Payout by private foundations and public charities is the source of funds from which flow the grants that support much of the nonprofit activity in our society. Other things equal, higher payout means higher grants, and higher grants mean more nonprofit activity.

Under current IRS rules, private foundations are required to distribute yearly a minimum of 5% of their net investment assets as payout. Payout is not limited to a foundation’s grantmaking; it may include administrative expenses, program-related investments, amounts set aside for future charitable projects, and trustees fees.

The concept of a legally-mandated payout was instituted by Congress in the Tax Reform Act of 1969.Initially, foundations had to pay whichever was greater —either all their investment return, or 6% of net investment assets. Revisions made to the IRS rules in 1981 set the minimum payout rate at 5% of net assets, where it has remained ever since. The context for the 1981 rule change was the previous decade during which payout had exceeded asset returns, with a resulting erosion of foundation endowments.

In the nearly two decades since then, asset returns have generally exceeded the minimum payout level, and a record amount of new giving to philanthropic institutions has completely altered the payout context. While Congress has not yet revisited the issue of whether 5% may now be too low, we can be sure that it will eventually. What would be the economic rationale for such a shift in policy?

Congress Has Achieved Its Goal: The 1981 regulations that relaxed the minimum payout rate to 5% were intended to help private foundations rebuild their endowments, or corpus. Total foundation assets have grown in real terms by almost three times since then. Rebuilding has long since been completed.

Grants Payout at Lowest Rate in 20 Years: During that same period of growth and rebuilding, foundation grants payout declined from 8% in 1981 to below 5% in 1997.Many foundations clearly have adopted the legally mandated 5% minimum payout rate as a de facto maximum rate.

The Rate of Gifts Received Has Created a New Dynamic in Philanthropy: Contrary to expectations in 1981, the goal of increasing foundation assets and grantmaking capacity in line with economic growth has been met almost entirely by new foundation creation and gifts into existing foundations (84.5% of the increase), not by reinvestment of earnings on existing assets. This historical pattern looks likely to continue in the foreseeable future. A forthcoming report from the Boston College Social Welfare Research Institute estimates that intergenerational wealth transfer over the next 50 years will be substantially larger than the previously estimated $10.4 trillion, providing an enormous source of new wealth for philanthropic institutions and nonprofits.

Foundations Could Give Out More and Maintain Corpus: Proponents of the payout status quo often cite findings of a study conducted in 1990 by DeMarche Associates, CFA, and updated in 1995 by Carter Harrison, Jr., CFA, which concluded in favor of maintaining the 5% payout rate. Applying De Marche/Harrison ’s methodology to the 20-year period 1974-1995,Table 3 shows that a typical foundation could have afforded a grants payout rate as high as 8% without reducing its corpus. This study refutes the methodology of the DeMarche study, however, and looks at foundation assets for the larger purpose of social policy rather than wealth maximization.

It is Time for a Change: While clearly intending to help foundations with the 1981 payout regulations, Congress also required a minimum payout rate to prevent tax-advantaged foundations from becoming sterile warehouses of wealth. Unfortunately, that is exactly what has happened, due to the extraordinary investment returns and rates of new giving into new and existing foundations, combined with declining grants payout rates. The legislated 5% minimum payout rate has served to suppress grants payout at a time of growing need in our society.

The conclusion is compelling: a minimum payout rate of 5% may have been right for 1981,but it is too low for today.

Executive Summary, National Network of Grantmakers