The Competitive Disadvantage of Foundation Giving

A growing chorus of complaint has emerged about foundation giving in recent years. According to critics, foundations do not distribute enough in grant payments to justify their privileged position. On average, foundations pay out about 5.5 percent of their total assets each year and many critics believe that is just not enough.

Now comes a novel twist on that critique from the Harvard Business Review. A recent article in HBR suggests that foundations are a comparatively inefficient way for society to redistribute social resources. In "Philanthropy's New Agenda: Creating Value," Mark R. Kramer and Michael E. Porter argue that the amounts foundations pay in grants fail to cover the tax benefits provided to them by the government. More to the point, they argue, foundations are a less efficient mechanism for distributing wealth, when compared to 501(c)(3) public charities.

Writing in the November-December issue of HBR, Kramer and Porter write, "When a donor gives money to a social enterprise, all of the money goes to work creating social benefits. When a donor gives money to a foundation, most of the gift sits on the sidelines. On average, foundations donate only 5.5 percent of their assets to charity each year, a number slightly above the legal minimum of 5 percent. The rest is invested to create financial, not social, returns."

According to their calculations, because foundations pay out a small portion of their total assets each year, their financial contributions to society do not equal the taxes forgone. "When an individual contributes $100 to a charity, the nation loses about $40 in tax revenue, but the charity gets $100, which it uses to provide services to society. The immediate social benefit, then, is 250 percent of the lost tax revenue. When $100 is contributed to a foundation, the nation loses the same $40. But the immediate social benefit is only the $5.50 per year that the foundation gives away — that is, less than 14 percent of the forgone tax revenue.”

These numbers seem compelling, at first. But the comparison of foundations versus public charities is a red herring. This pairing sets up a false dichotomy. It may be true that most foundations give away a small portion of their total assets each year. But it is not equally true that, as the authors contend, “When a donor gives money to a social enterprise, all of the money goes to work creating social benefits.”

In fact, endowments are a large — and growing — source of income for public charities of all types. Churches, environmental groups, social service providers, and cultural groups have all come to understand the importance of developing an endowment to sustain and cushion a charity against cycles of plenty and drought. There is no reason to think that endowments for foundations are any less sensible than endowments for public charities.

Higher education institutions have long appreciated the importance of endowments, a fact that should not have been lost on Mr. Porter, who holds the endowed C. Roland Christenson chair at Harvard Business School. Neither should it have been a surprise to the editors of the Harvard Business Review, whose parent institution sits on a $15-billion endowment, by far the largest holdings of any private educational institution.

It might equally be asked why Harvard needs such a vast and ever-increasing endowment of its own. It could certainly be argued that this fund might provide greater social returns if it were spent on more scholarships for needy students. For that matter, some of these riches could be devoted to solving urban problems in Cambridge or Boston, where the university is essentially exempt from local taxes.

But Harvard is not alone. A recent survey of colleges and universities conducted by the National Association of College and University Business Officers has found that roughly 500 institutions held endowments amounting to nearly $200-billion last year. Needless to say, all contributions to higher education are fully deductible, whether the funds go to support current expenses or to build up endowments.

The simple fact is that endowments play a key role in sustaining many types of nonprofit institutions. And none of them is required to demonstrate the immediate social benefits to society to justify the tax deductions that are used to encourage creating those endowments.

If the endowments held by private foundations produce too little immediate social benefit to warrant the tax preferences, at least foundations have to make some minimum charitable distribution. Public charities, on the other hand, can build up endowments without making any distributions.

Kramer and Porter set forth their provocative calculations of the social returns of foundations as a premise for their larger argument, that foundations have a special obligation to deliver more effective philanthropy. The main thrust of the HBR article is that foundations should develop meaningful strategies to improve their own performance. And who could argue with that? In support of this point, however, they argue that foundations have a responsibility to be more strategic because they are a relatively inefficient way for society to employ community resources.

It is understandable that the authors might want to spark up a relatively non-controversial essay on improving the performance of foundations. They recently established a for-profit consulting firm, the Center for Effective Philanthropy, to help foundations develop and implement strategy. And the HBR piece certainly has generated a fair amount of interest in their work.

Unfortunately, many readers may fix on the provocative premise, that foundations are warehouses of wealth, and ignore the other, more valid, argument that these warehouses should develop more effective and efficient systems of inventory and distribution.

That's exactly what happened in one important case. Nelson Aldrich, writing in the November issue of Worth Magazine, argues that it is time to ask whether rules governing foundations should be rewritten, citing the article by Kramer and Porter as his main source. He briefly acknowledges the main point of the article, but focuses most of his attention on the calculations of social return. According to Aldrich, the HBR article “should send shudders of alarm through foundation boardrooms.”

In the Worth article, which is not coincidentally featured on the website of the Center for Effective Philanthropy, Aldrich concludes that, “it is in the public's interest that as much of their money as possible be put to work as soon as possible.” But is it?

For many, the ,Worth and HBR articles promise to advance the cause of bringing about a higher payout rate for foundations, either by urging individual funds to make changes or through legislation sparked by such press scrutiny. One problem is that it is far from clear that foundations should, in general, pay out much more in grants. But more to the point, this sort of reasoning could also unwittingly call into question the legitimacy of foundations more broadly.

For the most part, criticism of foundation payout policies flows from left-leaning organizations that call for increased grant disbursements as a way of meeting dire needs in society. Most prominent among them, the National Network of Grantmakers has launched a campaign, “One Per Cent for Democracy,” which calls for an increase in payout from 5 per cent to 6 per cent.

Of course, this year's campaign against foundation spending policies is only the latest in a long line of efforts to rein in foundations. They are, indisputably, institutions that operate with much freedom and privilege. And there is a deeply rooted skepticism of such elite institutions, rooted in populist rhetoric both from the right and the left. In some cases, the skepticism was justified. For example, the reforms in the Tax Reform Act of 1969, were a necessary response to significant and pervasive abuses carried out by foundations that operated more in the interest of their donors than the intended charitable beneficiaries.

But just as often, foundations are criticized for grantmaking policies that are entirely defensible. The most familiar criticism, that foundation payout is too low, is closely linked to the argument that foundations should be forced to spend down their assets entirely, in a fixed period of time.

In some ways, the two arguments are mirror images of each other, with some people contending that foundations should increase their annual payments (which would cause them to go out of existence). The flip side, of course, is that foundations should not be permitted to live on in perpetuity, (which would force them to give away a larger portion of their assets each year). Curiously, most of the calls for increased payout come from the left, while those who challenge foundation perpetuity do so from the right.

But determining whether a foundation will exist in perpetuity or what its level of payout will be should not be a question of politics. Currently, foundations are given wide latitude in crafting a spending policy. And that is as it should be.

Sorting out the questions of payout and perpetuity should flow from the charitable goals of any particular foundation, not from some rigid formula. Certain charitable purposes require immediate attention, while others will be with us always. The donor who chooses to invest in a cure for AIDS or an end to global warming might rightly wish to direct his or her foundation to spend all of its resources within a decade. But the person who wants to fight poverty or racial hatred might want to create a fund that can continue to operate far into the future.

Philanthropy — and foundation giving in particular — occupies a much larger role in the United States than in many other countries, which generally rely much more on governmental agencies to deliver social and cultural goods. But private giving cannot serve this role unless regulators, politicians, and voters agree that philanthropy is carrying out its part of the bargain.

Foundations surely need to deliver an adequate social return to justify their existence. And it may be that research needs to be done to see if tax preferences and philanthropic practices are properly aligned. But this sort of research should be conducted and debated as a serious topic on its own. Such an important issue should not be relegated to a small supporting argument in justifying a particular approach to foundation management.

An unhealthy practice has emerged in philanthropy, to criticize one form of giving or another for being self-rewarding, inefficient, or unjust. While the most common complaint involved foundation payout, other critiques abound. For some years, alternative funds heaped scorn upon United Ways for keeping social change groups out of workplace giving campaigns. In more recent years, community foundations have criticized efforts by Fidelity Investments and other financial services companies for setting up new charitable giving vehicles that are closely linked with their commercial enterprises.

Each of these debates when taken to extremes threatens to undercut a fundamental element of American philanthropy: diversity. Donors are encouraged, through the Internal Revenue Code, to give to a variety of institutions through a wide range of giving vehicles. Taxpayers may deduct contributions through foundations, trusts, bequests in wills, or straight gifts of cash. A great strength of our system is the freedom of each donor to find the right vehicle for his or her particular circumstances.

Serious talk about philanthropy should not exaggerate the benefits or drawbacks of one form of giving over another. Unfortunately, this line of argument could backfire, calling down on philanthropy new regulations or restrictions that would make charitable giving less appealing. Charity gadflies should consider their complaints well, or they may provoke unintended consequences that would result in fewer philanthropic resources for everybody.

Vince Stehle is program officer for the Nonprofit Sector Initiative of the Surdna Foundation.