To Live Forever, Foundations Should Give Away the Minimum, Reports Say

Two new reports on foundation spending policies recommend that those that want to exist in perpetuity should give away only the minimum amount that is legally required.

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Under federal law, foundations must distribute at least 5 per cent of their investment assets, on average, each year.

Among the reports’ highlights:

* The recent stock-market boom would have allowed a typical foundation to give away a higher-than-usual proportion of its assets without eroding its endowment, according to a report prepared by DeMarche Associates, an investment consulting company, for the Council on Foundations. But it warns against doing so because inevitable market fluctuations over a long period of time make that policy inadvisable.

* Paying out more than the law requires would put foundations at a high risk of having their assets decline in real terms during a slack economy, according to preliminary findings from a report to be released this week by Goldman Sachs Asset Management.

The reports come at a time when two prominent groups — the National Network of Grantmakers and the National Committee for Responsive Philanthropy — are urging foundations to increase to 6 per cent the share of assets that they award to charitable causes.

Many grant makers are opposed to changing their spending policies, saying that if they give much more than the legal minimum — especially during hard times — they will gradually erode the value of their endowments and end up with no money left to give.

The council’s report says that a typical foundation that distributed 6 per cent of its assets every year from 1950 to 1998 could have maintained — and actually increased — the size of its endowment, after accounting for inflation. But the report strongly warns against spending so much.

A foundation that distributed 6 per cent of its assets over that 49-year period, the report says, would have been rescued only because of the stock market’s unprecedented growth from 1995 to 1998, when the Standard and Poor’s 500 index rose by more than 20 per cent in each year. Over the previous 23 years — from 1973 to 1995 — the assets of a typical foundation spending 6 per cent would have declined.

In calculating how much to distribute each year to meet the legal payout requirement, foundations are allowed to include employee salaries, rent, and trustee compensation, among other expenses.

The council’s report updates a study that was conducted first in 1990 and again in 1995. The report analyzes three spending scenarios for a hypothetical foundation with $1-million in assets in 1950. If that foundation had spent 5.5 per cent (the 5-per-cent legal minimum plus a 0.5-per-cent investment-management fee) annually since then, its portfolio would have grown to about $13.7-million last year, or $1.9-million after adjusting for inflation.

If the foundation had distributed 6.5 per cent annually over that period, its initial endowment would still have grown by almost 24 per cent in inflation-adjusted dollars, to about $1.24-million.

But had the foundation distributed 7.5 per cent, its initial endowment would have shrunk almost 23 per cent in real dollars, to $772,000.

What’s more, the report says, a foundation that stuck to the 5.5-per-cent minimum spending rate would actually have distributed more over the period than if it had used either of the higher payout rates. By last year, it would have been giving away $684,000; a foundation using the 6.5-per-cent rate would have distributed $510,000, however, and one using the 7.5-per-cent rate would have given out $370,000.

Moreover, during the 49-year-period, aggregate spending would have totaled $7.2-million at the 7.5-per-cent rate, $8.4-million at the 6.5 rate, and $9.7-million at the 5.5 rate.

“Lower initial spending results in higher aggregate spending over time,” the report observes.

The report on the Goldman Sachs study also supports that conclusion. The study, based on an analysis of historical data as well as 5,000 computer simulations, says a foundation that paid out 6 per cent annually through the 1970s and invested 70 per cent in stocks would have seen its assets lose half their value, after inflation, by the end of the decade.

It would not have recovered its initial asset value until May 1997.

Foundations should resist the pressure to increase their standard payout rate, says James-Keith Brown, director of the institutional non-profit group at Goldman Sachs Asset Management. In fact, Mr. Brown adds, “We would say that if they had an option — which foundations don’t — our preference would be to go down.”

Some people strongly disagree with the assumption that foundations should preserve their endowments today so they can distribute more dollars to charity tomorrow.

Says Perry Mehrling, chair of Barnard College’s economics department: “If a foundation pays out less, it pays out more — that is the fallacy that is their slogan. It is ignoring the time value of money: Giving today is worth more to the people who are getting it than the possibility of a gift tomorrow. The pie in the sky is not worth as much as the pie on the table.”

The National Network of Grantmakers commissioned Mr. Mehrling to study the payout issue. In a report on his study, released last month, Mr. Mehrling contends that a typical foundation could have given away up to 8 per cent of its assets during the past 20 years without significantly decreasing the value of its portfolio (The Chronicle, October 21).

The latest two reports on spending policies also make recommendations on how foundations should structure their investments.

The report done for the Council on Foundations observes that philanthropies that hope to exist in perpetuity must consistently achieve investment returns that exceed the aggregate amount they spend on grants, overhead, taxes, and investment management — plus the inflation rate. Assuming that inflation averages 3.25 per cent and investment management costs 0.5 per cent of assets, a foundation that distributes 5 per cent of its assets each year must achieve annual returns of at least 8.75 per cent if it is to preserve its capital.

A foundation that distributes 6 per cent of its assets every year can maintain the real value of its portfolio over time “only if it can count periodically on unusually strong market performance,” the report says — such as a recurrence of the extraordinary recent bull market. And a foundation that distributes 7 per cent of assets each year will probably see its purchasing power gradually erode, the report predicts, even in robust markets.

Many foundations — particularly smaller ones — seek to do grant making over the long term but measure their investment performance by a much shorter timetable, which causes them to avoid taking as much risk in their investments as a longer perspective would permit. “A foundation with a perpetual grant-making objective should allow a long-term investment horizon that should lead to a more aggressive asset mix and higher returns,” the report says.

To achieve a consistent return of 8.75 per cent, its hypothetical model suggests that a foundation should have no more than 45 per cent of its assets in cash or bonds. The rest should be in equities (including international stocks), venture capital, and real estate.

The Goldman Sachs study goes even further. It recommends that diversified portfolios with no more than about 30 per cent in fixed-income investments be considered by grant makers that seek to distribute 5 per cent of their assets each year while preserving their endowment’s value.

During a 10-year period, foundations that spend 5 per cent a year and invest 70 per cent of their assets in equities face a 34-per-cent probability that their portfolio will lose at least 10 per cent of its value during the decade. That likelihood rises to 40 per cent for foundations that have half their assets invested in equities, and to 53 per cent for those with only 30 per cent of their assets in equities.

Copies of “Spending Policies and Investment Planning for Foundations: A Structure for Determining a Foundation’s Asset Mix” will be available next month from the Publications Department, Council on Foundations, P.O. Box 98293, Washington 20090; (888) 239-5221; http://www.cof.org. The price is $40 for members and $67 for non-members.

Copies of the report “Sustainable Spending Policies for Foundations and Endowments” are available from James-Keith Brown, Managing Director, Goldman Sachs Asset Management, 85 Broad Street, New York 10006; (212) 902-1000. Or send e-mail to: jk.brown@gs.com.

Stephen G. Greene contributed to this article.