Payout Redux

Friday, April 9, 2010

By Charles H. Hamilton
Senior Fellow, Philanthropy New York

In recent years, much has been made of payout rates. On the one hand, many writers have favored increasing the 5 percent minimum required of foundations because it “reaffirms some of the basic principles of effective grantmaking, such as mission clarity, focus and impact” (Beyond Five Percent: The New Foundation Payout Menu). But it does no such thing; payout does not determine mission or effectiveness. Calling for higher payout requirements seems more related to political agendas or the unquestioned conceit that giving now is always better than later. On the other hand, much of the statistical research clusters around 5 percent as the minimum that allows foundations to be enduring institutions: taking into consideration market cycles, expenses, excise taxes, and inflation. But the minimum has become the unquestioned ceiling for most foundations because foundation officials and boards are cautious (or lazy) and fail to align budget and mission. This may be a good time to revisit the payout question.

I have come to believe that, if there is to be a payout rate, 5 percent is a proper, balanced minimum rate allowing potential endowment (and grantmaking) growth for those crisis times, special needs, or opportunities that always occur and need responding to. But any mandated rate should allow wide choice of the goals, strategies, and lifespan decisions needed to meet mission. I do believe that we need updated time series data on appropriate payout rates; I also believe that in times of recession like these, foundations should spend over 5 percent to at least keep spending level—with the understanding that over time this will mean eating into their endowment capital and their future.

Whatever the payout rate, foundations should approach it in two ways. First, it should be the result of explicit decisions aligning budget, mission, strategy, and impact. A single regulated rate does not fit all foundations or all situations. Several intrepid researchers have even suggested that “nothing other than the elimination [of] any and all mandated payout rates” will “clearly encourage foundations to adopt a payout rate that strategically links mission and payout decisions within foundations” (The Foundation Payout Puzzle, by Akash Deep and Peter Frumkin). The mere thought caused arrhythmia among policy wonks and was so politically radical that the idea was quickly put back into the bottle!

Second, foundations should understand the implications of their payout decisions. For instance, the cost of higher payouts became clear to me when I was told the story of a foundation in the 1970s that heeded President Nixon’s call for private charity to do more. They increased their giving for 10 years or so; it took decades to recover their endowment. In another example, another foundation was regularly paying out about 7 percent. That is a perfectly fine choice for a board to make, but I thought they should understand what their decision meant. An analysis of spending over time showed that the higher payout resulted in less total money being given to grantees. In both of these cases, the added endowment draw was unsustainable, and meant less money was available to be spent over time (even at a higher payout rate) on those issues and grantees each foundation cared about. A higher payout not only eliminates assets from net worth, but it also eliminates the power of compound interest that those assets would earn.

Whatever the payout rate, attention to unintended consequences is also crucial. A mandated payout rate in excess of 5 percent almost guarantees foundations will eventually run out of money and close. It has been suggested, however, that this will be offset by the creation of new foundations. But a higher rate that forces spend out will very likely decrease the attractiveness of foundation formation to some donors and increase the attractiveness of other estate decisions (for current consumption, or for children or favorite charities, for example). It could further decimate philanthropy.

Some have urged an indirect approach to increase payout: eliminating foundation administrative expenses from the 5 percent minimum (currently, administrative expenses related to charitable activity can be included in the 5 percent calculation). This is an ironic and self-defeating idea, just as foundations finally begin to understand that administrative expenses are integral to the organizational health and program effectiveness of their grantees—which is the case for them as well. Eliminating administrative expenses from qualifying distributions would decrease the due diligence, public policy, advocacy, communication, and technical assistance direct expenditures of foundations by effectively increasing their “cost” in comparison to grants.

None of this, though, means that 5 percent is the proper ceiling! What is a sensible foundation to do? It depends, and that is the beauty of a diverse and independent philanthropic sector. As a general rule, I would suggest that foundations make sure they meet the 5 percent minimum but otherwise ignore it. Thoughtful consideration of mission and strategy will determine whether more than 5 percent is a proper payout. One writer has suggested that foundation boards develop a written payout strategy; perhaps this could address the inevitable ups and downs of market cycles and the approach to take for crisis periods or unusual opportunities.

Since most foundations report they intend to be enduring institutions, maintaining fiduciary care and being concerned about future impact are important. In good times, endowments may grow, leading some to raise the “warehousing of wealth” alarm. Assuming, however, that asset growth is permanent is to ignore the risk of market cycles. Over time, markets also go down and wreak havoc on endowments and the nonprofit sector in general (see the 1970s, 1987, 2003, and the last two years). If foundations are careful about their assets (and asset growth), they can respond to those inevitable rainy days, crises, or unique opportunities without jeopardizing the foundation’s future. If only they would do so.

Now is a rainy day! Unfortunately, treating the payout minimum as a ceiling has meant that giving runs cyclically with economic growth: as the economy and endowments grow, so does giving. And as the economy sours and endowments take a beating, giving goes down. (The current excise tax regime for foundations further encourages this cyclical behavior.) Thus a great many foundations reduce grantmaking budgets precisely at a time of greatest need, adding turmoil to the nonprofits they are supporting. Those reductions will continue for several years to come as the economy slowly rebounds. (And yet it should be noted that many foundation staff members I’ve talked to have admitted that smaller grantmaking budgets have been an opportunity to cull less effective grantees. We really need a recession to do that?) It would generally better serve grantee health if grantmaking ran countercyclical with the market. Foundations could dip into their endowments for short periods without bringing their own existence into question or decimating their ability to respond to grantees in the future.

There can be real costs to higher payouts (mandated or chosen) that result in lower grantmaking in subsequent years or even lead to spending out. And there can be real social costs to not paying out more, depending on the economic situation and the mission for which a foundation cares. A minimum rate of 5 percent seems to make sense and allows for the kind of diversity and choices of lifespan, mission, and strategy that makes philanthropy a vibrant part of civil society. I would feel a tad better about that sentence if I really believed most foundations were deliberate in their decision-making around this issue. We need more discussion, openness, and questioning about this issue, without a lot of baggage; we need foundations to become less complacent. At the end of the day, though, I trust the imperfect results of publicity and press—as well as the often maddening diversity among thousands of foundations—more than tinkering with a one-size-fits-all mandated rate, and basing that tinkering on all sorts of political agendas while ignoring the unfortunate, unintended consequences embedded in them.

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