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FROM MPR NEWS
The Changing Face of Philanthropy in Minnesota:
a radio series on giving in the New Economy.
   F U R T H E R   R E S E A R C H

IN FAVOR OF FIVE PERCENT - THERE'S A PLACE FOR PERMANENT FOUNDATIONS
by John E. Craig, Jr.

reprinted from the Council on Foundations magazine, Foundation News and Commentary

According to the Foundation Center, the combined assets of private, independent foundations grew by 25 percent in 1997. While unusually large, this growth reflects the continuing impact of the prolonged bull market in stocks, which has both spurred growth in existing foundation endowments and generated the creation of many new foundations. Indeed, the number of grantmaking foundations doubled between 1980 and 1997.

American foundations originated in the early 1900s as an alternative to traditional annual giving. As revealed in their biographies, the wealthy Americans who developed the foundation model back then took their giving very seriously. Many actually found it difficult to give away very large sums of money each year in a responsible fashion. More important, early foundation donors wanted to improve society, not just dispense charity. They believed that social progress required research into the causes of complex problems, systematic and long-term approaches, careful monitoring of the use of funds, and partnerships involving the active participation of the donor in the work funded. In short, early foundation leaders believed-and demonstrated-that their consistent engagement could add value to the work they sponsored. It was from this ethos that the concept of perpetual foundation endowments emerged.

  FACTS & FIGURES

Donors with at least one family member who volunteers give twice as much of their income than do those who don't volunteer. 47% of donors contributed and had a volunteer. These households gave an average of 2.5% of their household income, compared with 1.2% among the 23% of households that contributed but did not volunteer.
More Facts & Figures

 

Once perpetuity was established as an objective by the early foundations, the issue of an appropriate annual spending rate ("payout," in the industry vernacular) had to be addressed. The eventual development of data on long-term financial market returns provided foundations with guidelines that are widely applied today. The math is simple: Permanent endowments can maximize their risk-adjusted returns with an asset mix in the neighborhood of 70 percent equities and 30 percent fixed income. Since 1900, U.S. equities have had an average annual return of 10.3 percent, and bonds of 5.4 percent, producing a weighted return of 8.8 percent. The average inflation rate for this period has been 3.1 percent, while average annual investment costs (brokerage and investment manager or mutual fund fees) have been around .7 percent. Thus, historically, a foundation maintains the real value of its corpus by spending around 5 percent annually. Such analysis underlies the current federal requirement that foundations spend at least 5 percent annually. (These numbers are based on data in U.S. Historical Capital Market Returns: 1999, Cambridge Associates, Inc., 1999). Additionally, several studies have demonstrated that foundations spending at this rate are able to generate a larger flow of dollars over time than those spending at higher rates because of the effects of compounding returns on a stable capital base.

Running with the Bull
Recent market returns and the consequent growth in foundation assets and numbers, as well as pressing social needs, have given rise to questions about the adequacy of the 5 percent minimum payout requirement.

Since the beginning of the current bull market in the summer of 1982, the average annual return on U.S. equities has been 19.5 percent. An unprecedented four-year run of annual returns exceeding 20 percent occurred between 1995 and 1998. It may be that the world economy and financial markets have changed so fundamentally in recent years as to make the long-term record on returns an unreliable guide for the future, but few market seers are yet prepared to dismiss it.

If the available long-term evidence still points to 5 percent as the rate assuring perpetuity, the question remains, is there justification for perpetual endowments? It seems to me that there is. Consider the following: Annual charitable giving fluctuates with the ebb and flow of economic activity, and it is wise to have a permanent core of endowment-based givingthat is there through thick and thin. History shows that a prolonged booming economic environment generates new foundations, but that in long economic slumps the emergence of new foundations is minimal.

Foundations are a major source of social capital that otherwise would not exist. Foundations play a role that business and government do not fill in making long-term investments to improve society. No small part of the sense that "anything is possible" in this country derives from the presence of foundations with long-term horizons and the capacity to underwrite research, innovation, and new talent. John Evans, M.D. has written about the importance of foundations staying the course when tackling social problems: "Foundations have to make a choice between making the wave and riding the wave. To make the wave requires intensive investment over an extended period of time." Perpetual foundations provide this capacity.

Well-run foundations add value in their grantmaking, even in straightforward charitable giving. They provide a degree of accountability that is wholesome for the institutions receiving grants, however much recipients may chafe under a foundation's due diligence procedures. Permanent foundations provide a body of experience and examples regarding effective practices on which new foundations draw, and help to shorten the period of casting about for direction that is common for foundations in their formative years. Foundations with short lives sometimes are felt to be closing their doors just when they have gained sufficient experience to be truly effective in their fields, or may build up expectations for continuing support that other institutions are unprepared to assume.

Foundations provide the capital for infrastructure in the nonprofit sector that makes volunteerism, fundraising, and new program initiatives possible. The nonprofit investment banker and venture capital role is one to which perpetual foundations are particularly well suited, and the voluntary sector - including foundations with short-term horizons - would suffer in the absence of these reliable windows of financing. The perpetual foundation model stimulates a larger amount of charitable giving than would otherwise occur. Congress originally set an effective payout requirement higher than 5 percent in 1969, but after careful study and public hearings on the issue lowered the rate to 5 percent in 1981-in large part due to evidence that a higher rate had dampened the creation of new foundations. The majority of newly created foundations are expected to receive their principal endowments over the next 15 years. Raising the minimum payout requirement and closing out the opportunity for perpetuity could well divert transfers that are now expected.

Permanent foundations are an important part of the social fabric of many communities around the country. Focus groups and surveys conducted for the Council on Foundations reveal that foundations are admired for the work in their communities, regarded as performing essential tasks, valued for their independence, and seen as a part of the American tradition. In cities where permanent foundations survive beyond the lives of their benefactors and even the industries that generated their wealth, they can be especially important in later renewal and revitalization.

Rapid distribution of the assets of all perpetual independent foundations would enable only a one-time and relatively small increase in current revenues for social welfare and cultural purposes in the United States-but produce a drought thereafter in nonprofit investment capital.

This country benefits greatly from a decentralized voluntary sector that helps address the needs of a diverse society. Diversity in the foundation sector accounts in part for the adaptability and flexibility that has enabled these institutions to respond to a wide variety of changing social needs. The current 5 percent minimum payout assures that foundations do not become sterile warehouses of wealth, but allows a variety of choices regarding spending strategies and longevity. In sum, there is a place for permanent foundations, just as there is for those that choose to spend down their assets over a relatively short period. A far more important question than the payout rate is whether foundations are being accountable, making a difference in society, and adding value in their grantmaking.

Foundations with high payout rates are just as vulnerable to the pitfalls of the sector as those paying out the required minimum. All foundations - and especially those with perpetuity as an objective - should regularly and rigorously examine their activities and attempt to assess whether their accomplishments justify the foundation's continuation. Perhaps the most constructive aspect of the payout debate is that it puts a sharper focus on the very high standards of accountability and performance that should apply for all foundations.

John E. Craig, Jr. is executive vice president and treasurer of the Commonwealth Fund in New York City.


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