Fixing a Problem of Foundation Payout

The topic of private, non-operating foundations’ payout has not been popular as of late. This is not surprising as we are still in the aftermath of one of the worst financial crises to hit the U.S. Arguably, however, this topic shouldn’t be tied to how well or how poorly foundations’ investments are faring; rather, payout should be an ongoing discussion as it represents a timeless question of what we want foundations to achieve. Hence, I’m bringing this topic up again, but with a different approach to this conversation. Rather than advocate for a solution based on a personal ideology of what I think foundations should be doing, I’d like to revisit a technical benefit of tying foundation payout to investment performance, a long-forgotten part of the original tax code that was jettisoned with too little deliberation. To get to my point, it’s worth pausing on (1) the genesis story of payout to contextualize why this topic has been so controversial and (2) the ideologies underlying the payout rate before moving on to (3) my own suggestion of how foundations can maximize charitable spending while retaining donors’ privilege of grantmaking.

If you’ve been in the foundation sector long enough, you’ve read countless articles and listened to innumerable speeches of the pros and cons of either maintaining the 5% minimum distribution rate or raising it to increase charitable spending. The notion of the payout requirement is rooted in the Tax Reform Act of 1969 (TRA 1969), which is what first recognized and regulated private foundations. One way to think of payout then is that it is a defining characteristic of foundations and is what distinguishes private foundations from any other type of charitable entity.

TRA 1969 was an outcome of years of distrust of endowed philanthropies. Before the Act was passed, endowed charitable organizations, such as the Ford Foundation, were being roundly criticized for protecting wealth and not distributing it for taxpayer benefit. Beginning in 1961, Congressman Wright Patman of Texas made it his personal mission to go after what he considered to be tax shelters for the elite, and his efforts were rewarded with the signing of TRA 1969 by President Nixon who declared, “Tax-free foundations were brought under much closer Federal scrutiny. . . . [as] congressional consideration of this matter reflected a deep and wholly legitimate concern about the role of foundations in our national life.” Patman’s suspicion of foundations was not unfounded. Private foundation expert Troyer (2000) recalled that when he entered law practice in the late 1950s, tax lawyers and estate planners used to advise clients to establish endowed nonprofits as a way to avoid estate taxes and as an instrument to maintain control of wealth.

What TRA 1969 effectively did was distinguish between private foundations and public charities (the former fails the public support test) and required that foundations must distribute a minimum amount of their wealth annually. (I should mention that all this pertains only to non-operating foundations; operating foundations’ direct charitable activities exempt them from payout.) At the time, there was very little consideration given to determining an appropriate minimum rate: Hence, the rate was set without “any systematic data about the consequences it would have on the operations of foundations” (Salamon, 1992, p. 119). When TRA 1969 passed, the minimum distribution requirement was set at an annual rate of 6% adjusted based on investment rates and market yields. In other words, legislators favored a distribution rate that was on par with investment yields so that money gained would be spent. Put more bluntly, the winning sentiment was that foundations should not last into perpetuity and wealth should be given away for the good of all. But this sentiment did not last, and under much pressure from foundation executives, the law was changed to a flat 5% rate in 1981 (TRA 1981).

What are we to make of this history? My own view is that the 5% rate should be seen as a compromise between those arguing for preserving wealthy elite’s privilege to practice philanthropy (i.e., the ‘private interest’ position) and those who see foundations’ tax-subsidized assets as accountable to the public good (i.e., the ‘public interest’ argument). Although there was strong opinions from both sides, there is nothing clear-cut in the historical documents or in the legal codes that definitively answers which viewpoint is more correct. In actuality, TRA 1969 and TRA 1981, taken together, reflect a great deal of ambiguity by making private foundations beholden to both public and private interests: TRA 1969 mandated spending for the public good while TRA 1981 protected foundations’ ability to exist into the future. Given the lack of clarity in policy, it’s no wonder that the payout rate has remained a source of contention over the years.

Hence, much of the debate over payout pivots on the fundamental differences in opinions of what and whom foundations should serve. Consequently, such an outsized ideological cage match has diverted attention from smaller details of payout regulation that merit attention. For instance, under current regulations, there is no answer to the question of what happens to foundations that realize greater yields on investments that surpass charitable spending. In other words, what should happen to foundations that grow wealth at a greater rate than they redistribute it? The answer, I would argue, lies in the original TRA 1969 notion of tying spending to investment returns.

I suggest that a foundation’s payout rate be determined by comparing its charitable spending rate and its yield on investments, minus rate of inflation, over a 25-year time horizon. (A variable payout rate is not a new idea [cf. Frumkin, 1998] but what I propose is a much longer time horizon to support intergenerational equity.) So, let’s say that a foundation averaged distributions of 5% over a 25-year period and over that same period the average rate of inflation was 5.17% (this is actually the averaged inflation rate between 1975-2000), the foundation would then need to distribute at a rate of .17% more over the next 25 years. The calculation begins with a foundation’s first tax return and if the averaged inflation rate is below the mandatory minimum, the 5% still applies. In actuality, most foundations distribute more than 5% of non-charitable use assets so, given the rate of inflation, this proposal will not likely result in public charities experiencing a huge windfall. What this proposal does do, however, is ensure that wealth does not growing disproportionate to charitable obligations. In sum, by basing adjustments in payout rate over the long term, this would protect foundations’ financial ability to work toward perpetuity while ensuring that any investment gains beyond rates of inflation are spent for the greater social good.

What this proposal does not do is resolve the debate about whom foundations should primarily serve—foundation owners or the public good. Hence, I'm not going to touch the question of how payout should affect perpetuity, which would require greater clarity in policy about a foundations' social role. Short of that, however, an adjusted payout rate minus inflation over nearly a generation timespan ensures that foundation wealth does not grow at the expense of taxpayers’ expectations for social benefits. Although there has been criticism of even having a payout requirement (Deep &Frumkin, 2001), we now know empirically that mandating distributions has been effective. Desai and Yetman (2005) discovered empirically that foundations behaved more charitably in response to government regulations and oversight. Furthermore, Worthy (1975) found that foundations paid out less before the mandatory distribution requirement than after its implementation. Therefore, the payout requirement is working and merits continued refinement, particularly in calibrating the balance between competing desires for wealth accumulation and charitable spending.

Works Cited

Deep, A., & Frumkin, P. (2001). The foundation payout puzzle (Working paper no. 9). Cambridge, MA: Hauser Center for Nonprofit Organizations, Harvard University.

Desai, M. A., & Yetman, R. J. (2005). Constraining managers without owners: Governance of the not-for-profit enterprise (No. w11140). National Bureau of Economic Research. Retrieved from http://www.nber.org/papers/w11140

Frumkin, P. (1998). The long recoil from regulation: Private philanthropic foundations and the Tax Reform Act of 1969. The American Review of Public Administration, 28(3), 266–286. doi:10.1177/027507409802800303

McGlaughon, K. (2013). Foundation Source annual report on private foundations (No. 2). Fairfield, CT: Foundation Source. Retrieved from http://www.foundationsource.com/resources/FS_2013_Annual_Report.pdf

Renz, L. (2012). Understanding and benchmarking foundation payout. New York, NY: Foundation Center. Retrieved from http://foundationcenter.org/gainknowledge/research/pdf/payout2012.pdf

Salamon, L. M. (1992). Foundations as investment managers, part 1: The process. Nonprofit Management and Leadership, 3(2), 117–137. doi:10.1002/nml.4130030203

Troyer, T. A. (2000). The 1969 private foundation law: Historical perspective on its origins and underpinnings. The Exempt Organization Tax Review, 27(1), 52–65.

Worthy, K. M. (1975). The Tax Reform Act of 1969: Consequences for private foundations. Law and Contemporary Problems, 39(4), 232–254.

Is Criticizing Private Foundations Anti-Capitalist (i.e., Marxist) or Pro-Capitalist?

Working on a dissertation that seeks to address empirically the notion of private foundation effectiveness, I’ve been struck by two things: the lack of critical inquiry on this topic and how criticism of foundations has been stifled. On the first point, of course, people pontificating and expressing their opinions have spilled lots of ink, but much of this is subjective and reflects ideology not facts. Certainly, personal expressions by those knowledgeable about the field can be useful, but without including a critical, discourse-dependent approach to inquiry, conversations about private foundations neither become increasingly sophisticated nor elevated beyond a shouting match. This lack of scholarship is a far cry from my other academic experience, which was in art history, which I can’t help but use as a comparative foil. In my graduate studies in art history, I was bombarded with criticism—discourse on identity, how we perceive, and the notion of power and otherness. As frustrating as it was to be reading semiotics than visiting a museum, I appreciated being able to move beyond appreciating art on the basis of personal aesthetic pleasure to understanding the construction of meaning that says a lot about who we are as a people.

In building my literature review of private foundations, there is very little critical study of its effectiveness. Hence, in the absence of empirical data, I’ve been mining references for different ways in which people have critically analyzed foundations, particularly around the notions of accountability and effectiveness. In that process, I found something interesting that has no room in my study, so I’ll talk about it here instead. There’s something odd and disturbing in how people treat those who criticize private foundations.

There seems to be two kinds of treatment of people who express any kind of criticism of private foundations. One kind of reaction is to accept their criticism and laud the person for being an important voice in the field. These folks are perceived as being an intellectual scholar or enlightened leader: They are warmly invited to circulate among foundation board trustees and to speak at foundation-only conferences. Joel Fleishman (2009) falls into this camp as do many foundation CEOs and presidents who express self-critical opinions, such as “we need to do more” and “this is not our money.” When I consider why these folks are so well received within the private foundation community, it’s because they are moderate in their ideas of what foundations should be doing. Instead of calling for increased regulation, such as increasing taxes on private foundations or increasing the payout floor beyond 5%, they ask foundations to self-regulate their giving to give more to the poor, consider sunsetting, and be less secretive and more transparent. The bottom line is that their recommendations stop short of increased governmental regulation and do not upset the general social order. Take, for example, Fleishman (2009). In the same book in which he suggested that foundations should pay out more and that more foundations should sunset, he is also quite firm on the point that foundations have the Constitutional “right to disburse [funds]” in any way they choose (pp. 15-16). This “autonomous” right to freedom of grantmaking is a position that has a large following, reflected in the membership of Philanthropy Roundtable. (I may return to this topic later, as there’s also interesting going-ons with those who believe that foundations should be considered as having tax immunity (freedom from government) than tax subsidy of helping re-distribute wealth [see, for example, Reid, 2013].)

This type of critic does not upset any apple carts and, in fact, makes the case for why those in power should stay in power: Elites still get to be elites, and their ability to self-initiate any improvements in charitable practice depends on them staying in power. This notion of philanthropic elites is an important notion well established by a body of research generated by a group of smart women whose names, coincidentally, all start with “o.” Odendahl (1990), Ostrander (1984), and Ostrower (1995) studied the elites and found that their participation on nonprofit boards and their charitable giving reified their elite status, placing them in a social circle of other elites and reinforcing class divisions between high and low.

The other type of response to critics of private foundations is to accuse them as being a Marxist enemy of capitalistic and, hence, undemocratic. Take, for example, Fleishman’s criticism of Roelofs’s (2003) book “Foundations and Public Policy: The Mask of Pluralism.” Fleishman warned: “There is a small body of Marxist-oriented scholarship about foundations, much of it politically marginal and factually shaky” (cited in Van Til, 2008, p. 124). I’m both discouraged and ashamed that such a revered foundation scholar like Fleishman takes to dismissive name calling (come on, can’t we have an intellectual debate without accusing people of being a sickle-wielding communist?).

Roelofs’s work has as much of an important place on foundation executives’ book shelves as Fleishman’s works do, particularly among funders who want to redress social inequities and not inadvertently re-institute them. Roelofs (2007) perceived private foundations through a critical lens of power and social inequities (listen up all you social justice funders!). She contended that private foundations reinforce the existing social order “promoting consent and discouraging dissent against capitalist democracy” (p. 480). For example, intellectuals who are disenfranchised by the existing social order and want to promote change often find an outlet in being employed within the nonprofit sector, such as private foundations. (This pretty much describes every smart, value-forward program officer I know.) By being employed in an industry that depended on capitalism for its success, these folks are quieted by their involvement in these civil society entities, which exerts a cooling effect on the possibility of a revolution that fights against the established hegemony (Roelofs, 2007). (Hmm, maybe Egypt’s best way to stymie revolution is to proliferate its own civil society institutions!) Roelofs (2007) posited that the United States is without the kind of protest movements that marked the 1960s and 1970s because of philanthropic institutions that exert social control: “Radical activism was often transformed by foundation grants and technical assistance into fragmented and local organizations subject to elite control” (p. 485).

Does Roelofs sound like a revolutionary manifesto? Not to me, but that may be because I’ve felt personally the cooling effects of working for private foundations. Any program staff member who has worked for many years in a foundation (after the stars have fallen from their eyes) would likely find Roelofs’s message to be a no-duh, not a polemic. (Yes, working for foundations does provide wonderful opportunities to make change, but I’ll talk about those in another post.) There have been moments when low levels of wealth redistribution, which make no dent in addressing the gross inequalities and inequities in society, frustrated me. A concrete example of this is foundations’ efforts to pay out only the bare-minimum amount of 5% distribution of assets rather than give away more money to truly try and fulfill their missions. Hence, I welcome Roelofs's contribution to the literature, which helps funders be more enlightened about and effective in attempting to redress inequities--an effort that is directly in line with creating a more democratic society.

In the last decade, there has been a renewed effort for ‘social justice philanthropy’ to try and solve inequities of resources, opportunities, and power. For those of you in that camp (and anyone else), you may be interested in learning more along the lines of what I’ve written about here. This line of thinking about how foundations reflect or fight the negative effects of capitalism is important because it helps illuminate how your foundation may be accidently complicit in re-enacting injustices. The learning from these writings is the intellectual basis for how your foundation can ‘move the needle’ permanently in your funding, rather than ‘move the needle’ temporarily as so many foundations do. There is a still-too-small body of writing that critiques private philanthropy but for more, start with Robert Arnove’s writings in the 1980s. He pioneered thinking about ‘liberal’ foundations that tried to fight inequities but actually ended up re-enacting socio-economic systems in grantmaking that corroded democratic accountability in decision-making. See also the special May 2007 issue of the periodical “Critical Sociology” critiquing private foundations, which includes an article by Feldman (2007) who attests to Arnove and Roelofs’s contentions by describing how progressive journalists and nonprofits avoid scrutinizing private foundations inadvertently because of subservience to private foundation funding.

Works Cited

Feldman, B. (2007). Report from the field: Left media and left think tanks--Foundation-managed protest? Critical Sociology, 33(3), 427–446. doi:10.1163/156916307X188979

Fleishman, J. L. (2009). The foundation: A great American secret; how private wealth is changing the world. New York, NY: Public Affairs. Retrieved from http://books.google.com/books?hl=en&lr=&id=fR4IYOB9RUsC&oi=fnd&pg=PR7&dq=joel+fleishman&ots=-MY11uDRS7&sig=EK3oDOsPzDS7qq4ua7EtgRQyInA 

Odendahl, T. (1990). Charity begins at home: Generosity and self-interest among the philanthropic elite. New York, NY: Basic Books, Inc., Publishers.

Ostrander, S. (1984). Women of the upper class. Philadelphia, PA: Temple University Press.

Ostrower, F. (1995). Why the wealthy give: The culture of elite philanthropy. Princeton, NJ: Princeton University Press.

Reid, A. (2013). Renegotiating the charitable deduction. The Exempt Organization Tax Review, 71(1), 21–31. Retrieved from http://www.philanthropyroundtable.org/topic/philanthropic_freedom/a_boundary_to_keep

Roelofs, J. (2003). Foundations and public policy: The mask of pluralism. State University of New York Press.

Roelofs, J. (2007). Foundations and collaboration. Critical Sociology, 33(3), 479–504. doi:10.1163/156916307X188997

Van Til, J. (2008). Searching for critical issues in philanthropy. Nonprofit Management and Leadership, 19(1), 123–128. doi:10.1002/nml.209