Strange Math

Here’s the world’s simplest math problem.

My wife Pat and I often meet a pair of friends for a movie. If there’s a risk that the show will sell out, I run over to the theater ahead of time and buy all four tickets in advance. When our friends arrive, we hand them their tickets and they pay us back what they owe us.

So the question is this: how many tickets did the movie theater sell?

Four, of course.

But in the parallel universe of donor-advised funds (DAFs), where double-counting comes as naturally as breathing and dissembling, the answer would be six.

Let me try to explain the inexplicable.

A recent article in The Economist delved into the phenomenon of donor-advised funds, which are taking over the philanthropic world like kudzu. Among the issues that the authors investigated was this: Which nonprofit has received the most in grants from Fidelity, Schwab, and Vanguard Charitable, the three largest commercial gift funds? Was that lucky grantee the Salvation Army? Doctors Without Borders? No – the largest recipient of charitable grants from those three commercial gift fund giants in the period studied was… Fidelity Charitable.

Huh?

If this makes no sense to you, let me tell you about my friend Leah. She had a donor-advised fund at Organization A, a DAF sponsor. She was annoyed with Organization A, concluding that its fees were too high. So she transferred her $250,000 DAF to create a donor-advised fund at Organization B. The transfer of Leah’s $250,000 was essentially an administrative action akin to shifting bank accounts from one financial institution to another. She was not “giving” the money to Organization B. But Organization B, like all donor-advised fund sponsors, is legally a public charity, so consequently the transfer was considered a $250,000 grant from Organization A, the same as if the money had gone to a soup kitchen or a college.

The large grant dollars flooding into Fidelity from rival commercial gift funds are essentially transfers of accounts. These transfers probably result from people like Leah hunting for low fees and high investment returns. The donors’ financial advisors also seem to play an influential role in these DAF-to-DAF transfers. I say that because the third-largest grantee from the three mega-funds, according to The Economist, was the American Endowment Foundation (AEF), a donor-advised fund sponsor I wrote about several years ago.

The American Endowment Foundation promotes itself heavily to financial advisors. In fact, its hook is to tell financial advisors that if their clients open DAFs at AEF, the financial advisors can retain a “management role,” which is to say, they receive ongoing fees for managing the investments. Moreover, American Endowment Foundation pays financial advisors management fees for funds of any size, whereas Fidelity and Schwab require a  minimum fund size of $250,000 for that kind of fee-generating arrangement. (Vanguard says it pays no management fees at all to financial advisors.) I have the suspicion that many financial advisors are convincing their clients to move their established DAFs from the Big Three (Fidelity, Schwab, and Vanguard) to AEF so that they (the advisors) can begin to draw a management fee. (Am I being cynical? Yes. For good reason.)

But whatever the cause of this migration of DAF funding from one sponsor to another, the findings of The Economist demonstrate that double-counting is endemic in the donor-advised world, because DAF-to-DAF transfers count as grants. This introduces yet a new dimension of distortion and speciousness into the donor-advised fund industry’s claims of high distribution rates.

To understand the context, it’s important to know that, over the past few years, as critics have expressed concern about the growth of donor-advised funds, the industry has done everything it can to publicize and exaggerate its reported spending rates. Donor-advised funds methodically began to supplement their feel-good-but-hollow claims (“We’re expanding the philanthropic pie!” “Donor-advised funds are democratizing philanthropy!”) with puffed-up grant distribution numbers, hoping that the public might not notice many core problems with the industry. “Stop carping!” the donor-advised fund industry seemed to be saying. “Look at the high payout numbers!”

Well, fine. Let’s look at those payout numbers.

One would think that the way in which DAF payout rates are measured would be standardized and obvious. After all, calculating the payout rate would seem as simple as this equation:

Grants/Assets = Payout Rate

But there’s no consensus, first of all, on whether the assets number should be drawn from the start of the fiscal year or the end. Several years ago, the National Philanthropic Trust (NPT), itself a donor-advised fund sponsor and the source of a much-cited annual report on the DAF industry, made a simple-but-significant shift in the way it calculates payout. Earlier, NPT relied on the end-of-year numbers for determining the assets. Then NPT started using asset numbers from the start of the year. Because assets grow during the year, the result, presto-change-o, was an increase in reported industry-wide annual distributions from about 15% to 20%.

Meanwhile, the NPT calculation – whether using the start-of-year or end-of-year assets number – doesn’t account for money that’s contributed and distributed within the same calendar year. Let’s say that a donor contributes $100,000 into her DAF in February and distributes it all by December. The DAF industry counts the $100,000 in the grants total, but it doesn’t count a single penny of that money among the assets, because the $100,000 was not present in the donor-advised fund either at the start or the end of the year. This greatly inflates the supposed distribution percentage.

Fidelity Charitable (which refused to comment for this article) has its own unique and utterly inappropriate way of calculating its DAF payout rate, borrowed from the world of nonprofit endowment management. To figure out its assets number, Fidelity uses the average size of its assets over the past five years. Because of the dramatic growth in its assets in recent years, this sleight of hand by Fidelity drastically inflates the percentage supposedly distributed. This led Fidelity one recent year to announce a lordly distribution rate of 28%. (For those of you struggling with the math, believe me that this is about as valid as my asserting that our house, which has a market value of about $250,000, is actually worth $500,000 – simply because we chose to list it for sale at that level. In other words, the 28% payout rate is not remotely accurate.)

On the other hand, The Chronicle of Philanthropy, using a formula developed by the IRS, put overall distributions from donor-advised funds in the most recent year studied at 14%. The approach used by The Chronicle and the IRS takes into account money that was deposited and distributed within the year. That calculation makes a huge difference – and it makes a great deal of sense.

But now, thanks to The Economist article, we know that a fairly significant portion of DAF grant dollars are not actually charitable grants at all, but transfers from one donor-advised fund to another. So the real payout rate to charity is significantly less than 14%. No matter: in the house of mirrors that is donor-advised fund accounting, a grant is a grant, even if the grant is to another donor-advised fund, and the industry will claim a payout rate of 20% or even 28%, and for the most part get away with it.

Which is to say that if the folks at Fidelity Charitable owned our neighborhood movie theater, they would have reported that they’d sold six tickets, not four, in the same way they count money shifting around from one donor-advised fund to another as grants to charity. This kind of slick and casual accounting is endemic to the world of commercial donor-advised funds. The people being hoodwinked are the taxpayers who subsidize DAF shenanigans through the charitable deduction, and the charities that are seeing dollars diverted into an unaccountable netherworld that claims to have charitable motivations, but doesn’t. The commercial donor-advised fund industry loves to preen in self-congratulation, while describing itself as an engine for philanthropy. But the bottom line – when calculated accurately – is this: DAFs are very good for donors, and a cash cow for Wall Street. But they’re not so good at actually getting money to charity.

Copyright Alan Cantor 2017. All rights reserved.

 

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4 thoughts on “Strange Math”

  1. This should reach a wider audience, especially philanthropists who just don’t understand commercial gift funds. Will government regulation catch up with this, especially in a culture of less government? I doubt it!

    1. Well, yes — it’s a challenge, Effie, to know what government might do with this information. There are certainly some Congressional staff members who are interested in reforming donor-advised funds, and I know many charitable regulators in state government are looking at this. But political will and pressure, especially given the dominance of the financial services industry in funding campaigns? It will be tough. That said, I think it’s important for nonprofit leaders to speak up and support reform.

      I like the observation from Schopenhauer that all truth passes through three stages: First, ridicule; second, violent opposition; and third, acceptance as self-evident. In the past six years, I’ve seen DAF reform pass from the first stage to the second stage. Given the abuses and lack of transparency around commercial donor-advised funds, I would hope that, eventually, we’ll get to the third stage.

      Thanks for writing!

  2. Thanks Al. I am encountering more and more of these. I recently had a private family foundation donor move assets to a DAF, creating an extra layer to apply for the funds. Is there anything else I should be on the lookout for with this new arrangement?

    1. Thanks, Loretta.

      One of this issues you’re clearly aware of is that your donors have not only created an extra layer, but they now can avoid the transparency of private foundations. Private foundations have to reveal each and every grant in their 990-PFs, as well as their investments and any honoraria paid to board members. I’m sure you’re familiar with poring over those returns as you prepare a proposal. It’s totally different with DAFs. You have no idea how large their fund is, or what the grants were, because it’s hidden within a public charity.

      I don’t have a simple answer for you, other than that, in terms of fundraising, it’s still all about the relationship with the donors. But you certainly have less information to fly by.

      Good luck — and thanks for writing!

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