Sustaining Philanthropy: Assuring the Longevity of Private Foundation Funds
Many private foundations strive for perpetual existence, a goal that brings distinct investment challenges over the passage of time. These foundations are tasked with the ambitious goal of not just preserving their asset base but also ideally growing it over time. Careful and strategic planning is essential to ensure the funding of their philanthropic work for the years and decades to come.
The Challenge of Meeting the 5% Distribution Requirement Year Over Year
With perpetual existence, foundations face a critical planning challenge: meeting the annual 5% minimum distribution requirement without depleting their endowment. This requirement stipulates that foundations must distribute at least 5% of their endowment’s average value each year. The calculation of this 5% has a one-year delay, meaning the distribution amount for any given year is determined by the previous year's average asset values. Therefore, to calculate the required distribution that must be fulfilled by the end of 2024, foundations must refer to their average asset values in 2023. For instance, if 5% of a foundation's average assets in 2023 calculates to $100,000, this amount must be distributed by the end of 2024. While this ensures a steady flow of funds towards charity, it also means that the endowment is always under pressure with significant outflows each year.
Moreover, when inflation is factored into the equation, the challenge becomes even more pronounced. Inflation erodes the purchasing power of money over time, meaning that an endowment that is merely maintaining its nominal value is actually losing value in real terms. This necessitates even greater investment returns to sustain the endowment in real terms.
Managing a foundation's endowment presents challenges akin to those retirees face with their nest eggs, yet there are significant differences. Retirees typically have the flexibility to deplete their assets over time as they age, but foundations aiming for perpetual existence should not follow this path. Additionally, while retirees may adjust their spending based on market conditions, possibly reducing their withdrawal rates below 5% during tough economic times, foundations face a mandatory minimum distribution of 5% annually, irrespective of the market situation. This fixed distribution rate, particularly during severe bear markets, can significantly strain a foundation's assets and lead to rapid depletion of a foundation's endowment.
Facing these challenges, foundations must generate high investment returns to meet distribution needs, keep pace with inflation, and sustain or grow the endowment. To realize these objectives, foundations generally must allocate a large portion of their investment portfolio to asset classes with high expected returns. While these asset classes often come with increased volatility, their strategic inclusion is vital in ensuring the long-term sustainability of the endowment.
Embracing Assets with High Expected Return
The rationale for investing heavily in high expected return assets is straightforward: higher returns can greatly boost a foundation's capacity to support its causes in the long run. Private foundations, with their extended time horizons, are uniquely situated to weather market volatility and reap the benefits of the compounded growth such assets offer. The overarching objective of this investment approach is to maximize returns in the long run, thereby ensuring the sustained ability of the foundation to fulfill its charitable mission through time.
While investing exclusively in the single asset class with the highest anticipated return might seem appealing, this strategy is akin to putting all your eggs in one basket, presenting a significant risk. A more prudent strategy involves diversifying your investments across a range of asset classes, each with high expected returns. This method not only balances risk but can also enhance overall returns.
Diversification should include asset classes that, in the long-run, are likely to outperform traditional, lower-return investments such as bonds and other fixed income options. A well-rounded portfolio typically includes traditional stocks and may also encompass venture capital, select hedge fund strategies, private equity, real estate, commodities, and emerging market equities. Venture capital is particularly attractive for its access to high-growth companies before their initial public offerings. Real estate investments offer a hedge against inflation and a reliable income stream, while commodities provide added diversification and protection against specific economic changes and inflation shocks. Despite the risks, emerging market equities present opportunities to participate in fast growing economies. Collectively, these diverse asset classes can be combined to create a comprehensive portfolio focused on high returns, with each class contributing its distinct advantages.
However, asset classes promising high-returns often carry inherent volatility, leading to significant and rapid fluctuations in value. This volatility presents unique challenges for foundations, particularly concerning their annual 5% distribution requirement. Therefore, it's vital for foundations to find a balance between seeking high returns and applying strategic safeguards through effective risk management. By adopting a balanced approach, foundations can maintain stability and resilience, especially important in the face of unpredictable market conditions.
The Perils of High Market Volatility
The distribution rule for private foundations stipulates that they must pay out at least 5% of their endowment annually, based on the previous year's average asset values. This requirement seems straightforward in stable market conditions. However, the potential delay, extending up to one year, in paying out the 5% compulsory distribution after its calculation, can pose a critical vulnerability during market downturns.
Example Scenario: From Bull to Bear Market
Imagine a scenario where a foundation's endowment is valued at $10 million at the end of Year 1. The market is bullish, and asset values are at their peak. Based on these values, the foundation is required to distribute $500,000 (5% of $10 million) by the end of Year 2. However, suppose the market experiences a drastic downturn during Year 2, where the foundation's endowment value drops by 50% to $5 million.
Now, the foundation faces the following predicament. The $500,000 distribution, which was a reasonable 5% of the endowment in Year 1, suddenly represents 10% of the current reduced endowment of $5 million. To meet this compulsory payout, the foundation is forced to liquidate assets at bear market prices, incurring substantial losses. At the end of Year 2 the foundation is left with just 4.5 million of assets.
The ripple effect of this forced liquidation at depressed market values intensifies the negative impact of the market downturn, further depleting the endowment. Moreover, the assets sold during this period lose the chance to regain their value when the market eventually rebounds. This, coupled with the reduced endowment base, diminishes the foundation's future earning potential, adversely affecting its long-term capacity to support its charitable activities.
The Role of Liquid and Nonvolatile Holdings in Risk Management
In risk management for perpetual foundations, it's crucial to maintain a balance between high-growth assets and stable, liquid holdings. High-growth assets are key for achieving long-term investment goals, but incorporating liquid and nonvolatile holdings, such as short-term government bonds, money market funds, and low-risk bond funds, is essential for ensuring stability and meeting immediate financial obligations.
These stable assets serve a pivotal role in the portfolio, particularly in market downturns. Their defining features — very low risk and high liquidity, which is the ability to quickly convert them into cash — can make them excellent candidates for meeting the mandatory 5% annual distribution requirement. The stable portion of the portfolio acts as a financial buffer, ensuring liquidity during market downturns and safeguarding the foundation's ability to meet its distribution obligations without resorting to selling high-growth, volatile assets at unfavorable times.
To effectively manage risk, foundations should allocate a certain percentage of their portfolio to these liquid, nonvolatile assets. Generally, each 5% allocated to stable assets enables the foundation to meet its distribution requirement for one year without dipping into the rest of its high-return-focused portfolio. Therefore, a 5% allocation is sufficient for one year, 10% for two years, 15% for three years, and so on. It's advisable to opt for at least a 10% allocation, providing two years of coverage. However, this is the minimum recommendation, and a higher percentage may be a wiser choice for preserving the capital for long-term growth.
Asset Rebalancing
Asset rebalancing is an essential investment strategy that should play a pivotal role in ensuring an organization's portfolio remains aligned with its specific objectives and risk tolerance. This process involves several essential steps to maintain a well-balanced investment approach. The first step is regularly reviewing the foundation's actual investment holdings to verify whether they are in line with both the investment policy and the planned asset allocation. Regularly monitoring how the actual holdings compare with the planned holdings is crucial to ensure the portfolio remains in harmony with its intended risk profile.
In instances where a notable divergence occurs between the actual holdings and the planned asset allocation, a proactive portfolio adjustment becomes imperative. This realignment is vital in preserving the targeted asset allocation and in reducing the risks associated with market volatility. Often, this adjustment process entails selling assets that have outperformed and redirecting investments towards underperforming assets, a step that might be emotionally challenging for some investors.
A specific aspect of rebalancing, especially pertinent when raising cash to meet the 5% distribution requirement, involves selling parts of the portfolio that have significantly increased in value. These high-performing assets, often exceeding their intended allocation percentage, can disrupt the portfolio's balance. By selling these assets and channeling the proceeds towards grants, foundations can move towards their preferred asset allocation. This method not only promotes the desired level of diversification but also systematically capitalizes on gains from high-performing assets, simultaneously allowing time for undervalued assets to potentially appreciate.
Understanding Put Options as a Risk Management Tool
Put options are financial instruments that give the holder the right, but not the obligation, to sell a specific amount of an underlying asset at a predetermined price within a specified time frame. In the context of a private foundation, purchasing put options can be likened to buying insurance against significant drops in the market value of their investment holdings. This strategy is particularly valuable for foundations due to the inflexible nature of their annual 5% distribution requirement.
When implementing put options, foundations need to determine the appropriate level of coverage. This involves assessing the overall risk exposure of their investment portfolio and deciding how much of it should be hedged. It's a balance between the cost of the options (which can be seen as an insurance premium) and the level of protection needed. Foundations typically purchase put options on assets that are more vulnerable to market volatility, such as stocks or equity funds.
By concentrating the put option strategy on just 5% of the portfolio, foundations can achieve a more cost-effective balance between risk management and expense control. This focused approach to hedging ensures that the foundation has a safety net for its most immediate financial obligation—the 5% required annual distribution—without incurring the higher costs associated with hedging a larger portion of the portfolio.
While put options can provide valuable protection, they can be expensive. The premiums paid for these options can reduce the overall return of the portfolio. Foundations should carefully consider factors such as market conditions, volatility levels, and the duration of the options. Options with longer durations provide more protection but are more expensive. Therefore, foundations should conduct a thorough cost-benefit analysis to determine whether the protection afforded by the options justifies their expense.
It’s important to integrate put options within a broader risk management framework. This involves combining them with other strategies like asset diversification, rebalancing, and maintaining liquid reserves. Put options should not be seen as a standalone solution but as part of a comprehensive approach to managing investment risks.
The Strategic Importance of Distribution Rates in Sustaining Foundation Endowments
The distribution rate is a critical factor in private foundations' decision-making, impacting the long-term health or decline of their endowments. Foundations usually must distribute at least 5% of their endowment each year. This rate, when considered in conjunction with investment returns, plays a significant role in determining the growth or reduction of the endowment. This directly impacts the foundation's ability to maintain consistent funding for charitable projects over the long term.
Opting for a distribution rate above the minimum 5% boosts the foundation's immediate philanthropic impact. However, this choice comes with a caveat: it leads to an immediate decrease in the endowment's principal. While a high distribution rate may appear viable during periods of high investment returns, it can prove unsustainable in bear markets. Therefore, foundations should consider a flexible distribution strategy, one that is attuned to the fluctuations in market conditions and variances in investment performance, rather than sticking to a rigid dollar amount.
Additionally, it is important to understand that if a foundation's charitable expenditures exceed 5% in any given year, the surplus can be carried over for up to five years. This carryover allows the foundation to offset the minimum distribution amount required in future years, providing an opportunity to balance higher distributions in prosperous times with the need for financial conservatism in less favorable periods. This flexibility is a critical aspect of effective endowment management, ensuring both immediate impact and long-term sustainability.
Timing of Charitable Grants
In managing their endowments, foundations face an additional strategic decision: the timing of their charitable grants. To safeguard the endowment, the conservative approach is to distribute these grants early in the year, soon after the precise calculation of the 5% minimum distribution requirement is determined. This calculation is based on the average asset values from the previous year. For example, by making distributions in January or February, foundations minimize the risk associated with market fluctuations that could occur over the course of the year.
The rationale behind early distribution is rooted in market dynamics. When foundations delay their distributions, say until December, they expose their endowments to nearly a full year’s worth of market volatility. This extended period increases the likelihood of encountering a bear market, which can significantly deplete the endowment's value. In contrast, distributing grants earlier in the year, such as in the first quarter, limits the exposure to just a few months of market changes following the calculation of the required distribution amount. This approach can reduce the risk of substantial market downturns affecting the endowment’s principal.
Conclusion
The challenge of simultaneously addressing immediate charitable needs in the present and ensuring the longevity of private foundation funds is a delicate balancing act. Effective management demands a nuanced approach that encompasses both investment and distribution strategies. These strategies must take into account the erosive impact of inflation and market volatility on endowments. A key element in this approach is the adoption of a diversified investment portfolio, incorporating high-return asset classes, which is crucial for fostering long-term growth and sustainability. However, it is equally important to temper this approach with robust risk management strategies. These include maintaining a balance between high-growth and stable, liquid assets, conducting regular asset rebalancing, and considering the strategic use of financial instruments such as put options. Moreover, foundations should adopt flexible distribution strategies that are responsive to the ever-changing market conditions. By effectively navigating these multifaceted challenges, private foundations can fulfill their philanthropic missions over the long haul, while also providing timely charitable support in the here and now.
Seeking expert guidance? We're here to help!
At CPA KPA, we're passionate about magnifying the positive impact of foundations. Feel free to reach out to us anytime at 888-402-1780 for a complimentary and obligation-free conversation. You can also conveniently submit your questions and inquiries through our contact page. Let's connect today and explore how we can help your foundation have a lasting and meaningful impact!
