Increasing the DQ permanently: a simulation study
Updated: Apr 22
How much should foundations give to charities each year?
Currently, foundations are required to spend 3.5% at a minimum from their invested funds annually on charities. As the COVID 19 pandemic drastically impacted charity finances, a campaign, called GIVE5, promotes foundations pledging to spend 5% this year.
Should we go to 5% permanently, or even go higher? In this blog, I explore the financial ramifications of increasing foundations' annual spending on a permanent basis. The results of a simulation, explained below, show that 6.5% is sustainable. This is a 3% difference from today's minimum and represents $1.2 billion of additional dollars for use by charities annually.
Foundations act as a sustaining resource for charities. Rather than spend a large donation immediately, donors sometimes create foundations to enable smaller annual levels of on-going support of charities for either a defined period or, most often, for perpetuity.
The foremost requirement to provide annual financial support to charities is an extensive investment portfolio. Foundations invest as profitably and ethically as possible in various investments such as public stocks, bonds, real estate, and similar assets. The fund's income of rents, interest, dividends, and capital gains provides money for two objectives: first, the annual support charities via disbursements, and second, if applicable, the growth to sustain the fund.
The balancing act of these two somewhat opposed objectives is the trick. I say somewhat opposed as the second objective growth, in the long run, supports the first objective of using the money for charities' daily operation. In this sense, they do not quarrel at all. However, over a short-term period of, say, one year, both are in direct conflict. Using money now reduces the savings for growth now and vice-versa.
Sometimes donors would rather wait for the fund to grow before using the money in charitable operations. Sometimes the opposite is the case with donors planning to spend all the money. Other foundations might prefer the benefits of growth such as increased prestige.
Government has the interest to ensure donations help society and that foundations' cannot simply hoard donated funds. In Canada, the government provides tax incentives to encourage donations and does not tax charities' earnings. Both policies maximize annual charitable expenditures.
Hence the Disbursement Quota
The Canada Revenue Agency (CRA), which administers the Income Tax Act (ITA), has struck a balance between the above objectives through a mechanism called the Disbursement Quota (DQ). The ITA via the DQ requires each charitable organization, whether a foundation or not, to distribute at least 3.5 % of the average of the prior 24 months value of assets not used directly for the charitable purpose.
In practice, this DQ applies mainly to foundations with investment portfolios greater than $25,000. Frontline charities spend most of their money in a given year to fulfill their charitable purpose and have relatively small investment portfolios compared to foundations.
As an example, if a school has a supporting foundation, the foundation invests to earn income, dividends, and capital gains for the school's eventual support.
The investments held by the school's foundation are not directly involved in delivering education. Thus, the DQ specifies that the foundation must transfer at least 3.5% of the school's accumulated property to provide education each year. The school can count on this transfer for budgeting annual expenditures and feel confident that annual budget is available for the foreseeable future.
The DQ ensures money donated in support of charity gets spent on charity and thus contributes positively to society.
Why increasing contributions now is important
Charities are experiencing hard times. COVID has hit some charities financially much harder than others. Imagine Canada forecasts a drop of between $4.2 billion and $6.2 billion in donations to Canadian charities due to the far-reaching repercussions of coronavirus. Think of the many charities relying on fundraising events. Even where donations have increased, such as for food banks, the need during this pandemic has grown much faster.
On the other hand, many foundations have done well due mainly to recently strong investment returns. Considering these circumstances, the 'GIVE5' campaign asks Canadian foundations to pledge at least 5% of our assets in this current year. A great many sizeable foundations have committed to meet this request.
Is permanently increasing funding via the DQ advisable?
A one-year voluntary increase in donations from foundations is welcome news. Is that enough? What should the requirement be for the DQ for the years ahead?
Over the longer run, charities are also predicted to have a significant shortfall. In a landmark study in 2018, Canada's Emerging Social Deficit Brian Emmett, Chief Economist at Imagine Canada well before the pandemic, predicted charities face a shortfall in revenue of $25 Billion by 2025.
Perhaps the government should raise the DQ to 5% (a level the DQ has been before) or even go higher. What DQ percentage could the government require that foundations give each year that balances spending and growth? The answer lies in balancing the two objectives, support and growth, over the possible gyrations of the investment markets.
To answer this question, I have built a predictive model to calculate potential outcomes at various annual DQ rates to inform the choice. My model simulates random market movements at each DQ rate over one-hundred years.
The model calculates two central values: 1) the fund's average annual level (the spending) and 2) the end value (the growth) over one-hundred years of random market gyrations. By knowing these values at various DQ levels, we can compare the expected results over many years and select an ideal DQ.
The ideal DQ would ensure the charity gets the maximum possible support annually without diminishing the fund's ability to continue to payout at that same DQ rate in perpetuity.
View details of the model's assumptions, calculations and results here.
The simulation results
The results shown in the tables below are probabilities, not guarantees. Results shown in dollars begin with a starting value of $1,000,000. Outcomes are in today's dollars as the effect of two percent inflation has been subtracted from the assumed growth rate. The proportionality of the results does not change with or without inflation.
In the first table, we address if a fund can deliver now and continuously at various DQ rates without the fund's significant risk getting smaller. By looking at the median value (where 50% of results are higher and 50% lower), we can see the most likely effects.
The table below shows for various DQ levels the Average and End values over one hundred iterations of one-hundred years each:
The results above for DQ lower than 6.5% show a strong and significantly growing fund. Even moving to a DQ of 7%, the median values enable a foundation to give 7% annually without experiencing a decline.
But the fund with a DQ of 7% would be diminished in capability half the time when results are lower than the median value. How much a higher DQ reduces the fund is addressed by the following table:
The above (second) table explains, for example, that the risk for an on-going DQ at 6% is that 8% of the time results in lower average fund values than the starting value. For about 11 % of simulations, the end value will be lower than the starting value. However, this means that in 92% and 89% respectively of simulations, the results would be higher.
The furthest right column shows that at a DQ of 6%, the Average End Value with lower-end value declined 28%. Remember, this only occurs 11% of the time. Mitigation over the one-hundred years would be a fundraising campaign of 28% or 0.28% each year.
At a DQ above 6%, results are increasingly higher chances of reduced average and end values.
By keeping the DQ at 3.5%, the simulator shows zero risks over one-hundred simulations of the fund's value going down or that the average fund value was less than the starting value. Even with no new donations! The average end value result was to grow 6.19 times the starting value.
The effect of fundraising (at least for public foundations) should not be overlooked. According to a Globe and Mail study published March 2018, the charities with the most considerable assets averaged 0.7% in the year of assets in gifted receipts. I suggest we could assume 0.7% as a proxy for the level of the public foundation's annual fundraisings.
Applying that assumed annual impact reduces the DQ by 0.7%. For example, choosing to set the rate at 6.5% with a 0.7% fundraising effort per year might move our results closer to 5.8% after taking fundraising into account. Appealing to donors is essential for a foundation's longer-term health, so the DQ level of 6.5% appears sustainable.
Setting a fundraising target of 0.7 % of assets per year is not a big stretch for public foundations. If the foundation is a private foundation and taking in no gifted receipts in a year, their DQ could be set lower by that same 0.7% factor for that year.
Moving to a DQ of 6.5% for foundations annually and 6% for foundations with no gifted receipts over the prior 24 months would allow much higher annual charitable giving while assuring the foundations remain strong. The impact of moving from 3.5% to 6.5% contributes 85% more per year for those foundations today at 3.5%.
The GIVE5 website reports that Charity Intelligence estimates a 5% commitment from all foundations would add $700 million in funding to charities. This DQ rise of 1.5% is a one-time event (1.5% is the difference of 5% less 3.5%).
Moving to a permanent 6.5% DQ would increase funding by 3.0%. Projecting from the Charity Intelligence data, this would mean adding $1.2 billion a year. That's another $30 billion over the next 25 years in much-needed funding.
Today the DQ level of 3.5% clearly gives priority to the growth vs. the spending objective. By reducing the priority given growth for setting the DQ level, the permanent DQ rate can be safely set significantly higher to spend on charities.
I would welcome your comments, and especially the opportunity to collaborate with anyone who wishes to investigate these findings further.