In 2020, despite tremendous economic upheaval driven by the COVID pandemic, U.S. donors gifted a record $471.4 billion to the arts, health, religion, education, and other charitable interests. Giving by private foundations was up 17% in 2020 to $88.6 billion—a vital funding source for causes around the globe.1
The weight of a fiduciary’s duty can be particularly challenging in economic environments where it’s difficult to consistently generate returns sufficient to cover a foundation’s 5% mandatory annual distribution requirement set by the IRS, as well as outpacing inflation and covering general administrative expenses.
As a result, it is more important than ever for perpetual foundations to strategically manage charitable distributions while ensuring satisfactory long-term investment performance. Otherwise, depressed returns and excessive charitable spending will quickly erode the foundation’s corpus making it difficult, if not impossible, to stay true to its original, perpetual intent.
“I resolved to stop accumulating and begin the infinitely more serious and difficult task of wise distribution.”
The 5% mandate
According to the IRS, a private grant making foundation must annually distribute at least 5% of the fair market value of its non-charitable use assets, computed on an average monthly basis. This amount must be distributed for charitable purposes by the end of the following tax-year.
Failure to comply with this requirement subjects the foundation to an initial excise tax equal to 30% of the under distribution. If not corrected, an additional excise tax of 100% of the under distribution is imposed.2 And repeated violations could result in the revocation of the foundation’s tax-exempt status.
Is more really better?
Of course your foundation can choose to distribute more in charitable grants each year than the IRS’ required minimum amount. Generally, an over-distribution for a single tax year (or in a small amount above the required minimum) won’t have a significant impact on the foundation’s long-term sustainability. But prolonged or large over-distributions, can negatively impact the foundation’s ability to meet its charitable obligations over time, and can even jeopardize its ability to exist in perpetuity.
Because the spending calculation is based on the previous 12 months’ market values, some foundations may feel tension between their giving and current market conditions. A disciplined distribution policy guiding when you’re allowed to consider over-distributing helps ensure that decisions are intentional.
During both good and bad times, there are advocates that encourage foundations to exceed the 5% requirement. However, foundations often feel obligated to make grants at a higher level when other funding sources (such as corporations and individuals) have reduced their giving. For example, in the immediate aftermath of the 2008 economic crisis, the Ford, Anne E. Casey, and Skoll Foundations all distributed more than 7% of their assets. And one foundation, the Annenberg Foundation, spent nearly 11% of its assets—leading to a 36% drop in its endowment value.3
Another reason why foundations exceed the 5% threshold is to support a favored charitable institution or program. This support might extend over many years to establish such a close relationship that it transcends the foundation’s desire to keep its charitable spending at the minimum mandated levels. Program needs or even organizational expenses might demand higher than usual support that the foundation feels obligated to meet.
Private foundations that make long-term commitments to an organization may feel that over-distribution is less important than sustaining support for a particular project or in general. And because of the way the required minimum distribution requirements are calculated, you can’t be sure of what you’re your foundation’s required payout amount will be beyond the current fiscal year. This makes predictable levels of future spending a challenge. If you make a large multi-year commitment at a specific dollar amount, a drop in assets could easily lead to a distribution in excess of 5%.
Finally, if your foundation isn’t mandated to exist in perpetuity by the original grantors, you have the flexibility to ‘spend down’ the endowment. Donors who want to address a specific charitable intent over a shorter period of time might create a ‘sunset provision’ that gives the foundation a limited term. In this case, the required minimum distribution amount isn’t a primary distribution consideration.
Relevance to not-for-profit endowment spending
For large endowments, especially universities, there’s an ongoing public debate as to whether the government should implement the same 5% required minimum distribution that private foundations are subject to.
For the 2020 fiscal year (July 1, 2019 through June 30, 2020), endowments between $51 million and $100 million averaged a 5% spending rate—the highest of any endowment size. Endowments below $25 million, on the other hand, had only a 4.1% average spending rate, and the largest endowments (in excess of $1 billion) averaged just 4.5%.4
While there may be variation across different sectors within the not-for-profit industry, the status quo allows organizations to choose their spending level for unrestricted endowment assets. Should this choice be taken away, not-for-profit endowments designed to exist in perpetuity could face many of the same challenges that private grantmaking foundations are dealing with today.
The potential impact of consistent over-distribution on your foundation’s investment portfolio
Distributing more than the mandated 5% of non-charitable assets, has a number of implications for private grantmaking foundations:
#1 Asset Value
Assuming an original corpus of $10,000,000, choosing a 5%, 6%, or 7% distribution rate has significant implications for the value of the assets over an extended period of time (30 years in this example). Employing a more conservative 5% distribution rate yields an expected ending asset value in March of 2051 of $12,856,365. This leads to an increase of nearly 45% in ending market value over the life of the foundation compared to a remainder of $7,002,856 in the 7% spending scenario—primarily due to being fully invested as assets accumulate over time.
#2 Range of Spending
It might be somewhat counter-intuitive to think that a high distribution rate yields lower overall charitable distributions. However, a deeper analysis illustrates that a consistent 5% distribution rate has the potential to yield a much higher charitable distribution in Year 29 than a foundation that’s been consistently distributing 6% (a 10% increase) or 7% (a 22% increase).
Once again, the primary driver of this higher available spending level is the accumulated asset value over a prolonged 30-year period of analysis. This analysis assumes the ‘middle of the road’ investment scenario in terms of long-term performance based on the following assumptions:
- 5%, 6% and 7% spending without inflation
- Asset allocation of 57.5% equity, 27.5% fixed income, 15% alternatives
- Fixed time horizon of 30 years
Expected charitable distribution in year 29:
While cumulative spending over a 30-year period for a 7% distribution policy exceeds a 5% distribution policy by $812,689 and barely exceeds a 6% spending policy by $207,725. This is another example of the increased asset value over time depicted in Exhibit 1.
About Truist Foundations and Endowments Specialty Practice
Truist has more than a century of experience working with not-for-profit organizations. Fiduciary stewardship is the heart of our culture. We’re not just a provider, but an invested partner—sharing responsibility for prudent management of not-for-profit assets. Our client commitment, not-for-profit experience, and fiduciary culture are significant advantages for our clients and set us apart. The Foundations and Endowments Specialty Practice works exclusively with not-for- profit organizations. Our institutional teams include professionals with extensive not-for-profit expertise. These professionals are actively engaged in the not-for profit community and are able to share best practices that are meaningful to their clients. Team members offer guidance and advice tailored to the various subsets of the not-for-profit community, including trade associations and membership organizations. Our Practice delivers comprehensive investment advisory, administration, planned giving, custody, trust and fiduciary services to trade associations, educational institutions, foundations, endowments and other not-for profit clients across the country.