Imagine a foundation calculating its grantmaking budget based on its asset values at the end of each quarter for the years 2006, 2007, and 2008.
Closing Dow Jones Average
Simple Rolling Dow Jones Average by Quarter
As the chart indicates, the effect on a foundation’s 2009 grantmaking budget over three years versus over one year is obvious. A foundation determining its 2009 grantmaking based on 5 percent of the average of these 12 quarters (11,903.37) will have a higher cash payout than a foundation that simply uses the average value of its assets at the end of the most recent year (although typically calculated on a monthly basis, for our purposes here, the average of the four quarters of 2008 would equal 10,809.99)
Investment experts and statisticians use several terms to describe this practice, such as “rolling averages,” “moving averages,” and “trailing averages.” A rolling average, for example, calculated by quarters for a one-year period (each quarter averaged with the previous quarter’s average) leads to a somewhat higher total average (the average of the three years of quarters calculated on rolling averages is 12,065.64).
The theory behind this practice is that by averaging asset values over a longer period of time the “volatility” of payouts is somewhat reduced: when you average the previous two “up” years, a sharp market decline like that in 2008 doesn’t pull down payouts. Conversely, in boom periods, the big “up” year is averaged against lower periods so that payouts don’t increase hugely either.
But foundation payout (or technically, “qualifying distributions” including grants, program-related investments, and most related administrative costs) must be no less than 5 percent of the value of a foundation’s total assets in the foundation’s previous fiscal year, right? Yes, but this multiyear averaging works well for meeting mandatory foundation payout requirements. Technically, a foundation bases its annual payout on the 12-month average value of its assets in the previous year. Even that one-year averaging reduces the volatility somewhat (compare the 10,809.99 average of the Dow during the four quarters of 2008, compared with the Dow’s ending value of 8,776.39).
The multiyear averaging helps foundations meet payout requirements because the IRS affords foundations up to five years to satisfy payout requirements in any one year. So, for example, assume that a foundation’s payout in a particular year, due to the multiyear rolling averaging generates an excess or surplus charitable expenditure. That excess may be “carried over” to help a foundation meet its payout requirements for up to five years in the future. Take the example in the chart again. A foundation’s payout based on the three-year rolling average (5 percent of 12,065.64) would be much higher than its required payout (5 percent of 10,809.99). That surplus could be applied to future years when the rolling average dips below the average asset value of the most recent year. This is calculated automatically on the foundation’s 990PF, so that past years’ excesses can be automatically applied to a foundation’s payout shortfall.
This is, of course, a simplified analysis. Payout is more complex, with aspects that most people don’t realize, such as permitting foundations to reduce their endowment value (for calculating payout) by 1.5 percent for “cash deemed held for charitable purposes,” etc. But if foundations choose not to comply with this minimum payout requirement, they can incur penalties. Since 2007, foundations have been subject to an initial penalty of 30 percent of the undistributed amount that should have been spent as qualifying distributions (previously it was 15 percent). And in addition to the penalty on the shortfall, foundations are supposed to distribute the rest of their required payout.
That is why it doesn’t hurt for a foundation to make some 5 percent-plus distributions to cover years when it might slide below. The conundrum is the foundation “excise tax.” According to the law, a foundation must pay a tax of 2 percent on its net investment income. That tax is reduced to 1 percent if a foundation makes qualifying distributions (or a payout) in excess of its average distribution over the previous five years. In other words, a higher average payout percentage means that a foundation has to keep meeting that average to avoid the 2 percent excise tax. Many foundations and nonprofits advocate strongly for consolidating the excise tax into a flat rate of 1 percent.
Foundations didn’t invent the practice of rolling averages. Endowment managers of all sorts have long used “moving averages” to smooth out payouts, whether for foundations’ qualified expenditures or retirees’ pensions. But it isn’t an inviolable law. A foundation may use averaging for calculating its payouts or discard it as it chooses. So despite the markets and despite rolling averages, some foundations because of their mission might increase grantmaking in 2009-and for entirely different reasons, others might slash their cash payouts deeply. For investment managers and foundation executives, these aren’t easy decisions to make.