How to boost charitable giving.

How to boost charitable giving.

How to boost charitable giving.

Moneybox
Commentary about business and finance.
July 3 2003 5:42 PM

The 5.4 Percent Solution

How much should foundations have to give to charity? More than they do.

Who could oppose a piece of legislation called the Charitable Giving Act of 2003? The nation's largest charitable givers, that's who.

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The House bill would require foundations to spend more on charity, and they're irate about it. Currently, to maintain their (largely) tax-exempt status, foundations must distribute 5 percent of their assets per year. But they're allowed to count administrative costs—executive salaries, rent, catered lunches, retreats at corporate conference centers, etc.—in that total. The bill would make the $400-billion-plus foundation sector devote the full 5 percent to charitable giving and pay administrative costs separately.

This isn't just another effort to defund the left. The bill, introduced in early May, has bi-partisan backing: The sponsors are Rep. Roy Blunt of Missouri, a Republican, and Rep. Harold Ford of Tennessee, a centrist Democrat. And the National Committee for Responsive Philanthropy, which sounds like a rightish group but has a leftish board,also supports the measure. It says that foundations counted $2 billion of their administrative costs toward the 5 percent spending requirement 1999, and that such funds could be better used in the field—especially now. House Ways and Means Committee Chairman Bill Thomas doesn't seem particularly eager to take up work on the Charitable Giving Act, but since it also contains crucial elements of President Bush's compassionate conservative agenda—like allowing non-itemizing taxpayers to take deductions for charitable donations—supporters expect the White House to push for passage.

The Council on Foundations is highly concerned, viewing the legislation as an unwarranted intrusion on its turf and as a change in a regime that has worked well for decades.

But the 5 percent solution doesn't stem from any tried-and-tested rule of portfolio management or philanthropic best practice. It's largely arbitrary, and it has changed several times over the past few decades. Congress in 1969 set the contribution floor at 6 percent, including administrative expenses, and then changed it to 5 percent in 1981. This paper by Peter Frumkin and Akash Deep of Harvard's Kennedy School of Government argues convincingly that the floor—whether it was 6 percent or 5 percent—functions more like a ceiling. The 5 percent solution, they note, "has had the effect of repressing foundation giving."

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Most foundations don't spend profligately on overhead. Sure, there are bad apples. (The New York Times last fall embarrassed the Markle Foundation by reporting on the spending habits of top executives.) But most foundations husband resources wisely and pay modestly compared to the for-profit sector. The bill's sponsors suggest that expenses should eat up about 0.4 percent of assets annually, meaning foundations would henceforth have to part with about 5.4 percent of assets each year. That doesn't seem onerous, especially when you consider the bill's sponsors are offering a carrot to the foundations in the form of a tax break.

And 5.4 percent certainly seems manageable, given foundations' historic returns. Frumkin and Deep found that between 1972 and 1996, "as a group, the foundations in our sample have returned 7.62 percent annually on their assets, while paying out an average of 4.97 percent." That's pretty good. A 1999 study by DeMarche Associates, which was commissioned by the Council of Foundations, concluded that foundations could have paid out 6.5 percent each year between 1950 and 1998, and their assets still would have grown by about a quarter.

For their part, foundations argue that what outsiders may view as administrative costs—conducting research, assisting grantees, finding new beneficiaries, soliciting new grants—are an essential component of the charitable work. In light of the recent and significant economic decline, the historic return of 7.62 percent may be difficult to replicate. Interest rates on government bonds yield significantly less than 5 percent, and the stock market has declined recently. The Council of Foundations argues that when you consider investment management costs and inflation,"a foundation must earn an average return of 9.5 percent return on its investments to sustain the purchasing power of its corpus, pay its investment management costs, and distribute 5 percent of its assets annually for charitable purposes." 

There is a more compelling financial argument to be made on behalf of lower pay-out levels. Less spending in the short term means more spending in the long term. The DeMarche study found that over the time period it examined, a foundation spending 5.5 percent of net assets annually would wind up giving more than it would have if it had been spending 6.5 percent annually.

At root, the bill exposes the conflict over whether foundations exist to make an impact quickly and divest themselves of assets, or whether they exist to perpetuate themselves—and enrich the executives who run them.

There's something to be said for foundations that live on borrowed time. In the early 1980s, Aaron and Irene Diamond (he was a real estate developer, she a former Hollywood script-reviewer who purchased the play that later became Casablanca) created the Aaron Diamond Foundation, and vowed to pay out some $200 million in assets in 10 years. Aaron Diamond died in 1984. Over the next several years, his wife gave generousy, providing tens of millions of dollars to support the research of Dr. David Ho, who helped develop the protease inhibitors that have extended the lives of millions of AIDS patients. She also made huge donations to Jazz at Lincoln Center, the Juilliard School, and Human Rights Watch. Irene Diamond died earlier this year, a sainted philanthropist. It may be that her foundation could have ultimately given away more money over the long term by sticking to the 5 percent solution. But mankind has arguably reaped far greater returns from her get-poor-quick scheme.