Stanford Law School

John M. Olin Program in Law and Economics

Published Paper Series

When Time Isn't Money:

Foundation Payouts and the Time Value of Money

(Published in Stanford Social Innovation Review, Vol. 1, Issue 1:51-59, Spring 2003; also in Exempt
Organization Tax Review, Vol. 41, issue 3:421-428, September 2003)

Michael Klausner

Stanford Law School

This paper can be downloaded without charge from the

Social Science Research Network Electronic Paper Collection:
http://ssrn.com/abstract=445982
 b y M i c h a e l K l a u s n e r

when
time
money isn’t
Foundation Payouts and the Time Value of Money

BILL GATES HAS SAID THAT WHEN AN AIDS VACCINE IS

produced, the Bill and Melinda Gates Foundation will fund the vaccine’s
distribution around the world even if the foundation has to spend down
its $24 billion endowment. For now, and until the vaccine is found, how-
ever, the foundation is distributing funds at about the legally required rate
of 5 percent per year.
In recent years, strong arguments have been made to foundation man-
agers and the U.S. Congress that foundations should distribute their assets
at a faster rate, beginning now. McKinsey & Company consultants Paul J.
Jansen and David M. Katz, writing in “For Nonprofits, Time is Money,” have
argued that we should view foundation grants as an investor would view an
investment.1 Former New Jersey Senator Bill Bradley, now a consultant to
McKinsey, joined Jansen in making the same argument in a New York Times
op-ed entitled “Faster Charity.”2 They argue that, just as investors would
choose to receive a dollar today rather than a dollar a year from now, so too
is a dollar of charity given today worth more to society than a dollar of char-
ity given in the future.
If the McKinsey authors are right, then the Gates Foundation may need
to reassess its strategy. Under their approach, the Foundation should discount
the social benefit of a future AIDS vaccine to a “present value,” just as an
investor would discount future investment returns to present value. This dis-
PHOTOGRAPHS BY MASTERFILE

counting exercise would reduce the vaccine’s value to a fraction – very likely
a small fraction – of the benefit that the vaccine will produce when it is actu-
ally distributed. Thus, more immediate grants to charity would appear

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 If the McKinsey
authors are right, then
the Gates Foundation
may need to reassess
its AIDS strategy.

more socially valuable in comparison, and to that

extent, the McKinsey authors argue that foundations
should accelerate their payout rates.
But the McKinsey authors are wrong. The dis-
counted cash flow approach they use is inapplicable to
the foundation payout issue. There are good reasons
for foundations to favor high payout rates under cer-
tain circumstances, and there may be reasons for the
law to mandate minimum payout rates, but the time
value of money is not one of them.
tions can increase the value of their grant making by increasing
Current Versus Future Charity their payout rates. They explain that they apply “a standard
The issue of foundation payout rates comes down to a tradeoff financial concept known as the ‘time value of money’”5 to reach
between charity for the current generation and charity for future this conclusion. This is the same “discounted cash flow” approach
generations.3 The lower the payout rate, the greater the amount that corporations and investors use in deciding whether a current
saved and invested, and hence the greater the amount that can investment is justified by its projected returns. To evaluate a
be distributed to future generations.4 Conversely, the higher the proposed investment, a company projects the investment’s future
payout rate, the lower the amount available for future distribu- cash flow and discounts it to present value using a discount rate
tion. The arguments of those who advocate higher payout rates that reflects the company’s cost of funds or the rate of return the
amount to arguments that foundations should provide more company can earn from an alternative investment. An individual
money to current charity and less to future charity. Foundations investor would approach an investment the same way, but in addi-
that resist higher payout rates are in effect arguing for more tion, an individual would consider whether he prefers immedi-
future charity at the expense of current charity. ate consumption to the opportunity to consume more in the
future when the investment pays off.
The Discounted Cash Flow Approach The McKinsey authors are not the first to apply the dis-
The McKinsey authors argue that a foundation dollar distributed counted cash flow approach to foundation payouts. The U.S.
to charity today is worth considerably more than a foundation Treasury Department and Congress implicitly took this approach
dollar distributed in the future. Consequently, they say, founda- in the 1960s when the payout rate was initially enacted. They were
troubled by the fact that a donor to a foundation takes a tax deduc-
tion at the time of the donation but the donated funds might not
HOW INVESTORS DISCOUNT reach actual operating charities until many years later. Congress

D iscounting helps investors compare investment

returns. Let’s suppose that an investor looking for a
return in five years has the choice of either putting $100
and Treasury believed that because of this delay, donors were get-
ting a tax benefit worth more than the charitable benefit they pro-
duced. Other advocates for higher payout rates have referred to
into an investment that is projected to return $15 (along the time value of money as well. I focus on the McKinsey authors’
with the $100 principal) in five years or putting the analysis, however, because no one else has provided such a full
money in a five-year CD at a bank that pays 4 percent explication of this argument.
interest. To determine whether the investment is a bet- The McKinsey authors begin their discounted cash flow analy-
ter deal, the investor would use the 4 percent interest sis by constructing a hypothetical foundation that will exist for 50
rate to discount the receipt of $115 in five years, and years (Sidebar, facing page). Their foundation begins with assets
would discover that the present value of the $115 is of $1,000, it earns a 10 percent annual rate of return on its invest-
about $95. If you invested $95 today at 4 percent, you ment portfolio, it incurs administrative costs at the rate of 1 per-
would collect $115 in 5 years. The investment is thus a cent per year, and it distributes 5 percent of its assets per year in
bad deal. It would be equivalent to trading $100 for $95 grants to charity. With these numbers, the foundation makes
today. This is confirmed by the fact that if you invested grants of $50 in its first year. In its 50th year, its assets will be more
$100 in the CD today, it would be worth $122 in five than $5,000 and it will make grants of $257. The foundation’s grants
years – or $7 more. over 50 years will total $6,355. (To make it all more realistic, it is
helpful to assume six zeros attached to these numbers.)

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 Looking out to the 50th year, the 365 days of food is
barely worth a breakfast today

Sounds like a valuable social institution to me, but the authors THE HYPOTHETICAL MCKINSEY FOUNDATION
are not sanguine about this foundation. They calculate the pre-
sent value of the foundation’s grants to society by discounting Year Assets Grants at Present Present
the 50-year stream of grants at two alternative rates: the 10 per- 5 percent Value of Value of
cent rate that the foundation earns on its investment portfolio, per year Grants at Grants at
and a 15 percent rate that they say the foundation could earn for 10 percent 15 percent
society by making grants today.6 Running these calculations, the Discount Discount
authors find that the foundation’s $6,355 in grants over 50 years Rate* Rate*
is actually worth less to society than the $1,000 with which the 1 $1,000 $50 $50 $50
foundation started. It is worth $830 using a 10 percent discount 2 1,034 52 47 45
rate and $500 using a 15 percent rate.They run various scenar- 3 1,069 53 44 40
ios through their spreadsheet to show that foundations that want · · · · ·
to increase their value to society should increase their payout rates · · · · ·
above 5 percent. They neglect to point out, however, that under · · · · ·
their valuation approach, the best a foundation can do is break 48 4,814 241 2.73 .34
even in terms of creating social welfare, and that, with the 15 per- 49 4,977 249 2.57 .30
cent discount rate, the only way a foundation can do even that 50 5,164 257 2.41 .27
well is to distribute 100 percent of its assets immediately – and TOTAL $6,355 $830** $500**
to do so without incurring any administrative costs. With a 10 per-
McKinsey’s hypothetical foundation begins with a $1,000 in total
cent discount rate, the foundation would break even over 50 assets. It then assumes annual disbursement of 5 percent of assets
years – or an infinite number of years – so long as it has no through grants, administrative costs of 1 percent of assets, and a
return on the remainder invested of 10 percent. While grants grow
administrative costs. With administrative costs, the foundation to $257 in year 50, the present value of the grants decline to $2.41
is a money loser from the start. The McKinsey authors explain using a 10 percent discount rate and to 27 cents using a 15 percent
discount rate. The present value of all disbursed grants and the
that skilled grant making can offset the ravages of time on a foun- remaining principal after 50 years is $830 at the 10 percent discount
dation’s social worth, but holding the quality of grants constant, rate and $500 at the 15 percent discount rate.
their point is simple: Future charity is worth less than present char- * Assumes, as McKinsey authors do, that grants are made at the beginning of each year.
ity, and it is the time value of money that makes the difference. ** Total includes net present value of remaining principal.

The McKinsey authors’ analysis is simply arithmetic. By

assuming a social rate of return on a foundation’s grants (15 per-
cent) that is higher than the rate of return on its investments (10 or 88.)7 So, the $241 in grants that the foundation will make in
percent), their calculations would lead the foundation to dis- year 48 is worth just 34 cents. Accordingly, if a grant will be made
tribute all its funds immediately. But if a foundation’s grants 48 years from now to fund a soup kitchen serving three meals a
yield only a 9.9 percent return for society, then those same cal- day for the full year (a total of 1,095 meals), the present value of
culations would lead the foundation to invest its cash forever and that grant is just one and a half meals – brunch.8 If the founda-
never make a grant! Something must be wrong with this approach. tion had a choice of serving just brunch today or three meals a
day for a full year in 48 years, the discounted cash flow approach
The Inapplicability of the Discounted would tell us it is a coin toss. This low valuation of the soup
Cash Flow Approach kitchen’s services is based solely on the fact that its clients’ hunger
The McKinsey authors’ analysis is flawed, not merely because of will occur in the somewhat distant future rather than today.
the numbers they use, but most fundamentally because the dis- There are several reasons why the discounted cash flow approach
counted cash flow approach is not an appropriate method for mea- is irrelevant to the foundation payout issue.
suring the value of foundation grants made in the future. When Most fundamentally, by discounting future grants to present
the McKinsey authors measure the present value of their foun- value, we would be saying that future grants are worth less to soci-
dation, the value of the grants that the foundation makes each ety than current grants. Using the soup kitchen example above,
year is divided by a discount factor. So, for example, the value of
grants made at the beginning of the 48th year is measured by divid- Michael Klausner is a professor of law and the Bernard D. Bergreen Faculty
ing the amount of money that will be distributed by 1.1547, or Scholar at Stanford Law School, where he teaches nonprofit law as well as
712. (Using the 10 percent discount rate the figure would be 1.1047, corporate and banking law.

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 Foundation payout rates come down to a
tradeoff between charity for the current generation
and charity for future generations.

a grant of $241 in 48 years is worth a lot less than a grant of $241

today; using a 15 percent discount rate, it is worth only 34 cents
today. But why? In the private investment context, if investors can
earn 15 percent on their money, they can convert the 34 cents into
$241 in 48 years. To an investor, therefore, receiving 34 cents today
and receiving $241 in 48 years are equivalent. But when we com-
pare a grant to charity today with one made in 48 years, we are
comparing the benefit of helping one group of people today with
the benefit of helping another group in 48 years. There is no sim-
ilar equivalence. Why would 34 cents worth of food to a group
of hungry people be worth the same as $241 of food to a differ-
ent group of hungry people simply because the two groups live
at different times? By invoking the discounted cash flow approach,
the McKinsey authors have adopted what economists refer to as
a “pure time preference” in allocating resources over genera-
tions. Such a preference is difficult to justify as an ethical or eco-
nomic matter. Frank Ramsey, who in 1928 was one of the first
economists to analyze resource allocation over time, described The discounted cash flow approach implicitly compares private
the discounting of funds allocated to future generations as “eth- return available in the financial market with the social return avail-
ically indefensible and aris[ing] merely from the weakness of the able from grants to charities, such as schools and soup kitchens.
imagination.”9
Secondly, there is no basis for discounting a future grant at the ing. The cost of that lost opportunity is the “return” that society
rate of return a foundation earns on its investment portfolio – the could have reaped if the foundation had made grants earlier. The
10 percent rate the McKinsey authors use. In the private invest- authors recognize that social returns are hard to quantify and that
ment context, the projected cash flows of a proposed invest- selecting a discount rate is difficult as well, but they select a 15
ment are discounted at the rate of return available on an alter- percent social rate of return as “a conservative estimate for the
native investment; by making the proposed investment, the upper end of our range of rates.”11 They base this claim on work
company or the individual would forgo the alternative investment done by the Roberts Enterprise Development Fund (REDF) to
(Sidebar, p. 52). For foundations, however, when a grant is deferred measure the impact seven nonprofit organizations had in running
to the future, there is no loss of an opportunity to earn a return business enterprises that train and employ an inner city popula-
on the foundation’s investments. On the contrary, as the McKinsey tion.12 If the authors mean to suggest that a significant number
authors recognize, the funds remain invested in the foundation’s of grants to charities will yield this sort of return, this is a wild
portfolio, earning a 10 percent return. This step in the authors’ extrapolation from REDF’s focused experience. There is no basis
discounting exercise amounts to inflating and deflating the foun- for concluding that the enterprises run by these seven organiza-
dation’s assets at the same rate, which results in a wash – there tions, or the social returns that they generate, are representative
is no loss of value as a result of delay regardless of the payout rate. of the entire charitable sector, which includes art museums,
The reason the McKinsey authors find that the value of the prep schools, soup kitchens, hospices, universities, and innu-
foundation’s grants is less than the $1,000 with which the foun- merable other sorts of organizations. Indeed, there is no reason
dation started is because their foundation incurs administrative to believe that the enterprises REDF has funded and studied are
costs in making grants.10 Although they recognize that skilled grant even representative of organizations with similar missions.13
making can produce social gains, their calculations include only Moreover, although foundations are commonly interested in
the cost of grant making, not the benefit. In the McKinsey making grants that will produce a return to society that contin-
authors’ calculations, even a penny of administrative costs would ues for some period of time, many grants – to the opera, sym-
render the foundation a net loss to society. The presence of phony, soup kitchen, and homeless shelter, for example – produce
administrative costs, however, is not a per se reason to increase pay- benefits that are better characterized as largely consumption
out rates. rather than investment.
Third, the McKinsey authors are correct in recognizing that Fourth, even assuming that a grant yields a social return – of
there is a social opportunity cost of forgoing earlier grant mak- 15 percent or whatever – the McKinsey authors’ application of

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the discounted cash flow approach assumes that this return will This approach would maximize the social return to the founda-
be maintained over the long run – 50 years in their hypothetical tion dollar. But efficiency is not the only value that guides foun-
foundation. When one applies a 1.1550 discount factor to a grant dation policy or public policy toward the nonprofit sector. Foun-
to be made 50 years from now, one says that the money could dations support diverse activities in the charitable sector, some
be invested today to generate a 15 percent return for 50 years. At constituting valuable social investment and some providing valu-
that level of sustained social gain a grant of $100,000 – say, to fund able consumption, some providing goods that other sectors do
a college scholarship for at-risk youth, or to support the local sym- not provide and some redistributing wealth. The application of
phony – would yield $108 million worth of gains to society at the the discounted cash flow approach to evaluate grants would sac-
end of 50 years. This seems unlikely, and it certainly has no basis rifice this diversity and with it values of equity, fairness, and
in REDF’s experience. community.
Fifth, even if a current grant to charity does yield a long-term
social return, unless the return continues in perpetuity, applying Balancing Current and Future Charity: A Fresh Start
a discount rate to future charity gets us back to the problem with So if the discounted cash flow approach is not useful, how should
which I began this analysis: the favoring of one set of beneficia- foundation managers think about the tradeoff between current
ries over another based simply on the period of time during and future charity? I will address this question in another article,
which they live. As I discuss below, there may be justifications to but here are the basics.
such a preference, but they are not found in the discounted cash The tradeoff between current and future charity is a version
flow analysis. of a problem with which policymakers, economists, and philoso-
Finally, if the discounted cash flow approach were applicable phers grapple when considering very long-term public investments
to the timing of grants, it would be applicable to the evaluation in energy production and environmental protection. How much
of grants themselves. The McKinsey authors do not extend their sacrifice should the current generation make so that future gen-
discounted cash flow approach this far, but let’s see what would erations can have a cleaner environment, cheaper energy, better
happen if we extend the approach to its logical conclusion. To health, and longer lives? The question for foundations is similar.
evaluate a grant, a foundation manager would discount its pro- How much charity should we withhold from the current gen-
jected social return. The discount rate, at a minimum, would have eration in order to provide more charity for future generations?
to equal the rate of return earned on the foundation’s investment The challenge of how to allocate resources among gener-
portfolio – 10 percent in the McKinsey authors’ hypothetical. This ations is fundamentally an ethical question, with economics
would lead a foundation to forgo grants that are expected to yield helping to highlight the tradeoffs. One realization that has
social benefits, if those benefits are less than the expected finan- come out of the debate over long-term public investment is that
cial return on the foundation’s investments. In other words, if the pure timing of a social benefit – whether this generation
grants to a soup kitchen or an opera or a school are not expected or a future generation enjoys the benefits – should be irrele-
to yield what the bank or the stock market will pay, the founda- vant to its social value from either an ethical or economic per-
tion should not make the grants. This surely is not a proper spective. So, for instance, if greenhouse gas regulation today
comparison. To compare the private return available in the mar- improves the lives of people living 100 years from now, the mere
ket with the social return available in the charitable sector, which fact that the benefit will be enjoyed by people living so far in
one implicitly does by using the former to discount the latter, is the future doesn’t make its social value smaller.14 The same is
an error of the apples-and-oranges variety. true of the future benefit that comes from a foundation’s deci-
Similarly, if a foundation were to follow the discounted cash sion to adopt a low payout rate today in order to support char-
flow approach, it would have to discount the projected social ity in future generations. There may be a temptation to care
returns from one grant by the social returns available on other more about the current generation than about faceless gener-
grants. Foundations already do this implicitly when they compare ations in the future. The economist Kenneth Arrow and his co-
two grants in the same field. But the discounted cash flow authors describe this temptation as discounting future gener-
approach takes it a step further. If, for instance, a foundation funds ations for “empathetic distance (because we may feel greater
research on the history of western civilization, the discounted cash affinity for generations closer to us).”15 Others explain the incli-
flow approach would require the foundation to discount the nation as “impatience” or “myopia.”16 No doubt this gut reac-
projected social returns from that research by the social return tion exists among us, but it does not amount to an ethical
it could achieve with a grant anywhere else in the charitable sec- principle or policy prescription. The philosopher John Rawls
tor – a grant to an enterprise that REDF supports, for example. concludes that “the different temporal positions of persons and

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 COST-EFFECTIVE GRANT MAKING IN PRACTICE
The Review asked Richard N. Goldman, co-founder of
the Goldman Environmental Prize, why they pay out
more than the traditional 5 percent.

“As the president of the Richard

and Rhoda Goldman Fund, I have
directed our staff to give aggres-
sively. For the past several years generations does not in itself justify treating them differently.”17
the Goldman Fund has been giv- Those advocating higher payout rates legitimately point to a
ing 10 percent of its assets. dire need for current charity. As a matter of advocacy, this
“My 50 years in philanthropy approach is understandable. But as a matter of analysis, we need
have convinced me that, for the to recognize that current charity comes at the expense of future
environment and other charitable charity, and that the mere timing of a generation’s presence on
causes, the ‘rainy day’ is upon us. this planet is not relevant to the social value of charity provided
The overriding interest of my to that generation. Moreover, because charity deferred to the
foundation is the environment future earns a return in the foundation’s investment portfolio, a
and my own years of supporting dollar withheld from the current generation can be expected to
environmental concerns around the world has convinced yield more dollars of charity for future generations. Ben Franklin
me that climate change is the most urgent of all the appreciated this aspect of the tradeoff and chose to hold off giv-
threats facing life in the 21st century. I believe that now ing a few thousand dollars to Boston and Philadelphia in 1790 so
is the time to address the climate change issue head on, that his gift would amount to several million dollars in 1990
simply because the opportunity will never come again. If (Sidebar, below). This is surely not to say that we should sacrifice
we do not act now, we will impose untold harm on all current charity for the future – in perpetuity. That would
future generations, and there will be nothing they can make no sense. The challenge is to come up with an analytic
do to remedy the situation. approach that focuses on the factors relevant to the tradeoff to
“This single issue has the potential to exacerbate society between current and future charity.
nearly all other environmental and social problems. It is That tradeoff presents three issues for a foundation to con-
incumbent upon foundations to make strategic invest- front in determining how much to save and how much to give.
ments to address a myriad of social and environmental Two issues reflect the goal of maximizing aggregate social wel-
issues that need to be solved soon or they will only com- fare across generations.18 The third reflects a goal of intergener-
pound into even more dire problems in the future. Peo- ational equity – a notion that there is a limit to what we can ask
ple in the future will thank us if we act now.” one generation to give up in favor of another generation for the
sake of maximizing total welfare.19 For environmental policies,

A Penny Saved: Ben Franklin’s Last Experiment

I
n 1785 a Frenchman named and Philadelphia with specific condi- some of the money on public works
Charles-Joseph Mathon de la Cour tions that the money could only be and loan out the rest for 100 years.
wrote a parody mocking Benjamin paid out after accruing interest for Two hundred years after his death,
Franklin’s American optimism. In 100 – then another 100 – years. He Franklin’s legacy would, according to
the story, a man leaves a small sum of hoped that the people of those cities his projections, total £4,061,000 (or
money in his will and after collecting would see his plan as “a testimony of about $9 million for each city).
interest for 500 years, it becomes a my earnest desire to be useful to Franklin died in 1790, and his plan
fortune. Ben Franklin wrote back to them after my departure.” The inter- was subsequently put in motion,
the Frenchman and thanked him for est on the money would be earned though not exactly as he had hoped.
the inspirational idea. from loans to “young married artifi- Because the loan program was not
And so instead of leaving £2,000 to cers, under the age of twenty-five administered vigilantly and because
Pennsylvania to make the Schuylkill year, as have served an apprenticeship the trade and apprentice systems
River navigable, which was his origi- in said town,” to assist them in setting waned with industrialization, neither
nal plan, Franklin left £1,000 (about up their business. At the 100-year city’s fund grew to Franklin’s expecta-
$4,500 at the time) each to Boston mark, each city was required to spend tions. After 100 years, Boston’s fund

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 How much sacrifice should the current generation make so
that future generations can have a cleaner environment,
cheaper energy, better health, and longer lives?
federal policymakers set the balance of environmental benefits rent charity in areas such as these, and surely others, produces
and burdens across generations. But the allocation of charity is benefits that compound in perpetuity at a higher rate than assets
decentralized. Each foundation, therefore, must consider these in the foundation’s portfolio, then not only will the current gen-
issues in the context of its own mission and the types of charity eration benefit from a grant today but future generations will be
it supports. better off as well.
Cost-Effectiveness A Brighter Tomorrow?
The first issue that a foundation should consider in setting a pay- Before salting its money away for future generations, a founda-
out rate is how cost-effective a grant to current charity would be, tion should also ask itself whether future beneficiaries of its mis-
compared to future charity, in providing a charitable service. sion are likely to be better off than current beneficiaries.20 For
Despite the fact that a dollar of today’s charity comes at the example, perhaps with continued economic growth over the
price of many dollars of future charity, certain kinds of charity generations, art aficionados of future generations will be wealth-
today will be more cost-effective; current and future generations ier than the art aficionados of today. If so, there is less reason to
will be better off if these charitable services are provided sooner save today in order to support the arts in the future. In addition,
rather than later. For example, if a foundation’s goal is to preserve economic growth over the generations is likely to mean more
open space, doing so sooner may be better than doing so later, donations to the nonprofit sector in the future. More immediately,
when the choice of open space to preserve will be more limited. some expect a massive flow of funds to the nonprofit sector as
Early preservation may mean better preservation for all gener- the baby boomers pass on their wealth over the next 20 years. If
ations. The same may be true of efforts to reduce population the charity sector of the next generation will have more funds
growth in an overpopulated region or to protect the envi- than the sector has today, then there is less need to sacrifice cur-
ronment (Sidebar, facing page), or to cure an infec- rent for future charity. Or perhaps the needs that a foun-
tious disease. It may be true as well of some edu- dation serves will be less severe in the future. A
cational programs, but only if one expects problem may be solved, or a service now in
the benefits of current education to have short supply may be abundant.21 If, for any of
indirect effects on the descendants of these reasons, future generations of chari-
current students in perpetuity. If cur- table beneficiaries are expected to be bet-

had grown to roughly 100 years, the roughly $100,000

$391,000, much of which was reinvested in Boston a century
used to help establish what is earlier had grown to $5 mil-
now the Benjamin Franklin lion, and the $39,000 rein-
Institute of Technology in vested in Philadelphia had
Boston; the remainder was grown to $2.25 million. The
reinvested for the next 100 Boston money was again given
years. Unlike Boston, Philadel- to the Benjamin Franklin Insti-
phia’s fund had stuck with the tute of Technology. The
loan program rather than Philadelphia money was divided
investments in the stock market among city and community foun-
and by 1907 had grown only to dations throughout Pennsylvania,
$172,000. The majority of that where it has funded, among other
was given to the Franklin Institute, things, scholarships for students
a hands-on science education attending technical college and pursu-
museum in Philadelphia. ing careers in trades, crafts, and
By 1990, at the end of the second applied sciences.

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 There may be a temptation to care more about the current
generation than about faceless generations in the future,
but that temptation does not amount to an ethical
conclusion or a policy prescription.
ter off than the current generation, then a foundation should put later to combat the disease. Delivery of the vaccine, even to the
a thumb on the scales of the current generation. This does not next generation (or the one after that), may well be more bene-
amount to discounting the future generation because it will ficial to society over time than adding yet more Gates Founda-
arrive on the scene in the future. Rather, it is a matter of giving tion funds to the AIDS effort today. This is the type of judgment
resources to those who are worse off rather than those who will that individual foundation donors and executives must make. If
be better off. there is a flaw in the Gates Foundation strategy, it is that there may
be more philanthropic dollars available to support the delivery
Intergenerational Equity of an AIDS vaccine when it is developed. At the margin, Gates
Intergenerational equity provides a basis for a foundation choos- Foundation funds may better used sooner. That, however, is also
ing to give a dollar of charity today rather than more dollars in the type of judgment that must be left to foundation donors and
the future. In contrast to the first two issues, this issue is not a mat- executives.
ter of maximizing welfare across generations. It is a potential rea-
son to favor the current generation at the expense of future gen- The Mandatory Payout Requirement
erations. This principle weighs against the goal of maximizing If there is not necessarily a downside to society for a foundation
aggregate welfare in the charity sector over the generations. As to favor future charity over current charity, then why do we
an ethical matter, there must be a limit to the extent of sacrifice need a mandatory payout rate? It is not because there is a mis-
any generation can be asked to make for future generations, even match, as Congress believed in 1969, between the value of the
if further sacrifice would lead to net gains in the future. In addi- tax deduction and the value of charity given in the future. As
tion, there may be situations in which certain members of the cur- explained above, there is no valid reason to conclude that future
rent generation have a particularly strong ethical basis for deserv- charity is necessarily worth less than current charity. Furthermore,
ing something more than members of future generations (and since future charity benefits from compound growth, the tax
more than others in the current generation). Innocent victims of deduction for a donation to a foundation is equal to the present
a war waged by the current generation, for example, may have value of the foundation’s future grants.
an ethical claim to funds that the current generation has accu- So why not allow foundations to distribute less now and defer
mulated for charity. Ideally, each foundation would strike a balance more resources to future generations? If foundation managers
between equity and wealth maximization as it deems appropri- were guided entirely by social welfare considerations in setting
ate for society as a whole. Just as foundations distribute their their payout policies, then no minimum payout law would be
funds across the charitable sector as they choose – focusing on max- needed. Foundation managers, however, seem to be influenced
imizing social returns or on other ethical considerations – they by the prestige associated with large endowments, and foun-
should do the same with their distributions over time. dation donors seem to be influenced by notions of immortal-
So how does the Gates Foundation’s AIDS strategy look ity associated with perpetual existence. Consequently, donors
under this approach? First, Gates should not worry about dis- and managers seem to have a personal bias toward lower pay-
counting the value of lives saved in the future as a result of an out rates. The minimum payout requirement responds to this
AIDS vaccine. The Foundation’s strategy should be analyzed self-interest in a fairly moderate way. It basically allows a foun-
based on the cost-effectiveness of providing less now and more dation to maintain its principal and to make grants in perpetuity
at the 5 percent rate. This allows donors immortality and forces
foundations to treat current generations at least equally with
FOUNDATIONS THAT PAY OUT 5 PERCENT future generations. In the long run, the minimum payout
Rockefeller Foundation requirement is expected to hold foundation endowments con-
John D. and Catherine T. MacArthur Foundation stant, so it inhibits foundation executives from vying for pres-
Pew Charitable Trusts tige by growing their endowments.22
Should the minimum payout requirement be increased as
FOUNDATIONS THAT PAY OUT AT some advocates have urged? This is a difficult issue that goes
ACCELERATED RATES beyond the scope of this article. If the personal biases of foundation
Tides Foundation executives play too strong a role in allocating funds between cur-
Olin Foundation rent and future charity, an increased payout requirement might
Goldman Foundation be reasonable. Of the factors described above, the one that might
push in favor of a higher payout requirement across the board is

58 S TA N F O R D S O C I A L I N N O VAT I O N R E V I E W www.ssireview.com
 IMPLICATIONS TO MANAGERS
• Payout rates are a tradeoff between current and future charity.
• If a problem can best be solved now, for the benefit of current and future generations, we should spend more on it now.
• If we expect future generations to be better able to provide for themselves, we should spend more on today’s charity.

percent rate of return on the foundation’s investments presumably does, and it is

the comparison between the resources and needs of charity today hard to say whether the 15 percent social rate of return does. But as stated above,
versus charity in the future. If, as some expect, there will be a large discounted cash flow analysis does not depend on inflation, nor does the McKinsey
flow of funds to the charitable sector over the next 20 years, and authors’ analysis. Moreover, since the return on a foundation’s investments would be
expected to compensate for inflation, inflation is not relevant to the payout issue.
if we expect society to grow wealthier and charitable donations For these reasons, I will ignore it.
to increase with wealth over the generations, then perhaps foun- 7 The formula for discounting is the reverse of the formula for calculating what an
dations should anticipate this new money and devote more funds investment today will be worth in n years. To calculate the future value of an invest-
ment in n years, we would multiply the amount invested by one plus the expected
to current charity. From a policy point of view, there is no prob- return of the investment and we would do that n times – once for every year. To dis-
lem with foundations spending themselves out of existence as new count a future return, we divide the expected future return by one plus the return
foundations take their place. On the other hand, increasing the pay- available on an alternative investment, and we do that n times. The formula is pre-
sent value equals expected future return divided by (1+i)n, where i is the interest
out requirement to a level that would place foundations’ perpet- rate on an alternative investment. The McKinsey authors assume grants are made
ual existence in substantial jeopardy could make the establishment on the first day of each year, so that a grant made in the second year is actually
of foundations less attractive to donors, which could result in less made one year from the time of the foundation’s formation, and a grant made in
the 48th year is made 47 years from the time of formation.
charity for present and future generations. 8 That is, 1,095 meals divided by 712 equals 1.54 meals.
9 Ramsey, Frank. “A Mathematical Theory of Saving,” Economic Journal, vol. 38, no.
Conclusion 152: 543.
10 The negative net present value of the foundation, when discounted at the 10 per-
Discounted cash flow analysis is not helpful in thinking about cent rate, is simply the present value of its administrative costs.
foundation payout rates. That approach amounts to a pure 11 Jansen and Katz, p. 128.
preference for the current generation over future generations 12 http://www.redf.org/pub_sroi.htm. The REDF figures are actually estimates of
these enterprises’ capitalized value. It is unclear how the McKinsey authors inferred
with no ethical or economic basis. The allocation of charity annual rates of return from these figures.
across generations is analogous to the allocation of environ- 13 REDF itself warns against generalizing from its findings: “REDF’s specific SROI
mental resources across generations and should be analyzed the [social return on investment] Framework and the metrics it generates are not applic-
able for all foundations or to all fields of practice. It has been designed for, and its
same way. That analysis provides justification for favoring cur- research is based upon, our experience with social purpose enterprises run by non-
rent charity over future charity in some situations, but not as profit organizations to provide employment and training to disadvantaged people.”
an absolute matter. SROI Methodology: http://redf.org/download/sroi/sroi_method_5.pdf.
14 Some economists advocate discounting public investments in the environment,
using a “shadow cost of capital” approach in order to measure whether private
Acknowledgement: investment would yield more for future generations than an investment in the envi-
I would like to thank Scott Ashton, Joe Bankman, Bernie Black, Paul Brest, ronment. Other economists disagree with that approach. The shadow cost of capital
approach, however, does not apply to the foundation payout context because funds
Harvey Dale, Rob Daines, Paul Jansen, Mark Kelman, Jill Manny, David used for future charity are invested in the capital markets. There is no opportunity
Mills, and participants at the Conference on Charity in the 21st Century, cost of capital involved. For an excellent synthesis of the economic and philosophi-
sponsored by the National Center on Philanthropy and the Law, for helpful cal literature on this issue, see Revesz, Richard L. “Environmental Regulation, Cost-
Benefit Analysis, and the Discounting of Human Lives,” Columbia Law Review, vol.
comments on this paper. 99, no. 4 (May 1999): 941.
15 Arrow et al, “Intertemporal Equity, Discounting, and Economic Efficiency,” Cli-
1 Jansen and Katz, The McKinsey Quarterly, no. 1 (2002). mate Change 1995: Economic and Social Dimensions of Climate Change (James P. Bruce et
2 Bradley, Bill and Jansen, Paul. “Faster Charity,” The New York Times (May 15, 2002) al editors 1996): 125, 131.
p. 23. 16 See, for example, Cline, William R. The Economics of Global Warming (1992): 249.
3 The range of rates advocated – roughly 5 to 6.5 percent – would allow foundations 17 Rawls, John. A Theory of Justice (1971): 294.
to span generations. The only issue is how many generations. 18 This approach is based on the concept of a social rate of time preference. See
4 I assume that once assets are transferred to a foundation, they will remain in the Arrow et al, Revesz.
nonprofit sector and will be used only for permissible charitable purposes, and not 19 For a discussion of this consideration in the environmental context, see Cowen,
expropriated by foundation executives or otherwise dissipated. The expropriation Tyler and Parfit, Michael, “Against the Social Discount rate,” Justice Between Age
and dissipation of assets was one of Congress’s concerns in 1969 when it enacted the Groups and Generations (Yale University Press, 1992).
first payout requirement. Other restrictions, however, were enacted in 1969 to 20 In economic terms, the point here is that future generations of beneficiaries may
address this concern. If those measures are insufficient, they should be buttressed. derive a lower marginal utility from charitable services. If this is true, and all other
Since a payout requirement still leaves the bulk of the assets behind to be expropri- factors are equal, then aggregate welfare over the generations will be maximized by
ated or dissipated, it is an ineffective response to this problem. favoring the current generation somewhat.
5 Jansen and Katz, p. 124. The time value of money does not refer to the effect of 21 Of course, the foundation may change its mission over the generations, which
inflation on the value of a dollar. Businesses and investors would discount cash flows suggests that this cross-generational comparison would have to span the entire chari-
even if there were no inflation, and the McKinsey authors are not simply suggesting table sector.
that foundations take inflation into account. Rather, the time value of money 22 The run-up in the stock market during the 1990s, which increased foundation
reflects the fact that in a growing economy investors can expect to earn positive endowments considerably, has led some commentators to question whether the cur-
returns (net of inflation) if they invest. rent payout requirement is lower than the rate of growth of foundation endow-
6 The discount rate should reflect the risk of a proposed investment. For simplicity, ments. The burst of the bubble should now temper that concern, but I take no posi-
however, and since I believe this entire approach is fundamentally inapplicable, I will tion on that issue.
ignore this detail. The discount rate should also reflect expected inflation. The 10

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