One question we get asked at our seminars for trustees is whether a 5 per cent mandatory payout rate for chatitable foundations is fair and, if not, what a suitable rate would be.
The idea was proposed for UK foundations by two economists last year, but it was first introduced in the US in 1969. Under the Tax Reform Act, US foundations were required to pay out either all their investment returns or 6 per cent of net investment assets, whichever was greater. Following a decade of low returns in the 1970s, Congress lowered this rate to 5 per cent because foundations said their funds were being eroded too quickly. This highlights the danger of setting a fixed rate for all charities.
Without getting into an argument about whether government should be setting the rate that charities have to pay out, we can model how much an individual charity can withdraw on an annual basis. We would base this amount on the income the fund generates, the estimated capital growth from the portfolio over time and inflation, because many charities want to ensure they protect future beneficiaries in real terms.
The probable income from a fund is relatively easy to work out. UK equities currently yield about 3 per cent, UK gilt-edged stocks (government bonds) 3.5 per cent and overseas equities 2 per cent. One could reasonably expect a portfolio yield of about 3 per cent on that basis. To achieve a higher payout, a charity would have to invest more in higher-yielding assets, which might involve taking on more risk, or would have to take some money out of capital, which makes sense for many charities but not for permanently endowed charities.
Our models assume a return for UK equities of 5.7 per cent in real terms. This takes into account the yield mentioned above, an increase in the capital value of the stock and inflation - assuming the last is near the Monetary Policy Committee's 2 per cent target. Hence, a charity with a bias to equities should be able to achieve a higher total return than the 3 per cent provided by income.
By way of example, a charity with 80 per cent in UK equities and 20 per cent in bonds could, according to our models, generate a total return of 6.8 per cent per annum, or just under 5 per cent in real terms. This suggests that it should just be possible to withdraw 5 per cent per annum without harming future beneficiaries, as long as we do not have a prolonged period of poor equity returns. However, a fund that still had to follow the rules of the Trustee Investments Act 1961, and so had to have 50 per cent in bonds, would struggle to generate a total real return of 3.5 per cent a year.
This illustrates the danger of providing a set answer for all charities. A 3 per cent payout is likely to be achievable for many charities, but 5 per cent could involve taking on more risk than some charities are comfortable with, and assumes markets will behave in line with investment models - which historically they have not always done. If the aim of a defined payout ratio is to help charities, we think a solution tailored to individual foundations' needs would be more appropriate.