Rethinking Foundation Spending Policies

by Ehud Zion Waldoks

The financial crisis of the last few years has forced many foundations to radically rethink their spending policies. Many organizations had their capital wiped out; others have found it hard to maintain the high return rates they were dependent upon.

A one-day conference at Ben-Gurion University of the Negev brought together many notable names to present some original thinking on the new situation. A crowd comprised of foundation directors, consultants, donors, government officials and students from Israel participated in the “Endowment and Asset Management Conference: Payout Policies and their Financial, Managerial and Intergenerational Implications,” organized by the university’s Israeli Center for Third-Sector Research on November 7, 2011. Conference speakers laid out practical considerations that should guide the thinking of those involved with foundations.

“The restless financial markets of recent years have brought up some major dilemmas for philanthropic foundations, on whose support many nonprofit organizations rely. These dilemmas are not only on the investment side – how to invest endowment funds in turbulent markets, but increasingly also on the spending side: what should the foundation’s payout policies be? How should investment risk be distributed between the foundation and its grantees? What do different payout policies such as, for example, the new trend of lifetime spending and “sun-setting” the foundation in the donor’s lifetime, mean for the foundation’s management? What are the implications for the recipients’ sustainability, for the social impact of the foundation, and for internal relationships within the foundation like intergenerational transfer of leadership in family foundations?” Dr. Hagai Katz, director of the Israeli Center for Third-Sector Research and chair of the new MA Program for Nonprofit Management, said. “The professional and academic discourse around these issues to date has been scarce worldwide, and in Israel it has been virtually inexistent. Knowing that these are questions of huge importance for the foundations and their recipients, we decided to bring these issues to the fore and try to stimulate a professional and academic debate. For this reason we at ICTR joined forces with Prof. Simon Benninga from Tel Aviv University, the London Based Samuel Sebba Charitable Trust, and Dr. Zvika Afik from our University, to organize a first symposium on Endowment and Philanthropic Asset Management,” he added.

Alan Feld, Senior Managing Director at Bernstein Global Wealth Management a unit of AllianceBernstein, starkly laid out some of the new realities for foundations. Feld is a trustee of the AVI CHAI Foundation, which was endowed by Zalman Bernstein of the US and Israel.

“The days of spending in perpetuity are long gone. The volatility of the last few years came as a rude awakening,” he told the audience. Some foundations lost as much as 30% of their assets, he said.

In order to pay out at a 5% rate, he continued, 8% needs to be generated in returns to balance inflation.

“Earning 8% returns is no simple matter. To do so, meaningful risk has to be taken on and that makes boards feel uncomfortable. Moreover, it’s hard to give away 5% while assets are declining 25%,” he said.

Feld indicated that there are two drivers of foundation fiscal strategy: investment policy and asset allocation, which are intertwined.

The major question now for a lot of foundations, according to Feld, is whether the payout strategy needs to be modified in light of the volatility of the past few years. A lower yet steady distribution would extend the life of the foundation. However, others have chosen to adopt a sunset policy – where a date is set for the closing of the foundation. The AVI CHAI Foundation, for instance, will put itself out of business in 2020, Feld said. At the same time, it is looking for ways to extend the programming that goes on at Beit AVI CHAI in Jerusalem.

Bernstein Global Wealth Management has developed a Wealth Forecasting System to help foundations make these decisions, Feld said. A complicated statistical and mathematical system, it sorts through more than 10,000 potential outcomes.

“It’s a way to make decisions based on something other than your gut,” he said.

One way to reduce volatility is to adopt “smoothing”, he offered. Instead of giving away 5% every year, take the average of a few years or five years and give that away instead, he suggested. Smoothing reduces the chances of a 10% drop to 1 in 71 from 1 in 7.

The AVI CHAI Foundation is one of the most well-known foundations to adopt a sunset policy, but there seems to be a small growing trend, according to Tony Proscio, a consultant and senior fellow at the Center for Strategic Philanthropy and Civil Society at Duke University. He outlined some of the challenges and considerations of such a policy.

One advantage of a sunset policy is that the goals of the foundation will not waver because the foundation will not outlive its founder. It can also serve to focus the will and energy of the foundation. Moreover, if the foundation ends with its founder, then the children and grandchildren are freed up to support, or not, their own causes. He gave the example of the Charles Bronfman Foundation, who decided to shut down his foundation and leave the remaining money to his heirs to distribute philanthropically as they saw fit. However, the challenge is to secure someone to continue to champion your causes once you decide to bow out.

“There are several barriers to ‘replacement’ funding: Foundations often ‘brand’ their causes and no other foundation wants to support a cause that they won’t receive recognition for doing so. There might also be a lack of alternative funding sources in that particular field,” he told the audience.

“At the end of the foundation’s life, how will it unwind its obligations? If there are organizations that are solely dependent on the foundation, is it the responsibility of the foundation’s board to ensure the NGO does not go under?” Proscio recommended to all NGOs that they diversify their funding so as not to become over-dependent on a single financing source. He also suggested offering other foundations branding opportunities and adopting a policy of tailing off to the end of the foundation’s life rather than a sudden exit.

Prof. Peter Frumkin of the University of Texas at Austin dissected the 5% payout requirement in the United States. Frumkin, who heads the RGK Center for Philanthropy and Community Service, critiqued the law as severely detrimental to giving.

“The 5% payout requirement was created as a floor for minimal giving. Instead, it’s become a ceiling. It was originally created as part of a last-minute political deal with no profound policy to justify it,” he explained.

According to Frumkin, a steady 5% payout rate doesn’t properly address the nature of today’s problems.

“There’s a fundamental disconnect between foundations’ payout strategies and strategic philanthropy,” he declared. The real question should be: What is the problem that I am working on and how much and when would be best to put money into solving it? If it makes sense to give 12% at the beginning, then that’s what should be done, he maintained.

The 5% rate is more about maximizing the financial return than the social return, he stressed.

Frumkin reasoned that the 5% payout rate has become ubiquitous for several reasons. First, foundations are on autopilot. A 5% rate would ensure perpetuity for as long as possible. Second, it is easily measurable as opposed to social returns. Third, trustees believe that 5% is prudent. Fourth, incentives to Foundation executives disincline any executive from bringing the foundation to an end rather than striving for perpetuity. Fifth, there is a belief among trustees that the NGO sector could not handle more than 5% a year. If given more money, it would be wasted.

Frumkin also pointed to vehicles with no payout requirement, such as donor advised funds, which in fact had “wildly divergent payout rates. In this case, deregulation was actually helping.”

Israel is considering just such a 5% payout requirement so the analyses of Feld, Proscio and Frumkin were especially relevant. Government officials took careful notes at the conference to bring back to their superiors. The second part of the day focused more specifically on the Israeli scene and the recent and potential changes in the law.

“Despite the threat of rocket fire on Beersheba and a general strike on the morning of the conference, the interest and the attendance in the conference were impressive. The audience was comprised of foundation officers and donors, professionals and consultants, nonprofit senior staff, academics, and students. The responses to the lectures and the panels showed that there is great interest in the foundation payout dilemma, and that the debate that was started in the symposium is a timely one, as it comes at a time when Israel is attempting to legislate a law for foundations. The payout issue and particularly the foundational question behind it – should foundations be perpetual or not, appears to be a core concern in such legislation. The connections made at the symposium are just the beginning of more work on the academic and the policy side that we are planning to undertake in the coming months,” Katz concluded.