Going for Greater Returns

Harvard offers novel investment option to donors

Harvard University has broken the mold for investing charitable-gift assets.The university is using a novel ruling it received from the Internal Revenue Service in October to allow donors to invest their contributions along with the institution’s high-performing endowment.

Over the 10-year period that ended in June, Harvard’s endowment — one of the nation’s largest — had annualized returns of nearly 15 percent, about four percentage points higher than the returns on a typical charitable trust managed by Harvard.

Charitable trusts typically pay dividends to donors, with the remainder going to charity upon their death. Thus, the better the returns, the bigger the payments to beneficiaries and the more money left for charitable uses. But tax and legal considerations have long limited charitable-trust investments to a rather conservative mix of stocks and bonds.

Harvard’s new investment plan is intended to overcome such limitations, and university officials expect the arrangement to attract more and bigger donations, further expanding the institution’s endowment of more than $19-billion.

No new gifts have yet been made under the arrangement, but current donors have asked to move about 70 percent of their charitable-trust assets already under management at Harvard — or a total of about $225-million — to the endowment-investment option.

“Donors have been extremely pleased with how their trusts have been managed and how they have performed,” says Anne McClintock, executive director of university planned giving. “However, we’ve always had people saying, ‘Gee, wouldn’t it be ideal if we could be part of the endowment?’”

Not All Approve

But critics of such an investment plan contend that mixing trust and endowment assets may go too far in creating financial ties between donors and charities and sets up the potential for conflicts of interest. Moreover, critics say that donors whose assets are invested along with endowments are likely to face higher income taxes than they might incur in conventional charitable trusts. And because of such risks, they say, charities will be under more pressure to earn higher returns on the funds.

The special IRS ruling, which Harvard publicly released in late December, shields charitable trusts from what is called the unrelated-business income tax generated by some of the endowment’s investments, such as its real-estate holdings. In most other instances, if any portion of a trust’s investment portfolio were to generate the income tax, the IRS would strip the entire trust of its tax-exempt status.

Before the ruling, then, Harvard, like most other nonprofit institutions, invested trust assets only in the kind of publicly traded stocks and bonds that are not subject to the income tax. For Harvard, that meant putting trust money in more conservative and less diverse investments than those in its endowment. Now, Harvard can effectively mix its trust assets with its endowment without jeopardizing the trusts’ tax-exempt status.

Not all the tax treatment is favorable under the new arrangement, though. A crucial hitch is that all the income distributed to donors from trust assets invested along with the endowment is to be taxed at ordinary-income rates, which could be as high as 35 percent for some donors.

In most cases, trust assets are invested in ways that aim to minimize the donors’ tax burden. The trusts at Harvard that are not invested along with the endowment, for example, are in a portfolio that is expected to produce income for donors that would be taxed at the capital-gains rate of no more than 15 percent.

Harvard officials say that they are banking on superior returns in the endowment to make up for the difference in the tax treatment of donors’ dividends. A recent advertisement in the university’s alumni magazine announcing the “new investment opportunity” for donors promotes the endowment’s earnings, and university fund raisers say they have been eager to tell donors how their gifts might piggyback on such success.

“People are giving to Harvard because of its mission, and the tremendous work it does,” says Ms. McClintock. “People will keep giving for those reasons, but now there’s a great new way to leverage their charitable gifts. The opportunity for greater returns might prompt people to give a little sooner — a [trust] now in addition to a bequest later — or perhaps to give a little more.”

Others May Follow

Charity officials around the country call Harvard’s move innovative, and many say they admire the university for finding a way to do what planned-giving experts have been talking about for years: investing trust money in highly diversified portfolios without jeopardizing the trusts’ tax-exempt status.

Stanford University is preparing to ask the IRS for permission to make a similar move, and other nonprofit groups with large endowments say they are considering whether to do likewise.

Still, not many nonprofit organizations are expected to follow suit, at least for now. Not only do most lack Harvard’s financial skills and resources — the university manages all its money through an independent subsidiary — but few groups have so consistently posted the above-average returns that Harvard’s endowment has.

As a practical matter, too, each charity looking to open its endowment portfolio to its donors’ trusts would have to petition the IRS to get what Harvard got last fall: a private-letter ruling, which is a decision that applies only to the specific facts and circumstances of the institution that asked for it.

Some institutions, too, may be waiting to see what happens with potential federal legislation that includes provisions to protect the tax status of charitable trusts even if they incur the unrelated-business income tax.

The legislation, which awaits a conference between the Senate and House of Representatives, would open more investment options for the trusts.

Hurdles Remain

Even if the legislation passes, or special IRS permission is granted, organizations would still have to overcome other hurdles before investing trust assets along with their endowments.

For example, Securities and Exchange Commission rules on who qualifies to participate in certain kinds of private investments might make it impractical or impossible for institutions to invest trust assets everywhere endowment assets are.

And while planned-giving experts and other observers say the new investment arrangement may work for Harvard and its donors, they also say that it raises tricky questions about the role of charities in tending assets, and about the potentially competing financial interests at stake.

“You may begin to wonder: Are they in the business of investment management or are they in the business of charitable programs?” says Bryan K. Clontz, a charity consultant in Atlanta who also runs a nonprofit group that receives unusual gift assets, sells them for a fee, and then passes the money to charity.

Thomas W. Cullinan, director of the National Planned Giving Institute at the College of William and Mary, in Williamsburg, Va., raises a similar concern. “This may not be the case at Harvard, yet a charity that stakes its reputation with donors on investment prowess instead of fulfillment of its charitable mission de facto undermines its mission,” Mr. Cullinan stated in an e-mail message.

Mr. Cullinan warned, too, that institutions that blend endowment funds and trust assets are likely to run afoul of the prudent-investor rules that are the law in most states.

Under the rules, he stated, trustees are required to implement “an investment strategy that incorporates risk-and-return objectives suitable to the trust, not related to any other fund or endowment.”

Commingling assets, adds Mark W. Yusko, chief investment officer at the University of North Carolina at Chapel Hill, “could create a situation where there’s a misalignment of interests” between the donors, who want sizable dividends subject to tolerable taxes, and the institutions, which want to maximize returns and the amount left in the trust.

“When it comes down to particular decisions,” Mr. Yusko says, “you would have to ask: Who are you working for?”

Prudent-Investor Rules

Harvard officials dismiss such concerns. Jack R. Meyers, chief executive of the Harvard Management Company, which invests the university’s endowment, says that the endowment’s portfolio is so well-diversified that the new arrangement is not in any danger of violating prudent-investor rules. He also says that, as with all charitable trusts at Harvard and elsewhere, trustees have the duty to balance the potentially competing interests between the donor and the charity.

In Harvard’s case, he says, it is particularly important for the university to work closely with donors to ensure that they understand the investment options for their gifts, and the resulting tax treatment. Donors can ask to have their gifts invested along with the endowment or in a different fund tailored to minimize the tax on the distributions they receive, Mr. Meyers says.

David Scudder, vice president of trusts at Harvard’s management company, says that the endowment-investment option might be better suited to younger donors, who expect to draw distributions from the trust as it grows over many years, than to older donors. The better rate of return expected from the endowment, Mr. Scudder says, would make up for the tax difference over time.

If, for example, the endowment funds annually outperform the trusts’ funds by about three percentage points, he says, it would take about six or seven years for donors’ after-tax income at the higher tax rate to catch up with what their income would be if it were taxed at the lower rate.

“Anyone living at least 14 or 15 years after establishing a trust is better off in the endowment,” he says.

Even given those odds, Mr. Scudder notes that a handful of donors who are 80 or older have already asked to move their trust assets into the endowment fund.

“They are happy to pay the extra tax,” Mr. Scudder says. “And because their money is likely to grow faster, they are happy knowing that there will probably be more left at the end of their life for Harvard.”