I pointed out it's not the university, but the endowment that needs to spend a certain amount to maintain tax-exempt status and that most of it is invested to make more money, which is not an educational purpose.
You've just pointed out that the IRS requires the endowment to make certain distributions. And you've even noted that the IRS required distribution is often much lower than the actual investment income earned. What does this mean? It means even after making the qualified distributions the endowment grows.
Let's say the investment pot has $100 principal and earns 8% a year. At the end of the first year the endowment has $108. Most endowments FBO educational institutions distribute 5% of the total assets:
Year Prin. Int. Dist.
---- ------- ---- ----
1 $100.00 $8.00 $5.40
2 $102.60 $8.21 $5.54
3* $105.27 $8.42 $5.68
4 $108.00 $8.64 $5.83
5 $110.81 $8.87 $5.99
As you can see as the endowment grows the amount of money that needs to be distributed grows as well.
It's interesting to note that the specific rule you've cited came into effect in 1970 precisely because endowments were reaping the benefits of tax-free earnings without actually using the money for the benefit of any of the tax-exempt activities. When did college tuition start skyrocketing? The mid-1970's.
 Professional experience: I'm a securities & investment attorney.
*Edit: Skipped a year's worth of numbers
Not in real terms it doesn't. When was the last time typical moderate risk investments had long-term returns more than 5% above inflation?
If you had $1000 1970 dollars in 1970 and it increased by nominal 3% annually until last year, you would have $4012 in 2017 dollars. That isn't a real >$3000 gain, it's a >$2400 loss (in 2017 dollars), because $1000 1970 dollars is $6418 2017 dollars.
> When did college tuition start skyrocketing? The mid-1970's.
This is also just after the Higher Education Act was passed, giving out low interest student loans.
The asset allocation for a $100MM+ endowment FBO educational institution typically includes about 10% PE, 5% VC, and 20-25% in alts (hedge funds, derivatives, long/short plays, etc). These aren't even close to "typical moderate risk" investment vehicles.
And the bigger the endowment, the bigger the percent allocation to those types of investments. For example, a super endowment like Harvard probably has closer to 50% of the portfolio in alternative strategies.
In terms of average long-term returns they are, if not worse. Major index ETFs have a very inconvenient tendency to edge out actively managed funds as a general rule, and university endowments are no exception.