Private Foundations Face Hard Choices
March 09, 2017
Today’s low expected returns for almost all asset classes pose significant challenges for private, nonoperating foundations aiming for perpetuity. Since these foundations must distribute 5% a year to maintain their tax-exempt status, if perpetuity is a goal, they must earn at least a 5% return to avoid spending down their capital—and even more, to maintain their spending power after inflation.Our forecasts suggest that even the most aggressive asset allocations are unlikely to achieve 5% returns, after inflation.
The Display below shows our median projected returns for various mixes of global stocks and taxable bonds for the next 30 years. The conservative portfolio, with a 30% allocation to global stocks, would return 5.6% a year on average. That’s enough to cover the 5% required distribution, but it would only support sustainable spending of 2.5%, assuming future inflation averages 3.1%. To maintain its spending power, the foundation would have to spend from principal.
The more growth-oriented asset allocations would likely have higher returns, but even the all-stock portfolio wouldn’t be able to spend 5% of assets a year, inflation-adjusted. While growth-oriented allocations generate higher returns, they also create more investment risk, defined as large short-term drops in portfolio value. We estimate that there’s a 91% chance that the all-stock portfolio would lose 20% from peak to trough at some point in the next 30 years, but only a 7% chance that the conservative portfolio would lose that much.
There are several ways that foundations can address the challenge of investing for perpetuity:
•Take more investment risk, perhaps shifting from a moderate to a growth allocation, with a higher weight in stocks, if its board is comfortable with the investment risk this creates.
•Attract additional contributions to offset any decline in assets due to lower investment returns.
•Accept a decline in the purchasing power of distributions.
•Decide that perpetuity is no longer paramount, and that spending down the foundation to maximize its impact over, say, a decade, is better suited to the foundation’s goals.
The views expressed herein do not constitute, and should not be considered to be, legal or tax advice. The tax rules are complicated, and their impact on a particular individual or organization may differ depending on their specific circumstances. Please consult with your legal or tax advisor regarding your specific situation.
The Bernstein Wealth Forecasting System seeks to help investors make prudent decisions by estimating the long-term results of potential strategies. It uses the Bernstein Capital Markets Engine to simulate 10,000 plausible paths of return for various combinations of portfolios, and for taxable accounts it takes the investor’s tax rate into consideration.