The 5 per cent minimum distribution looks modest until fees and inflation are added to it; then it sets a return hurdle most portfolios do not clear.
A private foundation can pay out 5 per cent a year indefinitely only if its return covers the payout, its investment fees and inflation. On illustrative assumptions that takes 8.10 per cent a year gross. At 7.00 per cent, the foundation shrinks by 1.07 per cent a year in real terms and keeps 72.3 of every 100 of purchasing power after 30 years.
Worked in full in The Family Office Professional by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Most family foundations are set up to last. The US rules require a private non-operating foundation to make qualifying distributions of at least 5 per cent of the average fair market value of its investment assets each year, under section 4942, and to pay an excise tax of 1.39 per cent on its net investment income under section 4940. The two interact: under section 4942(d) the excise tax is deducted from the amount that must be distributed, so a foundation paying exactly the minimum spends 5 per cent of assets in total on tax, charitable administration and grants. Family offices that run the foundation's portfolio alongside the family's own often treat the payout as a fixed cost and the portfolio as the family's. The arithmetic below shows why the payout is better treated as a return target.
| Input | Value |
|---|---|
| Investment assets | $100M |
| Gross portfolio return, a year | 7.00% |
| Investment management fees and costs | 0.60% |
| Share of net return realised and taxable each year | 60% |
| Excise tax on net investment income | 1.39% |
| Payout (excise tax plus qualifying distributions) | 5.00% |
| of which charitable administration | 0.50% |
| Inflation | 2.50% |
Net investment return = gross return − investment fees
Excise tax = 1.39% × net investment return × share realised, paid inside the 5%
Real growth = (1 + net return − payout) ÷ (1 + inflation) − 1
Grants = payout − excise tax − charitable administration
In Excel: =(1+(G-F)-P)/(1+I)-1, and real value after n years =Assets*(1+Real)^n.
Holding real value needs a gross return of 8.10 per cent, 7.50 per cent after fees, which is 1.10 points above the assumed 7.00. Put the other way, at 7.00 per cent the sustainable payout is 3.90 per cent, but the law does not allow a foundation to pay less than 5. The difference is not optional; it comes out of the endowment.
The grants shrink with it. In the first year the foundation makes $4.45M of grants. By year 30, on the same 4.45 per cent, grants are worth $3.25M in today's money. Over 30 years the foundation gives away 114.6 of today's money per 100 of starting assets: generous, but a declining programme, which the family should choose rather than discover.
There is a third lever besides return and payout: new money. A family that wants the foundation to keep its real value at a 7.00 per cent return has to add the gap each year. In the first year that is $1.10M on $100M, the difference between the 2.50 per cent the endowment needs to grow and the 1.40 per cent it actually grows, and the top-up rises with inflation thereafter. Many families do exactly this, funding the foundation from annual gifts or a bequest; the point is to know the number before committing to perpetuity.
| Gross return | Inflation 2.0% | Inflation 2.5% | Inflation 3.0% |
|---|---|---|---|
| 6% | 62.2 | 53.7 | 46.4 |
| 7% | 83.8 | 72.3 | 62.5 |
| 8% | 112.5 | 97.1 | 83.9 |
| 9% | 150.5 | 130.0 | 112.3 |
Each point of return is worth roughly a quarter of the endowment over 30 years, and half a point of inflation costs nearly as much as half a point of return. The required gross return moves one for one with inflation: 7.60 per cent at 2.0 per cent inflation, 8.60 at 3.0. A foundation targeting perpetuity is therefore committed to a growth-heavy portfolio, often with private equity in it, which in turn needs the liquidity planning the family applies to its own capital calls and spending.
The common mistake is to compare the 5 per cent payout with the expected return and stop: 7 is more than 5, so the foundation grows. It does, by 1.40 per cent a year in nominal terms, which is a real decline once inflation is counted. The second mistake is to overweight the excise tax, or to add it on top of the payout; at 5.34 basis points it costs less than a tenth of the investment fees, which are the cost a family office can actually negotiate, and it is deducted from the required distribution. The third is to forget that charitable administration counts towards the 5 per cent: grants are 4.45 per cent, not 5, and a foundation with heavy staffing gives less than its payout suggests. The same discipline applies to the family's own capital, where the question is the spending rate that preserves wealth per heir.
A 5 per cent payout is sustainable in real terms only at a gross return of about payout plus fees plus inflation, here 8.10 per cent. Below it, the foundation is spending down slowly, 1.07 per cent a year at 7.00 per cent. The figures simplify the rules, which measure assets on a monthly average and allow a year to distribute, and they are illustrative, not tax advice. The free workbook for this book prices the office that would run both portfolios, and the cost of that office belongs in the same hurdle.
Qualifying distributions: grants to charities and reasonable administrative expenses incurred for charitable purposes, but not investment management fees. The excise tax on investment income is deducted from the required amount. With 0.50 per cent of administration and 5.34 basis points of excise tax, a foundation paying exactly the minimum makes grants of 4.45 per cent, $4.45M on $100M. The base is the average fair market value of non-charitable-use assets.
Less than it sounds. The 1.39 per cent rate applies to net investment income, mainly interest, dividends and realised gains after investment expenses, not to the assets. With 6.40 per cent net returns of which 60 per cent is realised each year, it is about 5.34 basis points of assets, and because it reduces the required distribution it comes out of grants rather than the endowment.
The payout plus fees plus inflation, compounded. With a 5 per cent payout, 0.60 per cent of fees and 2.5 per cent inflation, that is 8.10 per cent gross. At 2.0 per cent inflation it falls to 7.60 per cent, at 3.0 per cent it rises to 8.60. At 9 per cent gross the foundation grows to 130.0 per 100 in real terms over 30 years.
This article is one calculation from The Family Office Professional. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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