Wall Street Muscles In

I really wish I’d been wrong in my earlier warnings about the growth of commercial donor-advised funds. But the latest Philanthropy 400 rankings from the Chronicle of Philanthropy indicate that the Wall Street acquisition of the nonprofit sector is, if anything, ahead of schedule.

It turns out that for the second year in a row, the second-largest “philanthropy” in terms of funds raised in the U.S. is an entity called Fidelity Charitable. Fidelity Charitable’s growth rate was an astonishing 89% over the year before, and with donations of $3.2 billion, it is positioned to overtake United Way Worldwide (that is, the combined United Ways of the entire country), which only grew 1% and raised $3.9 billion.

How is something named Fidelity considered a charity at all, let alone one that is poised to become the nation’s largest? Here’s a history lesson.

In 1991 the Internal Revenue Service issued a ruling that drew little notice, but that over time has turned the nonprofit world on its head. The IRS decreed that Fidelity Corporation could create an entity – at the time called the Fidelity Charitable Gift Fund, since rebranded as Fidelity Charitable – as a 501(c)(3) public charity. Gifts to Fidelity Charitable provide the donor with the same tax deduction as if she had donated the money to a soup kitchen or community health clinic or symphony orchestra. But rather than going directly toward some actual charitable good, the money is held in a donor-advised fund and invested in Fidelity mutual funds. It is presumed that some or all of the money will eventually be granted at the discretion of the donors to actual operating charities.

Donor-advised funds had long been the province of community foundations and national religious charities, but now, with the blessing of the I.R.S., Wall Street could create charities of its own – what I call NINOs, or Nonprofits In Name Only. Vanguard and Schwab followed suit with tremendously successful donor-advised funds of their own, which rank 13th and 18th in the latest philanthropy standings. (By comparison, the not inconsiderable fundraising machine of Harvard University checks in at number 21; Yale lands at 24.) Over the years practically every financial services firm has created its own version of donor-advised funds. Everyone on Wall Street is greedily grabbing a piece of the donor-advised fund action.

Why is Wall Street so invested in donor-advised funds? The answer becomes clear if you simply follow the money. Say you’re a wealthy client at Acme Financial Services. You go to Bill, your financial advisor. You tell him that you’d like to transfer $250,000 in stock to East Hackensack Community Music School as a donation for their capital campaign.

Let’s keep in mind how Bill gets compensated. If he is like many brokers, his company takes a percentage of your total funds under management with his firm as an annual fee, and Bill gets his share of that percentage as his own compensation. If you donate $250,000 to the Community Music School, then Acme Financial Services and Bill are managing a smaller account, and so both get a smaller fee. In other words, your charitable contribution will cause Bill to lose income. In the ancient past – say, twenty years ago – Bill would have smiled and processed the contribution, perhaps groaning inwardly. But now he can present you with an alternative.

“How about putting that $250,000 into the Acme Donor-Advised Fund?” he’ll say. “You can get the same full charitable deduction as if you gave the money to the Music School. And then next year, or the year after, you can donate the funds to the Music School or anywhere you’d like! You can have your cake and eat it too!”

What Bill doesn’t say is that if you pop those funds into the Acme Donor-Advised Fund, he will continue to draw his fees on that money, as though it were still in your personal account. And the longer money sits there, the longer he will get paid. In other words, he has a financial incentive to dissuade you from actually distributing money from your donor-advised fund to charity.

Many people ask me why I rant on about donor-advised funds. Isn’t the rise in donor-advised funds promoting charitable giving? No, it’s not. That’s the problem.  Overall charitable giving in the U.S. has been very steady – up only 1.5% above the inflation rate in the last year studied, according to the 2013 Giving U.S.A. Report. So when Fidelity’s take of the charitable haul is up 89% in one year, and when another donor-advised fund mill, the American Endowment Foundation, the outfit I examined in my last post and in the Chronicle of Philanthropy, finds its donations up a cool 103% over 2011, you have to realize that many actual charities are not getting funded as they had been previously. The money is going, instead, into donor-advised funds.

Yes, my challengers will say, but the money will eventually be going out to charity, so what’s the big deal? Well, I respond, that money won’t necessarily be going to charity at all. There is no federal requirement that funds in a donor-advised fund ever be distributed to charity. Though the more responsible donor-advised funds have policies requiring some sort of distribution, most do not, or they describe such requirements with a wink and a nod. A few months ago I called Schwab Charitable and said I was interested in opening a donor-advised fund. I asked: “Would I have to actually send money out to charity?” The woman on the phone chuckled and said that if I failed to make any charitable grants from my fund for five consecutive years, they would call to remind me to make at least one grant – but, she said, laughing, the minimum grant size is only $50, so that shouldn’t be much of a hardship for me.

It’s fashionable to mock United Way as a tired model, where donors give to a common fund mostly through payroll deductions. “The donors have no control!” say its critics. But think about how funds from United Way dollars are used: to underwrite the operating expenses of the community’s most vital social service agencies. United Way keeps the lights on at health clinics for the poor, childcare centers for immigrant kids, mental health centers, drug rehab agencies, Boys and Girls Clubs, after-school programs, and Meals on Wheels for the elderly. Now United Way is about to lose its position as the leading philanthropy in the U.S. The new model? An entity established by a major financial firm that warehouses charitable dollars on behalf of the wealthy, distributing charitable deductions to the donors, commissions to their brokers, profits to the sponsoring corporation, and nothing at all to charity until the donors give the nod.

I’m not against capitalism. I simply think the values and incentives of capitalism should not take over the charitable sector. I don’t think it’s possible to undo the damage caused by that IRS ruling in 1991. We can’t unscramble the egg. But we can minimize the damage by requiring a hefty annual pay-out of 20% from all donor-advised funds. Then the money would, indeed, do some actual good.

Copyright Alan Cantor 2013. All rights reserved.

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19 thoughts on “Wall Street Muscles In”

  1. Alan, Your continued comments and education of individuals around this issue is welcomed. As a leader of a non-profit organization I feel it is our job to strongly advocate for a change in the law that will require a mandatory distribution of funds from these “donor-advised funds” over an acceptable period of time. Are there any movements that are strongly pushing for this at this time? If not, I think it is time that this needs more traction. I would welcome thoughts from others individuals and their interests in getting involved.

    Gary L. Frost
    Chief Executive Officer
    Boys & Girls Club of Manchester, NH

    1. Thanks, Gary. I think this sort of idea can become a movement, but it takes people like you to speak up. I consider the nonprofit community to be filled with visionary and creative and dedicated and selfless individuals. But those same people can be terribly timid, because (for good reason) they fear angering funders and donors. It’s time we all speak up!

    1. I’m not a lone cowboy, Chris — but I don’t have an awful lot of people who have come out publicly in support. The most notable spokesperson on this issue is Ray Madoff, a professor at Boston College Law School, who has, among other things, gotten an op-ed published in the New York Times on the subject. (November 2011, I believe.) Sometimes I feel like a climate scientist back in the 1980s, telling people that something funny is happening to the earth, and hearing that it’s all his imagination. Seriously — it’s a problem. Speaking of the environment, in 2011 over a billion dollars more went into donor-advised funds than into all the environmental, conservation, and animal rights charities combined. Is that a good priority folks? Chris and others: come join us on the barricades!

  2. Thanks Alan, for sharing this important information that greatly affects charities that need support now to fulfill our missions. I’d like to hear more about how we, as charities, can connect to receive distributions from these donor advised funds in the most effective way.

  3. I would enjoy reading viewpoints from the Fidelity Charitable side of this debate supporting their position. I expect the ratio of individual and corporate profits over philanthropic impact is keeping them away from the conversation. Your position is well thought out and makes a compelling case for major change to this law.

  4. I thought that donor-advised fund management organisations, as charitable trusts, had the same obligation as any charitable foundation under IRS rules to distribute 5% of the capital or 85% of the income annually. If it happens that some individual fund-holders within these schemes don’t nominate enough grants to fulfill this, others compensate, so that the whole is likely to be compliant. Is this not the case? And is there publicly available information on this? Surely Fidelity has to submit IRS filings on its charitable activities. (I would be happy to see a higher threshold imposed, myself.)

    1. Your confusion is understandable. While donor-advised funds function in most ways like a private foundation, they are in fact a part of a larger 501-c-3 public charity. And the charitable moment, if you will, is when the funds are given from the donor to the organization that oversees the donor-advised fund. That means that the rule you reference requiring private foundations to spend down 5% of its principal to nonprofits every year does not apply: in the eyes of the IRS, the funds are already in the hands of a nonprofit. This concept makes sense with traditional community foundations, which perform many functions to support nonprofits in a given community, including overseeing donor-advised funds. A community foundation has a volunteer board drawn from the community, and it is recognizable in its make-up and structure as a public charity.

      On the other hand, when the sponsoring 501-c-3 is what is for all intents and purposes a nonprofit division of a financial services company, with trustees drawn for the most part from executives at the corporation, these regulations seem strange and inappropriate. But as donor-advised fund regulations currently exist, a gift to establish a donor-advised fund at Fidelity Charitable is every bit as much of a charitable deduction as a gift to the local food pantry. No required pay-out.

      1. Even more troubling–private foundations are able to meet their 5% distribution requirement by giving money to a donor advised fund–which, of course, has no distribution requirement of its own.

  5. I’m interested in your thoughts on donor-advised funds housed at community foundations. I work for a community foundation in Minnesota and always get nervous when people talk about required payouts from all donor-advised funds. Donor-advised funds at community foundations, or at least the donor advised funds that I work with at the community foundation that employs me, should be viewed differently in terms of payout regulations. Many of the donors I work with are letting a fund grow for a few years so they can award a larger grant that makes a bigger impact for the nonprofit they want to support. Sometimes, there are perfectly good reasons why a DAF wouldn’t pay out annually…at least in the community foundation sector.

    1. Thanks, Liz, for the thoughtful observation and question.

      I hear what you’re saying, and I have many friends at community foundations who have described just the scenario you talk about. I can see how allowing donors to build up their funds can be both attractive to the donor and potentially very helpful for the community. The challenge is that, if there’s some sort of reform of the donor-advised fund system, one size will need to fit all. I’m neither a lawyer nor a government regulator, but I’m fairly certain that there can’t be donor-advised fund rules that apply differently to community foundations vs. commercial gift funds. Technically, both types of entities are 501-c-3 public charities, even if I think that the IRS was misguided to give the commercial gift funds that status in the first place. Though you and I can claim that some kinds of nonprofits are more nonprofit-y than others, if you will, and therefore should have more leeway in how laws should be applied to their donor-advised funds, that kind of preferential treatment is not going to be either legal or realistic.

      And so the question becomes: do we try to rein in the abuses of the commercial gift funds, to the detriment of a sub-set of the donors to community foundations, or do we cater to the preferences of those few community foundation donors trying to build up their funds, and therefore lose an opportunity to get the vast majority of donor-advised funds to work better for society.

      If I were still working in the community foundation world, I would no doubt share your exact concerns. But as I am at some remove, and as I see the struggle of small nonprofits for operating revenues, and as I see billions more dollars each year going to the commercial gift funds, I lean toward the required pay-out for all. That’s truer to the needs of society, and that’s truer to the spirit behind the charitable income tax deduction.

      If this reform were implemented, it would certainly inconvenience some donors, and it would cause some disruption to the business model of many community foundations. I’m sorry about that. But part of me has come to think that the philanthropic pendulum has swung too far toward donor-centricity. I would guess that the ability to build up their donor-advised funds is important to your donors only because, well, they’ve been told that they can do that, similar to the way in which the commercial gift funds have told their donors that they can get a full tax deduction but then — wink, wink; nod, nod — not really have to distribute much money at all to charity. These are very nice options for donors, whether they are (as in the cases you describe) trying to build up their charitable heft, for the benefit of the community, or (as in the case, I’m convinced, of some of the donors to commercial gift funds) they have very little charitable intent.

      The bottom line, to me, has two components: 1) Is that ability to allow the fund to build up over the years the critical factor in someone setting up a donor-advised fund? And 2) Is allowing this perpetual build-up a good thing for meeting the needs of society? In my opinion, the answer to both questions is no.

      All of this said, it’s a worthy debate. What’s somewhat surprising is that this topic has rarely risen to the level of public discussion in the nonprofit sector — let alone the more general public. I hope we can engage an ever-growing circle in this discussion.

  6. This is an eye-opener for me. I’ve always been a proponent of DAFs – especially for those individuals that like the idea of a private foundation but don’t have the assets to warrent such a complex/involved giving tool or for individuals that want anonymity . Depending on the approach of the local community foundation sometimes a DAF makes the most sense for an individual and family. The distribution rule (or lack thereof) initally shocked me when I read it in your article, but PFs don’t have to distribute the entirety of thier assets either. I can see both sides of the coin on this one and will certainly do some further digging to learn more about both arguments. GREAT article! Thank you!

    1. Thanks, Stephanie! I appreciate your thoughtful comments.

      My criticism of some aspects of donor-advised funds should not be construed as an endorsement of private foundations. Private foundations, in many cases, are the ultimate charitable warehouses, with high operating expenses and low distribution rates that ensure their own perpetuity. Moreover, there are some cautionary lessons to be found in the history of how the 5% rule came about for private foundations — and the consequences. My understanding is that prior to the Tax Reform Act of 1969 there was no required pay-out rate for private foundations. Some private foundations distributed almost nothing, and this caught the attention of government regulators and legislators. Others gave away a very high rate — 10% a year or so. The Tax Reform Act of 1969 instituted a requirement that private foundations distribute at least 5% of their year-end assets. The intention was to set the 5% as the minimum, but in many ways 5% became the de facto maximum as well. Some of the more generous pre-1969 foundations actually scaled back their grantmaking to fit the new norm.

      So I recognize that when I suggest a required and high pay-out rate, we may all get burned by the law of unintended consequences. Currently on average donor-advised funds distribute well over 5%. (Commercial gift funds are actually more generous on average than community foundations, according to the National Philanthropic Trust’s reports, with payouts of over 18% or so. Donor-advised funds at community foundations have distributed in the 12% range in recent years.) If, in the effort to get all donor-advised funds to distribute something annually we set a low payout rate, then the overall distributions might actually drop. We obviously don’t want that!

      My take is that donor-advised fund donors get all the tax benefits of a gift to a public charity — the same as if they give to food pantries or the local Boys and Girls Club. If the donors really want to create a permanent charitable entity for their kids and grandkids to use, they should go through the hassle and somewhat diminished tax benefit of creating a private foundation. They also would have to accept the disadvantage of having each and every grant and expense made public, which is how things work with private foundations. (Essentially, the donors to a private foundation gain greater control, but in exchange, they lose any opportunity for anonymity.) On the other hand, if donors use the simpler and more tax-advantageous vehicle of a donor-advised fund, with all the tax advantages, efficiencies, and anonymity it provides, then they should be required to get the funds out to the community in actual charitable gifts within a few years. That’s where my 20% annual distribution suggestion comes from.

      I do hope this opens up wider discussion on the issue. Thanks again for weighing in!

  7. Alan,
    Would not the community foundations’ investment advisers be benefiting similarly from community foundation managed DAF’s perhaps as is being done by the managers of commercial DAF’s?

    While there certainly is that ‘firewall’ between the investment and grant sides, it seems that Assets Under Management – by growing it as large as could be possible, could certainly be rationalized as a way to diversify the foundation’s investment risk profile, as well as achieve lower management fee costs – benefitting both DAF and community-controlled grant decisions.

  8. Alan,
    I’ve long had the same feelings about commercial DAFs. Here is an article from over a decade ago in the WSJ where I speak out against them. http://online.wsj.com/news/articles/SB95747338696436842
    The irony was, at that time, my employer was a custodian for some Fidelity assets.

    I believe that more operating nonprofits, like universities, hospitals, social services orgs, etc should offer their own DAFs while providing a catalog of all of their funding needs. That granularity of funding needs is a missing component of many development efforts, yet it is exactly what donors increasingly desire. All of the recent stories about “donor intent” clearly illustrate this.

    Keep fighting the good fight.

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