August 18, 2005 | Read Time: 7 minutes
For years, the philanthropic world has debated whether private foundations distribute a big enough portion of their assets every year for good works, but the discussion has tended to stall over a single issue: whether the federal minimum payout requirement of 5 percent of investment assets should be higher, lower, or remain unchanged. Typically the debate has been framed by competing arguments related to investment returns. Many foundations argue that to distribute more than the minimum would jeopardize their portfolios and perhaps force them out of business. Those on the other side contend that grant makers could spend more without undue financial risk.
The time has come for the foundation world to move beyond this worn path of debate and engage in a strategic examination of how payout rates can better reflect the mission of each foundation. Foundation executives, board members, and donors should be expected to have a carefully crafted strategy that allows them to weigh the merits of spending more money now on good works versus deferring outlays until later. While the logic of strategically matching payout to mission may seem self-evident, studies of payout levels, along with the observations of scholars and other nonprofit analysts, suggest that too few foundations have taken this approach to heart.
To begin the process, each foundation — its board, executives, any living donors, and other relevant parties — should carefully consider several key questions, reviewing them periodically and using the fruits of the analysis to help shape spending practices. Those questions include:
- What is the proper role of private foundations in a democratic society and in what way is that role distinct from that of charities?
- How, exactly, does the foundation determine payout policies? Are the policies systematically reviewed? Are methods in place to invite suggestions from all relevant constituents, including grant recipients?
- Are administrative expenses counted toward the payout requirement, and, if so, what is the specific reason? Are the expenses legitimately related to the foundation’s mission, and in what way?
- How does the quality of leadership by executives, trustees, and donors affect the way the foundation shapes its payout policies and the way they are perceived? Does a proper balance exist between the duty to protect assets and the obligation to distribute assets in the form of grants?
- If the foundation seeks to operate in perpetuity, what is the distinct rationale for the policy?
A shift in institutional thinking about payout cannot come too soon. The issue has gained new urgency as demand for charitable services has risen and financial support from government and private donors has softened. Moreover, foundations are under scrutiny from Congress and the newsmedia over their spending and management practices, and it seems only a matter of time before regulators impose tighter standards on how grant makers must meet their payout obligations.
Matching payout to mission is, to be sure, a complex exercise that requires a foundation to carefully weigh its goals, the needs of its grantees, the influences of economic cycles, and the particular nature of its philanthropic work, then seek to achieve its grant-making objectives with the most prudent deployment of financial resources. Holding back on spending might make sense if a foundation believes needs will be greater or philanthropic approaches will be more effective in the future than they are now. An accelerated payout, on the other hand, might make sense if the foundation’s goals are justifiably immediate or if a problem might grow worse if spending is deferred. The point is that strategic thinking about missions and money needs to inform every foundation’s governance decisions.
The need for this approach is perhaps most compelling in the context of foundation growth and current payout practices. In a new study of how the payout requirement and other tax provisions affect grant makers, two accounting professors, Richard Sansing of the Tuck School of Business at Dartmouth College and Robert Yetman of the University of California at Davis, found that assets among nearly 3,800 foundations more than doubled in just six years, through the 2000 fiscal year, to $310-billion — an annualized growth rate of 13 percent. The 2000 figure includes the 35 largest non-operating foundations. About 74 percent of the growth was from investment returns and 21 percent from new donations.
The study concludes that wide variations do exist in payout rates. But foundations paying out more than 5 percent in grants and overhead tended to be smaller organizations, ones whose assets were growing at a higher-than-average rate, and ones that spent more on administrative costs. Thus, they presumably were newer foundations with significant money flowing in.
In fact, a little more than half of the foundations in the study followed the minimum-distribution requirement to the letter or appeared to use it as a guideline for their spending practices, according to Mr. Sansing. Moreover, the foundations that spent at the 5 percent level tended to be larger grant makers with little new money coming in.
Thus, one can reasonably conclude that the largest grant makers — the ones that control most of the assets held by foundations — are, on average, the most conservative in their spending policies.
Of course, a foundation could have many reasons to be conservative in its spending. Legal stipulations in wills and trust agreements, for example, may require a grant maker to operate in perpetuity, leading trustees to exercise extreme caution in disbursing assets. More broadly, the requirements of fiduciary duty naturally make the guardians of foundation assets fiscally conservative and risk-averse.
Yet the relative lack of pluralism in foundation payout rates suggests that many grant makers have accepted the 5-percent target without doing enough to weigh their spending practices against either their missions or the deeper questions that lie at the root of the foundation movement.
A shift in focus on payout toward a strategic, mission-based approach would accomplish several objectives. For one thing, grant money would be deployed with maximum effectiveness. By thinking more strategically about mission, and reviewing mission goals frequently, foundation officials would ensure that their focus remains on the intent and results of programs, not on meeting arbitrary payout guidelines or preserving assets for preservation’s sake. Such a shift would, over time, also help foundation officials to open a dialogue with living donors and prospective contributors about the pros and cons of seeking foundation perpetuity.
In addition, by systemically reviewing payout practices in light of program missions, foundations would be more sensitive to the needs of grantees and the financial challenges they face. A payout approach built on mission would encourage foundations to aid grantees with all aspects of program work that contribute to mission success, including supporting legitimate needs for operating help through so-called capacity grants. In addition, a stronger link between mission and payout would encourage foundations to take the long view in allocating resources, rather than automatically reverting to a target distribution rate of, say, 5 percent of assets. Such an approach would reduce the likelihood that foundations would leave charities in the lurch by withholding money during downturns in the economy, when support is needed most.
Moreover, by more closely tying payout to mission, foundations could defuse some of the regulatory pressure and public scrutiny that have arisen in recent months. If payout decisions, including spending on overhead and administration, are guided by mission goals, and if those decisions and goals are explained in ways people affected can clearly understand, foundations will reduce the mystery and suspicion surrounding their operations.
A frank dialogue among foundations — one that includes recommendations from trustees, donors, and grantees — focusing on how better to tie payout practices to mission is overdue. And so is a shift in institutional thinking if the debate on payout is to move beyond the traditional question of whether this percentage or that is the “right” number.
Thomas J. Billitteri, an independent researcher and writer, is a former news editor of
The Chronicle of Philanthropy. This article is adapted from “Money, Mission, and the Payout Rule: In Search of a Strategic Approach to Foundation Spending,” a working paper of the Aspen Institute’s Nonprofit Sector Research Fund. The complete paper is available at the Web site of the research fund (http://www.nonprofitresearch.org).
