Dec 02, 2008

Revisiting the Idea of Perpetuity

by Tim Ogden

Editor’s Note: A version of this article appears in the December 2008 issue of Alliance Magazine.

As most know, the US has the friendliest public policy towards private charity among developed nations. Gifts to charities and foundations are tax-deductible with only minor limits. In most cases, foundations’ earnings are tax-exempt as well (though there is a 1 percent to 2 percent excise tax). Once established, foundations are bound to distribute 5% (the level at which payout rate was set in 1976) of the current value of their assets each year.

It may seem strange to advocate a major shift in foundation payouts at a time when foundation endowments, like all of our investment funds, are being punished by the global downturn. Already major foundations like the Hewlett Foundation and the Bill and Melinda Gates Foundation have stated that the downturn will have a negative impact on their future grantmaking. It is exactly the current scenario that defenders of the 5% payout point to when suggesting that the status quo is wise public policy. The argument is that paying out at a higher rate would threaten their existence. When severe economic disruptions like the current one happen, they would end up much smaller and possibly run out of funds entirely and be forced to close. At least this was the argument that was used to defeat proposed changes to the 5% rate in 2003 on the heels of the last market meltdown.

There was a time when this argument made sense, but it no longer holds water. When the laws governing foundations were set up, the idea of permanent foundations was not outlandish. There is no question that having an active philanthropic sector is good for a society. And decades ago there was not the evidence we have now of the perpetual continuance of America’s tradition of generosity. When Mr. Carnegie and his peers set up the first megafoundations near the turn of the century, they did not know that not only some would follow in their footsteps but that there would be a virtual stampede.

Since 1987, the value of foundation endowments (in inflation adjusted dollars) has grown more than 500%. Excluding the creation of new foundations, the value of well-managed foundation endowments roughly doubled over that span. Even more importantly, the (again, inflation adjusted) value of foundation endowments per capita has grown more than 400%. Despite the current downturn, given the history, the expected increase in assets transferred generationally (even if far less than predicted), and the increase in wealth of the richest, foundation endowments per capita will likely double again within 10 years. By now there is surely sufficient evidence that the philanthropic sector is not in danger of disappearing from America—so why do we need eternal foundations?

There is also a question of the public value of protecting foundation endowments. The idea is that there is substantial public benefit from encouraging charitable giving and the establishment of large foundations. What many don’t realize is how inflation combines with the 5% payout rate to devalue the public benefit. A foundation that pays out the minimum of 5% annually (which the majority of foundations do) will be in existence for more than 500 years before it pays out the equivalent value of the original gift. As a case in point take the Carnegie Corporation. Adjusted for inflation, in its first 100 years of existence the Corporation has now managed to give away 20% of the value of Andrew Carnegie’s founding gift. What limited payout has allowed Carnegie to do is maintain the value of its founding gift—in other words it allows the Corporation to be eternal (and this seems to have been Andrew Carnegie’s goal). In fact the basic economics dictate that if the foundation’s investment returns do not exceed the inflation rate, the real value of the endowment will never be paid out.

Recent economic history has moved this issue out of the limelight. Over the last 20 years of low inflation and high returns, foundations have been paying out a great deal of the value of their endowments. The current and future economic environment which likely features lower returns and quite possibly higher inflation. That should put the issue of foundation payouts back on the agenda even if nothing else does. While deflation is also a real economic risk, a deflationary environment is also a powerful reason for increasing foundation spending as a fiscal stimulus.

Another of the arguments commonly mustered in defense of relatively low payout rates is the importance of stability and experience in the sector. Our largest social problems require long-term solutions – hence the need for foundations who can stay the course over the long term. Again, this argument makes sense in theory but is hardly supported by the reality. In practice, foundations change strategies and focus fairly frequently – as they should if a problem is eliminated or research suggests a better approach. But this undermines the argument that perpetual foundations provide stability.

It’s also hard to argue that perpetual foundations make better decisions than spend down foundations—does anyone really believe that Ford, for instance, has significantly bettered the Atlantic Philanthropies? Where stability does exist it is rarely a positive. Perpetual foundations limit the pressure for altering strategy based on changing contexts—a phenomena the Monitor Institute calls a “lack of survival anxiety.“ We’ve long since accepted that dynamism in our economy, creative destruction, is on net good for society. Wouldn’t philanthropy benefit from some good old-fashioned creative destruction?

There are other very good reasons for rethinking the fixed payout rate—cyclicality for instance. Under the current structure, when the economy is doing well, foundations pay out more. When the economy is suffering, foundations pay out less. Isn’t this the exact opposite of what we should want from philanthropic foundations?

So why don’t we consider some changes? For instance:

* Make the payout rate counter-cyclical: when the economy is in recession, foundations have to increase their payout rate. When the economy is growing, they can cut back payout and regrow their endowment.

* Index the payout rate to be 2% above the inflation rate. Providing that foundation’s endowment returns at least match the inflation rate, this would mean that foundations pay out the real value of their endowment in less than 75 years.

* Make the payout rate flexible while mandating that all foundations must pay out the inflation-adjusted amount of their founding gift within 50, 75 or 100 years. If their endowment is well managed, they could continue to live on for hundreds of years more on the accumulated investment income.

* Put a cap on the amount anyone can give to a foundation tax-deductibly, as suggested by Richard Posner. It’s hard to imagine that a limit of $1 billion (adjusting for inflation) would have a material effect on anyone’s giving. Given the size of some of the newer foundations, some might challenge this assertion – but let’s be honest. Gates and Buffett are clearly not driven by tax breaks. Megabillionaires could still create much larger eternal foundations if they are willing to do so without being funded by a tax break. And if the foundation gifts were smaller because of the reduced tax advantage, keep in mind that up to 50% of what wasn’t given to a foundation would be given to the public good, at least in theory, through estate taxes.

For a copy of the analysis of foundation endowment growth and other figures in this article, please contact us.