of increase as high as 12 percent. In FY 2008, the University spent $250 million on health care for employees and retirees. The continued escalation of costs is driven by factors including the development and adoption of new medical technologies, new pharmaceuticals with increasingly specialized uses, and the growing demand for medical care while the market for health professionals remains highly competitive.
Controlling Health Care Costs
A recent study by an actuarial firm showed U-M health plans perform with as much as 13 percent more financial efficiency than the average of other employer plans. The University’s well-designed medical and prescription drug plans and the highly efficient U-M Health System have contributed to this positive result, and to our lower-than-average 8�10 percent rate of annual cost increase. Prevention, early intervention, and wellness also help to reduce the pressures on the health care system and promote overall control of costs. The University’s health and wellness effort, known as MHealthy, addresses these important factors. With this year’s finalization of a five-year strategic plan, MHealthy is working toward long-range goals to raise the baseline of health in our community. MHealthy offers a spectrum of programs designed to support healthy lifestyles by increasing physical activity, improving nutritional habits, supporting smoking cessation, and promoting ergonomics and workplace safety for injury reduction. More than 10,000 employees have participated in team physical activity challenges alone.
Other MHealthy voluntary programs represent bold efforts to directly utilize the expertise of U-M faculty. Focus on Diabetes, for example, tests the effect on patient compliance with important medication regimens when the potential cost barriers of drug co-pays are removed. Focus on Medicines allows individuals taking multiple prescription medications to receive drug safety counseling and a complete medication review by U-M clinical pharmacists to minimize the number of drugs necessary and reduce University and patient costs with increased use of generic medications.
The University’s generic drug dispensing rate has increased to 68 percent of prescriptions filled, which is higher than the national average. A comparison of the previous two calendar years revealed a savings to the University and plan members of as much as $2.8 million in additional expense that would have been incurred had generic drugs not been utilized. Each 1 percent increase in the U-M rate of generic drug dispensing results in a savings of nearly $500,000 in reduced medication and co-pay costs.
Health Care Partnerships
U-M Premier Care is the University’s self-insured health plan, which is administered by Blue Care Network, a subsidiary of Blue Cross Blue Shield of Michigan (BCBSM). Launched in 2008, U-M Premier Care provides cost-effective managed care with access to all U-M Health System providers for more than 55,000 enrolled employees, retirees, and dependents. Our partnership with BCBSM extends beyond our health plan to the establishment of the Center for Healthcare Research and Transformation. This joint venture works to improve the quality of the state’s health care system and improve the way patient care is delivered. Similarly, the University’s Center for Value-Based Insurance Design is nationally known for its work in reducing barriers to health care access.
Physical Plant, Sustainability, and Cost Controls
Even in the face of ongoing economic pressures from the state and escalating health care and energy costs, it is essential that we invest in our future through strategic facility renovation and replacement. The University’s 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, the University has invested an average of $360 million per year for renovation and replacement of buildings and related infrastructure. FY 2008 was no exception as the University completed more than 327 projects across campus, an investment of more than $609 million. Many facilities to support the University’s academic, research, and athletic functions have recently been completed or are currently under construction to meet the University’s changing needs.
In FY 2008, completed projects include renovations to Medical Science Units I and II, renovation and enhancement of the Wilpon Baseball and Softball Complex, and construction of the Charles R. Walgreen, Jr. Drama Center and Stamps Auditorium. Projects scheduled for completion in FY 2009 include a new home for the Stephen M. Ross School of Business, a new student housing facility for the Flint campus, and the comprehensive renovation of Mosher-Jordan Residence Hall, which also includes the new Hill Dining Center. In addition, two of the largest construction projects in University history are continuing with the North Quad Residential and Academic Complex and the C. S. Mott Children’s Hospital and Women’s Hospital, which was discussed earlier, along with other new or upgraded clinical facilities. Work also continues on the Alumni Memorial Hall Museum of Art addition and renovation. Many of these important projects were largely made possible through generous gifts from alumni and friends of the University.
The Athletic Department, through sound financial management and additional revenue sources such as those from the Big Ten Network and donor contributions, continues to make significant investments in its facilities. Beyond the renovated and enhanced facilities for baseball and softball mentioned earlier, Michigan Stadium, home to the football team since 1927, is undergoing a major renovation. Construction is also underway on a new indoor practice field.
An updated master plan for North Campus was developed in FY 2008. Currently, the existing North Campus buildings include seven million square feet of space that has been built over the past 50 years. The updated plan’s themes include the creation of strong connections between North Campus and Central Campus, promoting campus vitality, optimizing development capacity, and respecting and incorporating environmental features. It, like former plans, also calls for making North Campus a more livable and accessible place that’s easier and more convenient to get around. A variety of enhancements designed to enrich campus life are under consideration for North Campus, ranging from areas for the arts and performances to retail opportunities.
Planet Blue, which will be more broadly introduced to the University community in FY 2009, is a three-year, campus-wide effort to cut utility costs and increase recycling in approximately 90 large buildings on the Ann Arbor campus with an education and outreach campaign designed to engage the students, faculty, and staff in the program. The University spends more than $100 million a year on utilities and Planet Blue’s goal is to cut those costs by 10 percent, through a combined approach that includes energy-saving technologies, building upgrades, and helping employees to change their behavior relative to energy consumption and conservation. In FY 2008, the University piloted Planet Blue in five buildings on the Ann Arbor campus, with very positive results. Many energy-saving actions already have been implemented in the pilot buildings while other recommendations are under review. Changes include everything from the installation of occupancy sensors for fume hoods to reducing operating hours for HVAC fans.
Planet Blue is part of the campus-wide Energy and Environmental Initiative that was launched in April 2007. Other components of this initiative include compilation and distribution of an annual report on consumption trends, research activities, and operations efforts, which can be read at http://www.oseh.umich.edu/Stewardship/reporting.html; 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 that green products are prominently promoted; and revision of construction and renovation guidelines to improve energy efficiency.
Financial Controls
The University continues to work with units across campus to assess and strengthen internal controls, based on best practices from the Sarbanes-Oxley Act. We are identifying the key risks and control points related to our major financial processes. In addition, we are leveraging process improvement initiatives such as online journal entries and automated cash handling/depository procedures to improve internal controls and make our processes more effective and efficient. This year we have added purchasing card process controls to the annual certification required for deans and vice presidents, which includes, among other elements, our campus-wide IT Security Initiative and employment controls. In FY 2008, the University also launched a new training program for new and future budget administrators that promotes responsible stewardship of the institution’s resources. Among the topics covered by the training are internal controls, financial analysis, and information management.
Conclusion
Thanks to the commitment and dedication of the University’s 32,000 employees and their unyielding focus on sound financial stewardship, the institution maintains the highest credit ratings from both Standard & Poor’s (AAA) and Moody’s Investor Services (Aaa). This is particularly encouraging in light of the challenging state economy that we’ve faced for a number of years. These ratings are important indicators of the University’s strong financial health and outlook. The University, in fact, is one of only three public universities in the country to maintain these highest possible ratings.
It is, once again, satisfying to receive an unqualified opinion from the Unversity’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 (PDF) is my certification of management’s responsibility for the preparation, integrity, and fair presentation of the University's financial statements.
I hope you’ll find the time to read Management’s Discussion and Analysis (PDF). It tells a story of financial strength, prudent financial policy, and perhaps most importantly, the ability and commitment to sustain the highest level of excellence in fulfilling the University’s mission for many decades to come.
Timothy P. Slottow
Executive Vice President and Chief Financial Officer