Perpetuity: the Real Issue in Payout Debate

Economists, foundation officials, and charity observers have been spending a tremendous amount of time recently talking up reports that arrive at an exact percentage of assets that foundations should be required to give away each year. Some studies, citing market performance over the course of many years, argue that the minimum should remain at the current 5-per-cent level. Others, citing great gains in the stock market over the past decade or so, argue that the minimum should be raised to 6, 7, or even 8 per cent.

The entire payout debate, however, is little more than an effort to hide policy behind mathematics. The hidden question concerns the appropriate role of foundations in society, and whether they should be allowed to last forever. Arguing over hypothetical numbers based on unpredictable assumptions about inflation, investment returns, and asset allocation is far easier than facing that fundamental issue squarely.

Legally, foundations are entitled to operate in perpetuity, just like any for-profit corporation. But that doesn’t mean that the people managing foundations should choose to operate them that way.

Some institutions in our society serve their missions best through longevity. Museums are repositories for the great cultural achievements of our society, and should be maintained as long as possible. Universities and libraries transmit knowledge across generations and must therefore endure. Many other institutions might be added to the list.

Do foundations belong on that list, too? They are not long-term repositories of culture or knowledge. Some may have a specific mission or strategy that requires longevity, but merely holding assets to generate income is not a compelling reason for them to exist forever. Each foundation, then, must examine its strategy to determine whether there is a good reason to defer its grant making into the future, and how many years it will take to fulfill its mission.

But when most foundations adopt a lock-step policy of distributing only 5 per cent of their assets, despite a decade of far greater investment returns, and treat the government-imposed minimum as a ceiling, they invite further government intervention. Instead of adopting a good-faith policy of paying out as much as they can prudently afford, foundations continue to demonstrate that nothing besides government regulation will ever determine payout.

There is another aspect to the perpetuity/payout debate that should be considered. For most institutions in society, immortality is not easily sustained. In business, the competitive pressures of the marketplace and the insistent demands of customers insure that no corporation will survive any longer than it can deliver needed products and services at least as well as its competitors.

In the case of charities, the constituencies they serve and the donors on which they depend insure that the organization is highly accountable for its performance each and every year. Permitting charities and businesses to survive indefinitely, therefore, presents no social-policy problems — either they contribute value to our society, or they go out of business.

Foundations, however, are different. Unlike businesses or charities, they are insulated from performance pressures. If they invest and spend conservatively, foundations will almost always survive in perpetuity — whether their grants are effective or not. The societal checks and balances that link survival to the delivery of social value are absent. That lack of accountability suggests that there are risks in encouraging foundations to survive indefinitely.

That does not mean that the government should legislate a change in foundation longevity. The far better course would be for foundations to monitor their own life spans and pay out a prudent amount based on a combination of their actual investment results and their social missions.

Judging from the growth in foundations’ assets over the past two decades, an increased level of payout clearly was warranted during that period. From 1978 to 1997, U.S. foundations took in contributions of $117.5-billion and made $153.4-billion in grants, while their assets grew by a total of $223.3-billion. Because foundations paid out more than they took in, the growth in their assets could only have come from their investment performance.

That rate of growth during that period was substantially greater than inflation. In 14 out of 20 years, growth in foundation assets, after foundations distributed their grants, exceeded the rate of inflation — often by a substantial amount. By my rough calculations, U.S. foundations collectively could have paid out nearly $100-billion more in grants over the past 20 years while increasing the value of their assets at the rate of inflation.

That represents a more-than-60-per-cent increase over the dollar value of grants actually made. Investment returns in 1998 and 1999 suggest that that surplus has further increased substantially.

To insure that foundations serve their social purpose rather than exist largely to increase their own worth, foundations could choose to distribute — or even be required to distribute — all their income and appreciation annually, after adjusting for inflation and reasonable operating expenses. But because returns can vary greatly from year to year, such an approach would work against the competing need of foundations to develop future budgets and strategies of charitable support over several years at a time. Flexibility is key.

With that in mind, foundation officials at the California Community Foundation, in Los Angeles, came up with a new policy. Because their investment returns in recent years had so far outstripped their giving, they decided, beginning last year, to declare a “community dividend” above the 5.5 per cent per year on their $200-million in unrestricted assets that they routinely gave away.

Foundation officials looked at the real growth in assets over the preceding three years — after accounting for payout, expenses, and inflation — and determined that that amounted to 3.25 per cent of assets, or $6.5-million. They then split the difference between meeting needs today and saving for the future by reinvesting half and adding the other half — $3.25 million — to their current-year grant budget. Even using only half the surplus, their current-year giving was increased by 37 per cent.

The dividend formula devised by the California Community Foundation is hard to argue with. The foundation has covered all its obligations prudently and still paid out only half its surplus. And it hasn’t promised to maintain that payout rate in future years: Each year it will continue to calculate a flexible payout, based on the extent to which its real investment returns exceed the 5.5-per-cent floor.

Most of the tremendous growth in foundation assets has occurred in the last three years. It is not too late for other foundations to examine their balance sheets and decide that they, too, can adopt a flexible payout policy instead of the ironclad 5-per-cent rule. If every foundation in America had followed the dividend formula above, roughly $7.5-billion more would have gone to charity in 1999, and foundations would still be growing at a healthy clip above the rate of inflation.

And, in the face of such good-faith conduct, the threat of government intervention would be moot.

Mark R. Kramer is managing partner of the Center for Effective Philanthropy and a regular contributor to these pages. His e-mail address is mkramer@effectivephilanthropy.com.