University heads claim financial instability is the number-one threat to the UK's higher education sector.

In research carried out by financial advisory firm Grant Thornton, 28 vice-chancellors were asked for their assessment of the health and prospects of the sector.

Of these, almost 80 per cent named financial stability and sustainability as a top concern, with 60 per cent identifying the closely related issue of pay costs as another.

David Edwards, director of Grant Thornton's education advisory group, said a recurring theme in responses was that of "payroll strain".

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He said that there was a feeling that vice-chancellors had settled pay at "a generous level" but there was "little scope" to recover the increased cost until a decision on the future level of tuition fees was reached after the 2009 review.

"Because pay is somewhere between 60 and 70 per cent of higher education costs, they are feeling the squeeze," he said.

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The 2006-09 pay settlement gave staff increases totalling more than 10 per cent over the past two years, with the promise of either 2.5 per cent or a rise equivalent to the retail prices index, whichever is greater, next month. As the current RPI rise of 5 per cent is far higher than predicted when the deal was agreed in 2006, the squeeze on finances will be tighter than expected.

One vice-chancellor surveyed said: "The payroll strain is unsustainable. After the bumper pay rises of 2008, the total pay and pension settlements in 2009-10 and 2010-11 need to be very modest if job losses are to be minimised."

Another said the sector was in "a classic price-cost squeeze", adding that there were "limits to the extent that these costs can be passed on to students, who are already paying high fees".

A third noted that higher education was a "labour-intensive business" and that "small government increases in funding do not meet staff salary aspirations", while a fourth vice-chancellor, from a Scottish university, said that universities north of the border "face a very difficult time ahead" with "no easy answers to the funding problems".

Vice-chancellors were asked to compare their situation to that of a year ago, and a majority said things had got tougher on the financial front in terms of competition and in achieving progress on the deregulation of tuition fees.

Another question asked whether things would get easier or harder in a range of areas over the next five years, and in all but one category vice-chancellors predicted things would get tougher, frequently citing the economic downturn and demographic change as key challenges.

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Mr Edwards said: "The respondents thought that pretty much on every front things weren't going to get any better."

Summing up the concerns of several others, one vice-chancellor said: "Others will wake up to competition, making recruitment a challenge in the light of changing cohorts, and tuition-fee deregulation is potentially problematic - uncertainty is the real issue."

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Asked in what areas immediate action was required, the vice-chancellors cited the physical estate on campus, market image and student experience. Mr Edwards said the focus on buildings was interesting given the high levels of capital investment in recent years. "Making buildings more than just serviceable, making them attractive to students, is important now, and that ties in with market image and student experience because universities are recognising students need to be dealt with like customers."

Paradoxically, although the picture the participants paint of a tough future are on the pessimistic side, all but two said they were optimistic about their own institution.

As one put it: "We are good at dealing with expected and unexpected changes and will survive. We control costs and recruit students."

But Mr Edwards cautioned: "There's a certain amount of horses for courses here: the view that everyone else is going to find it tough but we'll be OK. Looking at it in the cold light of day, the general feeling is that things are tough on almost all fronts and that will remain the case for the next five years."

Finally, asked to suggest what could be done to improve the situation for the sector, most respondents cited the deregulation of tuition fees, although more than a quarter also called for a relaxation of restrictions on visas for overseas students.

One suggested deregulating either fees or student numbers. "The higher education undergraduate sector is very unusual in being regulated by number and by price. There is considerable unmet demand for what my institution offers, but getting hold of additional student numbers is difficult. Permitting a freer market in student numbers would enable more students to attend those institutions they wish to," they said.

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john.gill@tsleducation.com.