Threats on the Horizon

The possible influx of untrained staff and trustees is far from the only threat facing foundation philanthropy. Foundations exist by the grace of God, Congress, and the Internal Revenue Code, and as some jaded foundation executives remark, not necessarily in that order. Congress can, at any given moment, create a threat to foundations by means of legislation; and federal agencies, such as the Internal Revenue Service, can do the same by issuing regulations. Only rarely in history have regulatory agencies or Congress deliberately drawn a bead on foundations, but in the course of aiming “silver bullets” at unrelated problems, members of Congress and regulators often discover that the bullet passes through its target and maims innocent bystanders. It is in fact these unintended consequences that often pose the greatest danger to foundations.

An example of such an unintended consequence springs from the desire to repeal the estate tax. Critics of the tax say that it is so confiscatory that upon the death of a senior member of a family, the survivors often find that the only way to pay “death duties” is to sell the family farm or family business. To prevent such hardships, many members of Congress wish to abolish the estate tax altogether. This would solve the problem of forced sales, but an unintended consequence would be a severe drop in the number of new foundations established, because substantial estate taxes encourage people to use charitable vehicles to escape the consequences of those taxes. For example, a study on tax-restructuring proposals, authored jointly by the accounting firm of Price Waterhouse and the Washington law firm of Caplin & Drysdale (1997), concluded that abolishing the estate tax would have reduced charitable bequests in 1996 from about $7 billion to about $4 billion. The challenge for foundations is to find some way to relieve the distress of family farmers and family business owners without destroying an important incentive to be charitable that has done so much lasting good for society.

There is no shortage of ominous ideas that occasionally make their way down from Capitol Hill. From time to time, someone on that eminence concludes that the 5 percent payout rate is too modest, and launches an effort to raise it. In fact, as previously mentioned, after the Tax Reform Act of 1969, the payout rate was higher, set first at 6 percent, then at 6.75 percent of the foundation's net asset value or all of the foundation's income, whichever was higher. And because the act imposed a 4 percent excise tax, the actual annual cost of running a foundation exceeded the returns of conservatively invested foundation portfolios. If the 6.75 percent of net asset value or all of net income rule had stood, most foundations would have been simply shrunken out of existence. The reduction to the minimum payout rate of 5 percent of net asset value (and the reduction of the excise tax to a maximum of 2 percent) allowed foundations to invest their portfolios in such a way as to meet total expenses (in most years) through income, reinvest excess income in their corpus (in good years), and only resort to invading the principal in bad years. This formula in turn allowed foundations to grow in order to offset inflation and meet future needs.

The big bull market of the 1980s and 1990s, however, brought some fabulous years in which foundation portfolios approached a 20 percent increase in assets. Critics complained that the 5 percent rule, which was meant to be a minimum, was being treated by foundations as a maximum. It was obscene, they said, for foundations to make 20 percent and pay out much less. Foundation leaders replied that overhead expenses and the excise tax caused the total demand on the portfolio to considerably exceed the nominal payout rate. Moreover, when they chose to reinvest any surplus in the corpus rather than pay it out in that year, they were increasing future payout, because 5 percent of the reinvestment would have to be paid out next year. It was a matter, they said, of investing in the future by planting the seed corn rather than eating it.

This view was backed empirically by a study conducted by DeMarche Associates for the Council on Foundations, which found that, over time, a 5 percent payout rate resulted in more payout than a 6 or 7 percent payout rate. This seemingly paradoxical outcome occurs because, over the years, a 5 percent rate results in greater portfolio growth than that yielded by either the 6 or 7 percent rates, and a larger portfolio makes possible a higher long-term payout (Trotter, [1992] 1995). Specifically, the study followed three hypothetical foundations, each beginning in 1950 with a corpus of $1 million, and each investing it in identical ways. One foundation paid out consistently at a 5 percent rate, another at 6 percent, and the last at 7 percent. Initially, of course, the higher-payout foundations paid out more, but the 5 percent foundation, due to its faster corpus growth, soon began to close the gap. By 1967, it was paying out more annually than the 7 percent foundation; by 1968, more than the 6 percent foundation. By 1994, the total payout of the 5 percent foundation stood at 27.4 percent more than that of the 6 percent foundation, and 67.2 percent more than that of the foundation paying out 7 percent.

These facts notwithstanding, as foundations grow in the future there are likely to be continuing efforts to raise the 5 percent payout rate. Most efforts will be motivated by an honest belief that foundations can afford to give more. A few will be veiled attempts to make foundations spend themselves out of existence. All would result, in the long run, in fewer dollars being available for philanthropic purposes—precisely the opposite of the result that well-meaning folks are trying to achieve.

A few foundation critics immodestly eschew the veil and bluntly call for the passage of laws to limit the life span of foundations. Over time, they say, foundation staffs stray from the intent of the donor, who would be horrified, could she or he come back to earth, to see what causes the foundation is now supporting. As a case in point, such critics often cite the Ford Foundation, whose generally left-of-center funding (so they say) would scandalize the famously far-right-wing Henry Ford. Most of these critics would like to see foundations established for a maximum life span of twenty-five to fifty years, paying out a combination of corpus and income during that time period to spend themselves into oblivion. This is a responsible act, they say, because the U.S. economy will always generate new wealth to replace the old.

Defenders of the foundation ideal argue that donors tend to be successful entrepreneurs who recognize the need to change with the marketplace. This was certainly the case with Andrew Carnegie and John D. Rockefeller Sr., who understood that inflexibility in philanthropy would be just as ruinous as inflexibility in business. Spending foundations out of existence, assert their defenders, has less to do with sound social policy than it does with dubious political ideology. It violates the first law of prudent asset management, which is to preserve the principal. It is also historically reckless; spending assets on the theory that they will be replaced in the near future would have been a dreadful mistake in the 1920s and the 1960s, and may be so again today. Similar reasoning has rendered the Social Security and Medicare trust funds insolvent. Properly managed, foundations can be a perpetual asset, and forever is a long time—long enough to allow society to repent at leisure a death sentence for foundations passed in haste.

The “limited life” advocates can point to some distinguished foundations that chose to spend themselves into the history books. Among them were the Rosenwald Foundation of Chicago, which partnered with the Rockefeller-funded General Education Board in its early years to bring educational benefits to African Americans in the South, and more recently the Aaron Diamond Foundation, which distinguished itself by supporting intensive research on the cause and cure of HIV infection. These foundations made a greater impact, say the critics, by spending more in a shorter time frame. Defenders respond that there was still no cure for HIV when the Aaron Diamond Foundation lapsed, and when the next dread epidemic is visited upon us, that foundation will not be there to take the lead on funding research to combat it.

It can be safely predicted that legislation aimed at limiting foundation life spans will be introduced on more than one occasion in the future. Such efforts are laden with political meaning and are usually introduced by those who disagree with the ideological direction in which foundations seem to be heading. The Council on Foundations takes a judicious middle view, holding that choice is important. A donor should have the right to choose to create a traditional perpetual foundation vehicle or a time-limited one. There is room for both under philanthropy's tent; however, it is unwise to arbitrarily force every foundation to do things in the same way. It is a safe prediction that foundation leaders of the future will be confronting this issue again and again as the field grows.

Daunting as such threats (and others as yet unanticipated) may be, foundation employees can take comfort in the fact that they are better organized and have more clout with which to do battle than ever before. When the hearings that led to the Tax Reform Act of 1969 began in the mid-1960s, philanthropy was ill prepared to defend itself, INDEPENDENT SECTOR did not exist, and few foundations belonged to a regional association of grantmakers. The Council on Foundations was in existence, but it did not have a government relations department. As the new century begins, INDEPENDENT SECTOR mobilizes an alliance between foundations and their nonprofit grantees; many foundations belong to a regional association; and the regional associations are united under the umbrella of the Forum of RAGs. The Council on Foundations has a strong and seasoned government relations team, and all three of these organizations work in tandem on Capitol Hill and in state capitals to represent the concerns and defend the prerogatives of philanthropic and voluntary organizations. The growth of the foundation world in the years ahead should increase the clout of foundations at the policy table. Although no one should discount the threats that the future may hold, none should feel that foundations are powerless to defend themselves.