Foundations and Endowments Specialty Practice

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1 Quanda M. Allen, CAP First Vice President SunTrust Banks The Long-Term Impact of Over Distribution on Private Foundations I resolved to stop accumulating and begin the infinitely more serious and difficult task of wise distribution. - Andrew Carnegie Private foundations are created by an individual, family, or business to fulfill a specific charitable vision. They are often established to exist in perpetuity. Fiduciaries of perpetual private foundations have a unique obligation to ensure that the foundation s assets are available to serve its charitable mission now and for generations to come. This delicate dance requires carefully balancing current charitable spending with future needs. In 2012, U.S. donors contributed $316.2 billion to the arts, health, religion, education, and other charitable interests. Giving by private foundations was up 4.4% in 2012 to $45.7 billion 1. U. S. private foundation giving is a vital funding source for causes around the globe. The weight of the fiduciary s duty is particularly true in the current economic environment where it has proven difficult for private foundations to consistently generate returns sufficient to cover their 5 percent annual mandatory distribution requirement set by the Internal Revenue Service (IRS) in addition to earning returns that exceed inflation and administrative expenses. As a result, it is more important than ever for perpetual private foundations to strategically manage charitable distributions while ensuring satisfactory investment performance. Otherwise, depressed returns and excessive charitable spending will erode a private foundation s corpus making it challenging, if not impossible, to stay true to its original, perpetual intent. The 5 percent mandate According to the IRS, private grant making foundations must annually distribute at least 5 percent 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 the required minimum distribution requirement subjects the foundation to an initial excise tax equal to 30 percent of the under distribution. If not corrected, an additional excise tax of 100 percent of the under distribution is imposed 2. Repeated violations could result in the revocation of a private foundation s tax-exempt status. 4 REASONS WHY A PRIVATE GRANT MAKING FOUNDATION MIGHT DISTRIBUTE MORE THAN THE MANDATED IRS 5 PERCENT REQUIREMENT 1. Increase funding for an organization or cause of particular importance to a foundation s mission when other sources of funding diminish 2. Provide longstanding support of a specific program, organization, or mission 3. Engage in multi-year commitments 4. Deplete assets using spend down provisions 1

2 Is more really better? Private foundations have the ability to distribute more in charitable grants than the IRS required minimum amount. An over distribution for a single tax-year or in a small amount above the required minimum generally will not have a significant impact on the foundation s long-term sustainability. Prolonged or large over distributions, however, can negatively impact a 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 might feel tension between their giving and current market conditions. A disciplined distribution policy guiding when private foundations might consider over distributing ensures that this decision is intentional. Rationale of over distribution During both good and bad times, there are advocates that encourage private foundations to exceed the 5 percent required by law. According to a 2009 Chronicle of Philanthropy Study on endowment spending, the Ford, Anne E. Casey, and Skoll Foundations all distributed more than 7 percent of their assets after the 2008 economic downturn. One foundation, the Annenberg Foundation spent nearly 11 percent of its assets which led to a 36 percent drop in its endowment value. 3 Many foundations may feel obligated to make grants at a higher level when other funding sources, such as corporations and individuals, have reduced their giving. Another reason why a private foundation might distribute more than 5 percent 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 private foundation feels obligated to meet. Private foundations that make long term commitments to an organization may feel that over distribution is less important than sustainable support for a project or organization. Because of the way the required minimum distribution requirement is calculated, a private foundation does not know what its required payout amount will be beyond the current fiscal year. This makes predictable levels of future spending a challenge. If a private foundation makes a large multiyear commitment at a specific dollar amount, a drop in assets could easily lead to a distribution in excess of 5 percent. Finally, private foundations that are not mandated to exist in perpetuity by their original grantors have the flexibility to spend down their 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 is not the most important distribution consideration. Relevance to not-for-profit endowment spending For large endowments, especially universities, there is a public debate raging on whether or not the federal government should mandate a 5 percent required minimum distribution much like the one in place for private foundations. If passed, this could significantly increase spending for endowments that have historically chosen a lower level of spending. In fact, a 2008 SEI research panel found that 46 percent of college and university endowments felt that a 5 percent minimum distribution requirement on their endowment would reduce the value of their endowments and hurt their institution s mission over the long-term because it would impair their ability to adjust spending to meet short- and long-term needs. 4 A more recent 2010 SEI survey of 177 endowments and foundations found that 91 percent have a formal spending policy with the majority in the 4-5 percent range. However, those without a formal spending policy report an annual spend of 5.4 percent. 5 Most notably, due to its large sample size, the 2012 NACUBO study found that the average college and university endowment spending rate was 4.2 percent. 6 While there may be variation across different sectors within the not-for-profit industry, the status quo allows the organization to choose its 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 grant making foundations deal with today. 2

3 The impact of consistent private foundation over distribution on investment portfolios Distributing more than the mandated 5 percent of non-charitable assets, has a number of implications for private grant making foundations. #1 Asset Value Assuming an original corpus of $10,000,000, choosing a 5 percent, 6 percent, or 7 percent 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 percent distribution rate yields an expected ending asset value in March of 2043 of $12,856,365. This leads to an increase of nearly 45 percent in ending market value over the life of the foundation compared to $7,002,856 in the 7 percent spending scenario. This is primarily due to the benefit of being fully invested as assets accumulate over time. Exhibit 1 Asset Value Over Time 30 years Year 30 5% distribution 6% distribution 7% distribution Value $12,856,365 $9,496,639 $7,002,856 #2 Range of Spending It might be somewhat counter intuitive to think that a high distribution rate yields lower overall charitable distributions. However, the analysis performed illustrates that a 5 percent distribution rate in year 29 has the potential to yield a much higher charitable distribution than one that has been consistently distributing 6 percent (a 10 percent increase) or 7 percent (a 22 percent increase). Again, the primary driver of the higher spending levels is the accumulated asset value over the period of analysis. This analysis assumes the middle of the road investment scenario in terms of long term performance. COMPARATIVE ANALYSIS OF FOUNDATION SPENDING 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 3

4 Expected charitable distribution in year 29: Distribution Rate Distribution Amount Assets 5% $699,096 $12,856,365 6% $628,928 $9,496,639 7% $548,497 $7,002,856 While cumulative spending over a 30 year period for a 7 percent distribution policy exceeds a 5 percent distribution policy by $812,689 and a 6 percent spending policy remains strong because of the increased asset value over time shown in Exhibit 1. Year 5% spending 6% spending 7% spending Cumulative Spending $17,825,667 $18,430,631 $18,638,356 Conclusion Because most private grant making foundations are established to exist in perpetuity and the required minimum distribution is fixed, intergenerational equity and sustainability are achieved by limiting over distribution and employing a diversified approach to investment management. Sources 1 Heavey, Susan. Charitable Giving grew in 2012, albeit modestly. Reuters. 18 June Web. 4 September United States Tax Code Title 26 Subtitle D Chapter 42 Subchapter A Web. 7 September Barton, Noel, et al. Smaller Nonprofit Endowments Outperformed Larger Ones in 2009, Chronicle Survey Finds. The Chronicle of Philanthropy. 2 May Web. 30 August philanthropy.com/article/smaller-endowments/ SEI. SEI Quick Poll: Endowments Not Responding to Spending Pressures. 13 March Web. 25 August SEI. SEI Quick Poll: How Nonprofits are Addressing Current Investment Challenges in Ongoing Volatility. 17 August Web. 26 August Nonprofits-Addressing-Current-Investment-Challenges.htm 6 Average Effective Spending Rates for U. S. College and University Endowment and Affiliated Foundations. NACUBO. March Web. 22 August NACUBO-Commonfund_Study_of_Endowments/Public_NCSE_Tables.html 7 Benchmark Indices used for Investment Return Assumptions ESTIMATED PORTFOLIO STATISTICS Portfolio and benchmark expected return and risk statistics are forward-looking assumption over the next 10 years and represents SunTrust s current expectations for the benchmark return and asset allocation shown. Expected return and risk are derived from a combination of mean-reversion analysis using historical data over the prior 25 years (if available), the Black- Litterman model and fundamental research. Expected returns are not guaranteed and are subject to revision without notice. Actual returns related to accounts managed by SunTrust will vary based on the investments contained within the accounts and the different methods of presenting performance data, i.e. net of fees, gross of fees, or a combination of these. This information should not be evaluated independent of or without reference to the investment advisory agreement and investment policy statement that more specifically addresses applicable investments and fees. Portfolio credit quality and income yield are representations of the average credit quality and income yield of the investments contained in the portfolio data is sourced from Wealthstation. Benchmark credit quality and income yield represent published Barclays Capital Aggregate Index data for the period shown. BENCHMARK INDICES An investor cannot invest directly in an index. Barclays US Aggregate Bond is an unmanaged index composed of securities from the Barclays Government/Corporate Bond Index, Mortgage-Backed Securities Index and the Asset-Backed Securities Index. Total return comprises price appreciation/depreciation and income as a percentage of the original investment. Indices are rebalanced monthly by market capitalization. The S&P 500 Index is an unmanaged index of 500 common stocks that is often used as a measure of the US stock market as a whole. The Russell 3000 Index measures the performance of the 3000 largest US companies based on total market capitalization, which represents approximately 98% of the investable US equity market. MSCI EAFE is an unmanaged market capitalizationweighted equity index comprising 20 of the 48 countries in the MSCI universe and representing the developed world outside of North America. Each MSCI country index is created separately, then aggregated, without change, into regional MSCI indices. EAFE performance data is calculated in U.S. dollars and in local currency. An investment cannot be made directly into an index.. BofAML US HY Master tracks US denominated below investment grade corporate debt publically issued in the US domestic market. An investment cannot be made directly into an index. JPM GBI - EM Global is a total return, unmanaged trad-weighted index for debt instruments issued by emerging market sovereign and quasi-sovereign entities; Brady bonds, loans, Eurobonds. The EMBI Global tracks total return for issuers in 31 countries. An investment cannot be made directly into an index. MSCI EM is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets - Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey. An investment cannot be made directly into an index. The Russell 1000 Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 2000 Growth Index measures the performance of those Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell 2000 Value Index measures the performance of those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. HFRI FoF Strategic index is comprised of strategies defined as seeking superior returns by primarily investing in funds that generally engage in more opportunistic strategies such as Emerging Markets, Sector specific, and Equity Hedge; exhibits a greater dispersion of returns and higher volatility compared to the HFRI Fund of Funds Composite Index. A fund in the HFRI FoF Strategic Index tends to outperform the HFRI FoF Composite Index in up markets and underperform the index in down markets. An investment cannot be made directly into an index. HFRI FoF Diversified Index is comprised of strategies defined as exhibiting one or more of the following characteristics: invests in a variety of strategies among multiple managers; historical annual return and/or a standard deviation generally similar to the HFRI FoF Composite index; demonstrates generally close performance and returns distribution correlation to the HFRI FoF Composite Index. A fund in the HFRI FoF Diversified Index tends to show minimal loss in down markets while achieving superior returns in up markets. An investment cannot be made directly into an index. MPT STATISTICS/OTHER MEASUREMENTS Risk-free rate used to calculate certain statistics is the 91 Day Treasury Bill. Alpha is a measure of risk-adjusted performance. Specifically, alpha measures the difference between actual returns and its expected performance, given its level of risk (as measured by beta). A positive alpha indicates the manager has performed better than its beta would predict. In contrast, a negative alpha indicates a manager has underperformed, given the expectations established by the fund s beta. Some investors see alpha as a measurement of the value added or subtracted by a manager. Beta is a measure of risk relative to the benchmark or market. It measures the relationship between excess return over T-bills (the risk-free rate) and the return of a benchmark index. Sharpe Ratio is a measure of risk-adjusted return that calculates the return per unit of risk, where risk is represented by the Standard Deviation. The high Sharpe ratio indicates the manager has benefited from taking risk. Standard Deviation is a measure of volatility and risk. Standard Deviation is a statistical measure of performance. When standard deviation is high, the range of performance has been very wide, indicating that there is a greater potential for volatility. Statistically, approximately 68% of the time, returns are expected to differ from the mean return by no more than plus or minus one standard deviation assuming returns fall in a bell-shaped distribution. A special thank you to Will O Reilly and Christopher J. Blayton of SunTrust Investment Services, Inc. for providing the asset simulations included in this paper. 4

5 About SunTrust Foundations and Endowments Specialty Practice SunTrust has nearly a century of experience working with not-for-profit organizations. Fiduciary stewardship is the heart of our culture. We are not merely a provider for our clients; we are 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 from our competition. 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 over 700 not-for-profit organizations. 1 We administer $30.7 billion in assets for trade associations, educational institutions, foundations, endowments and other not-for-profit clients. 1 1 As of December 31, 2012 For more information about private foundations and distribution strategies, contact your investment advisor or call Please visit us at The information and material presented in this commentary are for general information only and do not specifically address individual investment objectives, financial situations or the particular needs of any specific person who may receive this commentary. Investing in any security or investment strategies discussed herein may not be suitable for you, and you may want to consult a financial advisor. Nothing in this material constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur either profits or losses. Past performance should not be taken as an indication or guarantee of future performance. SunTrust Bank and its affiliates and the directors, officers, employees and agents of SunTrust Bank and its affiliates (collectively, SunTrust ) are not permitted to give legal or tax advice. Clients of SunTrust should consult with their legal and tax advisors prior to entering into any financial transaction. Securities and Insurance Products and Services: Are not FDIC or any other Government Agency Insured Are not Bank Guaranteed May Lose Value SunTrust Private Wealth Management is a marketing name used by SunTrust Banks, Inc. and the following affiliates: Banking and trust products and services, including investment advisory products and services, are provided by SunTrust Bank. Securities, insurance (including annuities) and other investment products and services are offered by SunTrust Investment Services, Inc., an SEC registered investment adviser and broker-dealer, member FINRA, SIPC, and a licensed insurance agency SunTrust Banks, Inc. SunTrust is a federally registered trademark of SunTrust Banks, Inc. DGD R3/14 5