At the 2003 annual meeting, the Philanthropy Roundtable held a panel discussion on the recent controversies over possible changes to the law governing minimum payouts by foundations. The lead speaker was Peter Frumkin, associate professor of public policy at Harvard’s John F. Kennedy School of Government. Excerpts from his talk follow.
In the first half of 2003, Representatives Roy Blunt of Missouri (R) and Harold Ford of Tennessee (D) introduced a bill in Congress, H.R. 7, that would no longer allow private foundations to include administrative expenses as part of their required 5 percent payout. The philanthropic community erupted in debate, and eventually the bill failed, in part because of strong opposition by many foundations.
Rather than dissect this year’s controversy, I want to set the issue of foundation payout in historical context. Let’s start with a quotation: “It was a period during which foundations were kicked in the shins and had their noses bloodied, and consequently we who work for them tend now to harbor an understandable sense of injustice. We resent the unfairness and shortsightedness of some of the features of the legislation and the extra burden these will cause us. We resent the irrational emphasis placed by the Congress on a few uncharacteristic instances of administrative caprice in foundations, while the overall positive record of foundations in American life was ignored. We resent the impression left with the public that foundations were simply indicted, tried, found guilty, and punished.”
Who said that? You may guess it’s someone at the Council on Foundations complaining about H.R. 7 this summer. Actually, it goes back 34 years to Alan Pifer of the Carnegie Corporation, who was speaking about the Tax Reform Act of 1969, which laid down the first major regulations imposed on American foundations.
The 1969 Act is where today’s controversy starts. It resulted from a long investigation by Representative Wright Patman, a populist Texas Democrat, who pursued his quarry for nine years with a long series of hearings. The regulations the Act imposed included a prohibition on self-dealing for board members, limits on the riskiness of investments of foundation assets, and a 20 percent limit on the ownership of one company’s stock. The Act also limited the political activity of foundations, largely in response to controversial grants by the Ford Foundation that involved voter registration. And, for the first time, a payout requirement was instituted, which the ‘69 Act set at 6 percent; an excise tax on net investment income was also established at a rate of 4 percent—both of which have since been lowered.
The 1969 debate involved great political contention. There was a movement to impose a 40-year death sentence on all foundations, and it came close to passing. But at the last minute of the last day, December 31, 1969, they came up with a substitute: the payout requirement. Instead of requiring foundations to go out of business, the legislators decided, we’ll impose a payout requirement to force foundations to give away a certain amount of their funds.
I’ve investigated this legislation and talked to people involved in the debate. There’s absolutely no evidence of any economic, legal, or accounting research to back up the 6 percent figure. The only rationale for that number was a sense that it might be about right. In a few years, it was lowered to 5 percent when economic times seemed tough, and three decades later that is the number we still live with.
What were the consequences of the Tax Reform Act of 1969? They are many and complex, but let’s focus on one. When the foundation world was confronted with these new demands, the response by the larger foundations was a substantial wave of professionalization. In my research, I find a massive influx of staff people into foundations and a whole set of new activities aimed at increasing the transparency and professionalism of foundations. You can see this reflected in the chart that shows administrative expenses as a percentage of grant outlays from 1957 to 1989. After 1969, administrative expenses zoom upward and nearly double. Ironically, given the recent congressional outcry over administrative expenses, we can trace rising administrative expenses to Congress’s regulation of foundations in the first place.
The heart of the current debate is whether the law should be changed to exclude administrative expenses from the 5 percent required payout. Assuming that foundations don’t react with massive lay-offs and cost-cutting, which I don’t foresee, we can predict there would be a small increase in the actual payout of foundations. Let me briefly sketch out the arguments on both sides of the issue that my colleague at the Kennedy School Akash Deep and I came up with when we began thinking about the payout issue.
On the side of higher payouts, there are at least four arguments. First, you may want to have a higher payout rate for your foundation because you believe in early intervention—get in early, solve problems at their root, nip them in the bud.
The second argument for a higher rate involves inter-generational equity. Shouldn’t the present generation, which has lost the taxes that would have been paid on money given through a tax deduction to a foundation, be the generation that benefits from those deducted dollars, rather than people 50, 100, 200 years later?
A third argument for a higher payout rate says, “With all the new entrepreneurs making fortunes and all the baby boomers about to pass on their wealth, the foundation world will have enormous new sums coming in. Today’s foundations can give more freely without worrying that the sector’s resources will be depleted.”
A fourth argument observes that if money went out the door more quickly, it would strengthen donor intent in foundations by avoiding the mission drift that most foundations suffer over time after the original donor’s death.
There are good arguments on the other side of the payout debate, however. And I’m sympathetic to both sides at some level. First, there’s the argument that the world is a dangerous place, and we’d better have money saved up for the long term because things are likely to get worse. We can’t solve a lot of these problems quickly; so we need resources to address them down the road.
A second argument observes that the financial markets are uncertain. How dare we pay out significantly more today if we don’t know what will happen financially tomorrow?
Then there’s the argument that we have 30 years of experience with the 5 percent rate. We know this works and allows foundations to preserve their endowments while doing public good. Why change?
And a final argument: Not only may current problems be worsening, new ones will crop up that we can’t even predict now; we must conserve our resources.
Now given these good arguments on both sides of the issue, you might expect foundations to have a widely dispersed array of payout decisions. Some should have low payouts, some high, reflecting their differing views. But when Deep and I studied payouts from 169 large foundations over a 25-year period, a period in which the payout rate went from 6 percent to 5 percent, I found the vast majority of these foundations hewed very close to 5 percent. Other data for more foundations tell a similar tale. It seems nearly everyone for the last 20 years has been clustered around 5 percent.
A lot of possible explanations for this convergence come to mind, and I’ve done numerous interviews with trustees and CEOs about it. For now let me just give three explanations. First, foundations are very cautious. They don’t want to make a big mistake, and so 5 percent, even though it was intended as a floor, has become a ceiling because of this aversion to risk.
Second, there’s a certain amount of prestige and pride associated with being big. The bigger you are, the more power you have. There is plenty of data that shows a clear relationship between the salary of a foundation head and the size of the endowment. So the larger the foundation grows, the more the staff earn, and similarly, the larger the foundation, the more likely the board will be compensated and the greater the likely compensation.
Finally, foundation board members, who are the ones usually making the payout decision, are very candid about their preference for focusing on finances rather than grantmaking. Trustees can closely measure their endowment’s performance. They can benchmark it against other foundations and see how well they are doing. They get excited during board meetings when finances are discussed, because they’re finally talking about something that makes sense to them. When it comes to the grantmaking, trustees often don’t understand how they can measure performance or know that their funds are being used wisely.
Foundations boards tend to be populated with businessmen and other people with backgrounds in finance. They are naturally attracted to optimizing performance on the financial side. Many board members have told me that they just don’t really believe staff claims about social returns because the evidence is often very anecdotal.
The Right Question
I would argue that today’s debate over payout is a bit off, because we’re focusing on the questions, “How high should the rate be? Should it include administrative expenses?” The real issue is, “Are foundations’ financial decisions strategically aligned with their missions?” If you’re working in the area of AIDS or some medical disease that has a time horizon of, say, 20 to 40 years, I think you’re foolish to pay out the bare minimum of 5 percent. But if you’re working on the global environment or some problem you think has a long time horizon, 5 percent may be too high. Given the plurality of missions in the foundation world, we should want and expect a variety of payout decisions. But we simply don’t see this variation.
In the end, I see the major challenge as, “How do we structure the payout rules so that foundations are connecting their financial decisions to their mission decisions?” The fact that so many foundations are so close to 5 percent is prima facie evidence that they are not making this link between their financial and social purposes.
As for the right public policy option, let me suggest one nobody is discussing—eliminating the payout requirement entirely. That’s an academic, blue-sky idea, of course, but think about it for a moment. If Congress took away this looming target of 5 percent that everyone aims at unthinkingly, and instead told foundations, “You have to figure this out for yourself,” I think it would have a powerful result, because it would force everyone to grapple with the question of how to align their social and financial strategies. That would be a wonderful thing in that it could not help but contribute to the formulation of intelligent strategy in the field of philanthropy—strategy that brings mission and finances into alignment.
Peter Frumkin is associate professor of public policy at Harvard University’s John F. Kennedy School of Government. He is the author of On Being Nonprofit, published in 2002 by Harvard University Press. He earned his Ph.D. in sociology from the University of Chicago.