I am pleased to report that the University of Michigan remains in excellent financial health. Our disciplined budget approach which balances 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.
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. From the Ford School of Public Policy’s Weill Hall at the southern edge of Central Campus to the Cardiovascular Center on the Medical Campus, to the Walgreen Drama Center on North Campus, our capital program is addressing these needs.
As part of our capital plan to make significant investment in state-of-the-art health-related facilities, this year heralded the opening of the Biomedical Sciences Research Building, the expansion of the School of Public Health laboratories and the completion of the Rachel Upjohn Building—Ambulatory Psychiatry and Depression Center. Plans are also underway for other significant Health System projects which include the C.S. Mott Children’s Hospital and Women’s Hospital replacement project and the expansion of the Kellogg Eye Center.
In summary, the University’s total net assets (assets less liabilities) grew by $1.1 billion this year to $9.9 billion. This increase is a result of many factors including: rewarding capital markets, which added $703 million to the endowment net of distributions for operations; generous donations of $151 million for capital and endowment purposes; a positive margin at the Hospitals and Health Centers resulting in a $79 million surplus for reinvestment in physical plant; 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.
Although the last four 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.
Despite several years of cuts in state support, as noted in the chart on page 6, we restrained tuition increases in 2004 and 2005 in hopes that the state funding picture would improve. However, the economic outlook for the state continues to be difficult, and we are looking to tuition, private gifts and a growing endowment to help sustain the high-quality education that people have come to expect from the University of Michigan.
The University’s base state appropriations declined again in FY 2006, setting a new precedent for a total decrease of $54 million, or 13 percent, from FY 2002 levels. In contrast, if our state appropriations had grown at the level of the Consumer Price Index since FY 2002, our appropriations would have been $82 million higher in FY 2006. To preserve the quality of a Michigan education, the University’s tuition rates increased in FY 2006 by 12.3 percent for resident undergraduates and 6 percent for nonresident undergraduates on the Ann Arbor campus, with an 11.9 percent tuition rate increase for the Dearborn and Flint campuses. Even with this FY 2006 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 increased financial aid and scholarship expenditures by 10 percent in FY 2006 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.
We are extremely pleased to report that the State of Michigan has acknowledged the importance of higher education with plans to provide an increase in state appropriations in FY 2007. The anticipated 3 percent increase enabled the University to set moderate increases in tuition rates for the coming year.
The University realized meaningful growth in its endowment primarily as a result of generous donations and strong investment performance, which generated a return of 16 percent in FY 2006. 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 $190 million in FY 2006, for a total of $821 million over the past five years.
The table below shows the endowment’s investment performance and results of the longterm 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, 2006 | Annualized three-year return | Annualized five-year return |
Long-Term Porfolio | 16.3% | 18.7% | 11.0% |
U-M’s Benchmark | 13.4% | 14.3% | 7.0% |
S&P 500/Lehman Aggregate Bond Index (80/20 ratio) | 6.7% | 9.4% | 3.2% |
The 16 percent return in FY 2006 follows a 19 percent return in FY 2005 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 4 percentage points above the customized market benchmark designed to capture the University's long-term diversified investment strategy and nearly 8 percentage points over the undiversified benchmark of the S&P 500 stock index combined with the Lehman Aggregate bond index in an 80/20 ratio. Over the same five-year period, the return of the broad equity market was 2.5 percent, as measured by the S&P 500 stock index.
In June 2006, the Board of Regents approved a change to the University’s endowment spending rule and extended the moving average period from three years to seven years, with implementation to be phased in over the next three years. This change is expected to reduce the volatility of distributions to University departments for operations, as well as better preserve and grow the endowment corpus over time.
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. We take great pride in the fact that the Hospitals and Health Centers have experienced a decade of solid finances, while also improving the quality of the care we deliver to patients. The Health System 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. We take great pride in the fact that the Hospitals and Health Centers have experienced a decade of solid finances, while also improving the quality of the care we deliver to patients.
In FY 2006, the Hospitals and Health Centers achieved an operating margin of 5.5 percent ($79 million) on revenues of $1.4 billion. This positive operating margin exceeds the previous year’s margin of 5.4 percent, and the budgeted margin of 4 percent. A positive operating margin is essential to fund 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 a challenging health care environment, the Hospitals and Health Centers will again target a 4 percent operating margin on budgeted revenues of $1.6 billion for FY 2007.
Achieving the tenth straight fiscal year in the black and the fifth consecutive year of increasing operating margin is an important sign of strong financial health for the Hospitals and Health Centers, as it prepares for an increasingly difficult health care finance environment.
Twenty years after launching M-CARE to provide innovative and high-quality health plans to the community, the Health System is in the final stages of completing the sale of M-CARE to Blue Cross Blue Shield of Michigan and its subsidiary, Blue Care Network of Michigan. We believe this transaction, which will be subject to regulatory approvals, will allow the innovative, high-quality plans and programs that M-CARE has built to be incorporated into an organization that shares many similar approaches to health coverage. Given the rapidly changing business climate in the insurance industry, this transaction will also allow 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.
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 2007 general fund budget. The current mix of revenues can be seen on the chart on page 9, which shows the FY 2006 operating revenue sources with and without the Health System and other clinical activities.
The University continues to balance significant cost pressures across various fronts with the need to eliminate activities and costs that do not add significant value to the overall mission of the University. Considerable cost pressures continue in a variety of areas, including the competition to attract and retain world-class faculty, increases in health benefit costs for current and retired employees, higher energy prices, and the increased costs associated with new regulations and information technology security. Over the past year, the University benefited from a range of strategies to offset these growing pressures and meet the budget needs of the University.
Employee and retiree benefits represent one of the most rapidly escalating costs to employers across the country, and the University of Michigan is no exception. To slow our rates of increase, we have actively managed the cost of our benefits. Diligent review of vendors and evaluation of competitive costs, for example, led us to select a new company for our employee life insurance plans, a change that preserved the coverage levels at a cost reduction for the University of $520,000 over the life of the five-year agreement. The University also continued to successfully mitigate the growth of costs for prescription drug benefits by making administrative improvements in pharmacy claims processing and mail order pharmacy services and has achieved a 57 percent generic drug dispensing rate in the U-M Prescription Drug Plan, reducing out-of-pocket expenses for plan members and aggregate plan costs for the University. Participation in Health Care Flexible Spending Accounts (FSA) is bolstered by service improvements including debit cards that allow direct spending from Health Care FSA accounts for eligible purchases with no claims filing. FSAs represent a benefit program where high employee participation saves tax dollars for both individual employees and the University. Over the past year, extraordinary participation and interest in the wellness programs of the Michigan Healthy Community Initiative encourage us to investigate greater integration of evidence-based wellness programming into our benefits programs to improve the future public health of our community and encourage rational consumer health decisions.
Effectively leveraging technology throughout the University helps better serve our current and prospective community of students, faculty, staff, retirees, parents, and donors by enabling them to conduct business via web technology 24 hours a day. Over the past year, for example, we implemented a new Web-accessible applicant management system which integrates the process of recruiting, selecting, and hiring candidates into a single system. This new system has streamlined the University’s hiring process and better aligns it with industry best practices. Our ongoing efforts to better leverage technology have also resulted in significant savings to the University and enabled us to restructure and consolidate many administrative processes.
As we look ahead, the University is launching an ambitious initiative to explore the utilization of space and facilities in order to make the best use of the physical resources that support its core mission. Although we have managed to control many of the operating costs of our space through ongoing energy and water conservation measures, it is time to think harder about how we use the space more efficiently as well. With increasing interdisciplinary research and teaching, and as we continue to use new technology to augment the learning process in ways never before possible, this initiative will be an important next step in identifying new ways to make the most of our facilities.
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.
The University continues to expand its state-of-the-art clinical, teaching, and research facilities to meet growing academic, research, and clinical needs. While there are major investments both this year and in the near future for facilities related to the clinical and research needs of the Health System, important investments are also being made in the academic and residential life facilities.
Of great significance to the research mission of the Medical School was the completion of the Biomedical Science Research Building in FY 2006. The building’s unique design fosters even greater multidisciplinary collaborations and creates conditions for accelerated visionary research and training that we hope will profoundly impact science and clinical care. 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. Several major Health System projects are also underway or in planning, including the C.S. Mott Children’s Hospital and Women’s Hospital replacement project, and the expansion of the Kellogg Eye Center, which will add clinical space to meet rising demand for services and better accommodate technology enhancements.
We continue to invest in important facilities which support both teaching and research efforts. Construction nears completion on the School of Public Health’s Crossroads and Tower Building renovation and expansion project which provides needed modernization of building systems and additional space to provide a crossroads of intellectual activity for research, teaching, academe and community. The Joan and Sanford Weill Hall, new home of the Gerald R. Ford School of Public Policy which opened this fall, enables the consolidation of three Ford School campus locations into a single facility with classrooms, a library, research centers, a computer laboratory, faculty offices and public spaces for conferences and lectures. With its new space, the Ford School is adding an undergraduate major, growing its faculty, and expanding the scope of its educational programming. Several major projects are also just underway, including the Stephen M. Ross School of Business Facilities Enhancement Project and Museum of Art and Kelsey Museum renovation and expansion projects. Many of these projects have been made possible by donors who support the Michigan Difference fundraising campaign.
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 10 Financial Report 2006 halls, which currently range in age from 40 to 90 years old. In FY 2007, Mosher-Jordan Hall becomes the first U-M residence hall ever to undergo a comprehensive renewal and renovation. The renovation of Mosher-Jordan seeks to preserve the existing historic areas and details, while creating new community environments by reconfiguring current spaces and completing significant infrastructure upgrades. Taking place along with this renovation is the creation of a Hill Dining Center which will enable the University to consolidate dining services for all of the Hill area residence halls. This innovative new dining center will be attached to Mosher- Jordan on the rear of the building facing Palmer Field and will feature a marketplace style facility with seating for 700 as well as a food emporium on the top floor with café style seating for 70. In addition, the University is more than half-way through a multi-year, $50 million program to upgrade the fire and life safety systems in its residence halls.
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 $288 million per year for renovation and replacement of buildings and related infrastructure. This year was no exception as the University completed more than 335 projects across campus, an investment of more than $424 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. Our recent efforts have focused on conducting comprehensive internal control reviews of key financial business processes and creating practical tools and resources to emphasize accountability for fiscal responsibility at all levels of the University.
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.
The continued financial health and resilience of the University 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, 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