Can Increasing Payout Rates Save the Day?

One of the responses to my post on Friday, in which I argued that staffed foundations should share their knowledge to offset the decline in their investment assets, was from people suggesting that foundations should also increase their payout rate. As a general prescription, this is probably a bad idea.

Foundations are required to pay out 5% of their investment assets each year. Why 5% and not some other number? One of the reasons is that there is a rule of thumb in finance that says that a pool of assets invested in a diversified manner has a very high likelihood of sustaining a 5% payout rate forever without depleting the assets. The 5% minimum is essentially the highest level that can be required of foundations without eliminating their option to exist in perpetuity.

I don’t think that all foundations should plan to last forever. But I do think their are valuable benefits to institutionalizing knowledge and creating long lasting organizations. That being said, there are also good arguments to be made for foundations to elect higher payout rates. While doing so may force them to spend down and disband the organization, they may be able to achieve more impact through this strategy.

Too often, proponents of higher payout rates pretend that their is no trade off involved. They imply that foundations can simply pay out higher levels of grants with no impact on future giving. In the comment below, Aaron Dorfman, the executive director of the National Committee for Responsive Philanthropy makes the case for higher payouts. Personally, I think Aaron’s argument ignores the hard reality that foundations that follow his advice are making a simultaneous decision to increase the likelihood that they spend down. But Aaron and NCRP are well positioned to lead the charge on this issue and I’m happy to highlight his views.

Aaron wrote:

For me, your post reinforces the necessity for everyone in our philanthropic community to create an expectation that private foundations do more than is legally required of them.

There was a moment when the recession’s effects first began to be felt when foundations were debating what to do. A few put a halt to grantmaking entirely, realizing that legally they didn’t actually have to make any grants this year to meet their payout requirement. But then nonprofits became more vocal about the threat to their operations in a time of increasing demand and decreasing revenue. A few courageous grantmakers started making public there commitment to maintain grants payout for 2009 at 2008 or 2007 levels. And they did this even though it means their payout rate for 2009 may be 7% or 9% of assets or higher. And this responsible approach became the most socially acceptable response in foundation circles.

We need to start now working to ensure that it becomes unpalatable for foundations to consider cutting back their grants payout in 2010, even if it would be legally permissible. Nonprofits will still be struggling financially well into next year, and they’ll need grantmakers to step up to the plate.

The moral obligations of private foundations go far beyond the legal requirements. Leaders of many private foundations realize this and will act responsibly. We need to highlight their stories and challenge other grantmakers to follow their lead.

Philanthropy requires making tradeoffs. There are good arguments for why foundations should engage in countercyclical grantmaking (giving more during bad times and less during good times). There are also good arguments for planning on spending down. But simply raising payout rates doesn’t tap into a pool of free money. We don’t want to create an environment where it is “unpalatable” for foundations to preserve their very existence. We want an environment where philanthropic actors make tough decisions based on a thorough understanding of the tradeoffs involved.


  1. Eric Foley says:

    Thanks, SSS. Where I still don’t quite follow your argument is in the area of foundations sharing their due diligence with major donors in encouraging them where to give. Just as spending down a foundation’s endowment shouldn’t be thought of as a pool of free money, I would likewise suggest that major donor giving should not be thought of as a pool of free money either. Unless you would contend that major donors will become more generous as a result of better due diligence provided by foundations, we’re still talking here about trading dollars, that is, moving major donors’ giving from one organization to another.

  2. Because staffed foundations have resources for evaluating their philanthropy and limited resources exist for major donors to do the same, I’m making the assumption that individual donors could engage in more informed, higher impact giving if they had access to foundation generated knowledge.

    In addition, I also think that donors give more when they have conviction that their money is making a difference. So I would suggest that more informed donors will result in more giving. But that wasn’t my point in the last post. Just an added benefit!

  3. Sean,

    I totally agree that there are important tradeoffs here. And I also agree that we “want an environment where philanthropic actors make tough decisions based on a thorough understanding of the tradeoffs involved.”

    But lawyers and financial advisors who give advice to foundations have historically been ultra conservative and the result has been a more timid form of philanthropy. And rarely, when making those tough decisions, do philanthropic actors include at the table those whose lives are most directly affected.

    NCRP was founded to be a voice for nonprofits and for vulnerable communities in discussions about philanthropy. Our role in making our sector stronger is not to present all sides of an argument. Our role is to make the most compelling case possible in the interests of the people we are seeking to represent. And then we trust that leaders of foundations will grapple with the tough issues and make the hard decisions.

    We recognize the substantial value that perpetual foundations bring to our sector, and NCRP has never advocated that all foundations become spend-down foundations. Our longstanding position that grantmakers can pay out at 6% in grants and maintain perpetuity has compelling data to support it, though I respect those who disagree and believe fervently that 5% is the maximum they can pay.

    Just two weeks ago, the Annie E. Casey Foundation had this to say in their press release announcing the retirement of president Douglas Nelson:

    “Since Nelson assumed the helm, the Foundation’s assets have grown from $590 million to nearly $3 billion. This growth occurred despite Nelson’s and the Board’s longstanding policy of routinely authorizing an annual pay-out rate of more than seven percent, well above the philanthropic sector’s five-percent norm.”

    There are many foundations that seek to exist in perpetuity who also routinely pay out at rates above the legal minimum. They are to be commended. And especially in this time of increased need, wise foundation leaders should not curtail their giving for 2010. Yes, they should weigh the tradeoffs. But in weighing the tradeoffs, I sure hope leaders of our nation’s foundations put enough weight behind the needs and interests of nonprofits and of marginalized groups.

  4. I think where we agree is that we both believe that foundations should operate in the way that best achieves their social impact goals and that their payout rate should be designed to maximize impact not simply perpetuate the foundation as an organization.

    But too often we see people advocating for a higher payout rate position the argument as if a higher rate is intrinsically morally superior to a lower payout rate. The payout rate is a tactical decision that foundations need to addresses within a framework of impact maximization.

    I also agree that historically, the people at the table making the payout rate decision tended to focus on what the foundation could payout without jeopardizing their sustainability. I hope that in the future, the program side of the house has more of a voice at the table.

  5. Al Mueller says:

    Let’s keep the payout for private foundations at 5% but make it EXCLUSIVE of expenses rather than count expenses toward the 5%. That forces foundations to do 2 important things: manage their expenses and actually get 5% out the door to recipients. Foundations are given the preferential tax treatment because they serve a legitimate public purpose. That purpose should include getting 5% of the assets annually out to worthy organizations and doing it in a cost effective manner.

  6. Al, I’m not sure I agree that the law should be changed to require that foundations exclude expenses from the 5%, but can see how this is certainly a reasonable approach for a foundation to take.

    It is wonderful to see another philanthropy advisor commenting here. Thanks so much!