As most know, the US has the friendliest public policy towards private charity among developed nations. Gifts to charities and foundations are tax-deductible with only minor limits. In most cases, foundations’ earnings are tax-exempt as well. Once established, foundations are bound to distribute 5 per cent of the current value of their assets each year. But is this enough? Do we really want eternal foundations?

It may seem strange to advocate a major shift in foundation payouts at a time when foundation endowments, like all investment funds, are being punished by the global downturn. It is exactly this scenario that defenders of the 5 per cent payout point to in defence of the status quo: during severe economic disruptions, foundations would end up much smaller and possibly run out of funds entirely and be forced to close. At least this was the argument used to defeat proposed changes to the 5 per cent rate in 2003 on the heels of the last market meltdown.

This argument made sense once but it no longer holds water. When the laws governing foundations were set up, the idea of permanent foundations was not outlandish. Having an active philanthropic sector is undoubtedly good for a society. When Mr Carnegie and his peers set up the first mega-foundations near the turn of the century, they did not know that not only would others follow in their footsteps but that there would be a virtual stampede.

A foundation that pays out the minimum of 5 per cent annually (which most do) will be in existence for more than 500 years before it pays out the equivalent value of the original gift. As a case in point, in its first 100 years of existence, the Carnegie Corporation has managed to give away 20 per cent, adjusted for inflation, of the value of Andrew Carnegie’s founding gift. Limited payout allows the Corporation to be eternal (which seems to have been Carnegie’s goal).

Since 1987, the value of foundation endowments (in inflation adjusted dollars) has grown more than 500 per cent. Excluding the creation of new foundations, well-managed foundation endowments roughly doubled over that period. Even more importantly, the (again, inflation adjusted) value of foundation endowments per capita has grown more than 400 per cent. Despite the current downturn, given the history, the expected increase in assets transferred generationally (even if far less than predicted), and the increase in wealth of the richest, foundation endowments per capita will likely double again within ten years. By now there is surely sufficient evidence that the American philanthropic sector is not in danger of disappearing. So why do we need eternal foundations?

Another common argument in defence of low payout rates is the importance of stability and experience in the sector. Our largest social problems require long-term solutions – hence the need for foundations that can stay the course. Again, this argument makes sense in theory, but in practice foundations change strategies and focus fairly frequently – as they should if a problem is eliminated or research suggests a better approach.

It’s also hard to argue that perpetual foundations make better decisions than spend-down foundations – does anyone really believe that Ford, for instance, has significantly bettered the Atlantic Philanthropies?

There are other very good reasons for rethinking the fixed payout rate – cyclicality for instance. Under the current structure, when the economy is doing well, foundations pay out more. When the economy is suffering, foundations pay out less. Isn’t this the exact opposite of what we want from philanthropy?

So, I’d suggest some changes. For instance:

• Make the payout rate counter-cyclical: during recessions, foundations have to increase their payout rate. When the economy is growing, they can cut it back and regrow their endowment.
• Make the payout rate flexible while mandating that all foundations must pay out the inflation-adjusted amount of their founding gift within 50, 75 or 100 years. If their endowment is well managed, they could continue to live on for hundreds of years more on the accumulated investment income.
• Put a cap on the amount anyone can give to a foundation tax-deductibly. It’s hard to imagine that a limit of say $1 billion (adjusting for inflation) would have a material effect on anyone’s giving. Gates and Buffett are clearly not driven by tax breaks. Mega-billionaires could still create much larger eternal foundations if they are willing to do so without being funded by a tax break. And if foundation gifts were smaller because of the reduced tax advantage, up to 50 per cent of what wasn’t given to a foundation would be donated to the public good through estate taxes.

Tim Ogden is Editor-in-chief of Philanthropy Action. Email timothy.ogden@philanthropyaction.com

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A longer version of this article, including downloadable spreadsheets with the calculations used in the article, can be found at http://www.PhilanthropyAction.com