If you're setting up a trust fund, how much capital do you need?
Originally published in Current, March 11, 1996
By Steve BehrensHow big do you make a trust fund that would pay out $260 million a year? Rep. Jack Fields (R-Tex.) says a billion dollars may be enough, but public broadcasters argue that $3 billion or $4 billion would be more like it.
Both may be overestimating what a carefully managed endowment can afford to pay out.
Payout rates of foundation and university endowments cluster so snugly around 5 percent, according to authorities in the field, that the rate has become a standard for prudent management.
With a 5 percent annual payout, the public broadcasting trust proposed in Fields' bill last month would have to equal $5.2 billion if it is to continue spilling out $260 million a year, the amount of the present CPB appropriation.
Fields was thinking that endowments could pay out a lot more. Opening the Feb. 29 hearing on his bill, the telecom subcommittee chairman said an endowment of $1 billion could generate annual income for public broadcasting equal to today's appropriations.
He had just read in USA Today that some mutual funds earned more than 30 percent last year on the huge sums that they invest, and he expected that sharp money managers could also obtain good rates for the pubcasting trust fund.
If they counted on doing that year after year, however, they would be either imprudent gamblers or magicians, judging from the common practice among endowment managers.
David Salem, president of the Investment Fund for Foundations, a Charlottesville, Va., organization that manages $700 million for 160 foundations and nonprofits, explains the thinking behind 5 percent:
"The stated intention of most perpetualized endowments is to sustain their purchasing power,'' says Salem. "That immediately leads to the conclusion: they can spend at the rate of long-term inflation-adjusted return.''
Most assume that their annual earnings, minus inflation, will be between 4 and 5 percent, he explains, so they spend at that rate.
Foundations with 5 percent rates of payout to grantees allow their assets to continue growing and end up paying out more money after 19 years than those that distribute 6 percent, a Council on Foundations study concluded last year. After 45 years, assets of the 5 percent foundation have grown by a quarter, while those of 6 percent foundations have fallen.
Even with a relatively stable mix of stocks and bonds, earnings fluctuate from year to year. Last year, as Fields noticed in the newspaper, the stock market was doing quite well. Colleges and universities with endowments of $400,000 or more earned a average of 16.6 percent, according to Joel Sommer, a senior research analyst with Cambridge Associates, an Arlington, Va., firm that surveys institutions on their endowment statistics.
But though those institutions earned 16.6 percent, they still paid out an average of 4.7 percent, according to Sommer.
One reason that payout rates in this vicinity are so well established is that the Internal Revenue Service requires private foundations to spend at least 5 percent of the three-year average of their assets. But even though the IRS rule doesn't apply to universities, museums and other nonprofits, they stick close to 5 percent anyway, according to Salem.
"It's very interesting and hugely relevant to what's going on on the Hill to note that while [those institutions] are free to adopt their own spending rates,'' he says, "most well-managed institutions are spending certainly no more than 5 percent, typically between 4 and 5.''
The trustees of Johns Hopkins University in Baltimore, for instance, voted two years ago to extract no more than 4.5 to 5 percent a year from their $800-million endowment, says university spokesman Dennis O'Shea. The school had been paying out slightly above 6 percent during the previous decade, and the trustees felt that had been "riskier than they wanted to be in protecting the value of the endowment.''
How often do foundations get aggressive and push their payout rates higher?
"I don't know of any examples of organizations that have done extremely well and have opted for spending rates of more than 5 percent,'' says Salem.
In absolute terms, however, their annual spending does rise as their assets grow. The Robert Wood Johnson Foundation, for example, saw its assets grow 40 percent because Johnson & Johnson stock soared, and plans to boost spending, the Chronicle of Philanthropy reported recently. But if it awards $288 million as predicted, that will still be about 5.5 percent of its assets at the beginning of the year.
A 5 percent payout rate is another way of saying that the endowment must be 20 times the desired annual payout.
Salem comments: "An objective observer would say that whoever the deep pocket is, if they want to create a one-time endowment ... that can forever fund the budgetary gap of $200 million to $300 million, they have to multiply that by 20.''
The results of the arithmetic are $4 billion to $6 billion.
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