More On Tax Planningfrom The Advisor's Professional Library
- Health Insurance: Health and Medical Savings Accounts A Health Savings Account is a trust created exclusively for the purpose of paying qualified medical expenses of an account beneficiary. Although they are popular, they are not without their pitfalls and the regulations can be complicated. Learn more about how to avoid federal taxation on the accumulation and distributions of HSA.
- Annuities: Estate Tax The value of certain types of annuities may be included in an estate’s value. Understanding the intricacies of these inclusions is a critically important aspect of estate planning.
Many wealthy individuals and families set up private foundations as a way to address specific social problems or to give back to the communities where they achieved their success. Others are motivated by income and estate tax rules that promote charitable giving. The foundation structure gives donors a modicum of control over their charitable giving during their lifetime and can create a family legacy.
In its execution, however, the private foundation structure can prove disappointing for many philanthropists because it fails to achieve the societal improvement the donors intended.
A recent white paper issued by Baird Family Wealth Group argues that while foundation donors have appreciated the tax and legal implications of philanthropy, they have struggled to articulate what their foundations should achieve. “The one important driver of this lack of focus on mission is the IRS requirement to pay out 5% of net investment income. This rule highly influences the spending policy of the foundation and, in turn, the way the assets are invested.”
Mission and Cause Should ‘Drive’
Lost in this process are the foundation’smission and the shape of the problem to be solved, the paper says. “Because the rules are defined and the mission is not, spend policy is predetermined, investment strategy standardized, and mission becomes a tertiary thought.”
The paper, “Move Over, 5%, and Let Mission Drive,” was written by Peter Frumkin (top left), director of the RGK Center for Philanthropy and Community Serviceat the Lyndon B. Johnson School of Public Affairs, University of Texas at Austin; and Christopher Didier and David Klenke (right), managing director and vice president, respectively, at Baird.
In a recent telephone interview, Didier said that many people who are new to the philanthropy/foundation world tend to rely on advisors who know about the foundation structure and the IRS 5% requirement, and so will set up their foundation in that way. They will then ask their investment advisor how to meet the IRS requirement, and get an asset allocation that accomplishes this.
“Once they’re in that allocation (meeting the 5%),” he said, “it’s very difficult to change that, particularly if the portfolio changes quite a bit. During the financial crisis in 2008, many foundations’ portfolios dropped in value quite a bit and if they were giving out 5% before, 5% of the now-reduced value was considerably less money. This caused and is still causing a negative impact for a lot of nonprofit organizations they supported.”
Mission, Spend, Investment Strategy…1, 2, 3
The white paper proposes instead that foundations clearly define their missions, create spend policies that correspond with those missions and set investment strategies appropriate to those policies. In this way, donors will realize the social benefits they seek.
Many factors will influence a foundation’s spend policy. But once the mission and the spend policy based on the shape of the problem to be addressed are in place, the foundation must design an investment strategy to support the spend policy.
The paper posits three main mission types and lays out investment strategies (and case studies) suitable to each one:
- Long-term missions, whose donors decide that their funds will be more effective in the future than today, will likely utilize a higher risk-reward investment profile, investing in instruments with higher volatility and attendant potential for big losses.
- Foundations with short-term missions should focus on assets with lower risk and lower return, and a possible small allocation to liquid equities.
- Some foundations with long-term missions will want to be prepared for near-term contingencies or inflection points, when a larger payout may be warranted. These can combine the two investment strategies, with the frequency and magnitude of the inflection points determining the tilt in one direction or the other.
“Structure is important,” Didier said. “Complying with IRS guidelines is important. But before you lock yourself into a strategy, understand very clearly what it is you want to get done. What are the goals and objectives? Have a clear idea of what that is so that the structure can then appropriately match those goals. If you’re able to do that, you dramatically increase your chance of being successful in that effort.”