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.
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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
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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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