March 10, 2009 – 10:49 am
Today’s post is a little math heavy, but I think it reveals something interesting about the value of philanthropic activity.
In investing, “discount rates” are used to value what something delivered in the future is worth. For instance if I offered to give you $10 today or $10 in one year, you would likely choose to accept the money today. This is because if you wait a year you:
- don’t have use of the funds until then and;
- there is a risk that I might not deliver the money as promised.
These two elements (the “risk free rate” and the “risk premium”) are added together to determine a discount rate used to value the $10 delivered in one year.
Let’s say the discount rate is 10%. This means that $10 delivered in one year is worth $9 today. Or said differently you would find it equally valuable to receive $9 today or $10 in one year. The 10% discount rate reduces the value of money received in the future relative to money received today. This concept is a fundamental underpinning of investing. Except in very deflationary environments (when “inflation” is negative), discount rates are always positive.
Except when you start thinking about philanthropy.
Human’s have a evolutionary trait that makes us value our children’s lives more than our own. Human parents routinely make decisions that bring hardship on them, but produce benefits for their children.
If you are a parent you know exactly how you’d answer the question “if you could choose to have a crime free environment during the course of your entire lifetime or your child’s, which time period would you pick?” Every parent would choose that their children benefit over themselves. This implies that, at least when framed as a choice between themselves and their children, human’s exhibit the use of “negative discount rates” in valuing social goods.
This might be technical, but it is not trivial. Discount rates reduce the incentive to invest for the future. When investors face high discount rates, they require a more attractive return opportunity to make them invest. But a negative discount rate would dramatically lower the hurdle needed to invest and suddenly make massive investments in eradicating poverty and crime, enhancing education and the environment make far more financial sense than if you applied more normal discount rates.
So what does all this mean other than a thought experiment? It means:
- The social value created by enhancing our shared environment is much larger than normally thought and therefore worth a much larger financial commitment to make it happen and;
- It highlights the way that human thinking changes when you frame a decision as an individual one (your child) vs. a group decision (the next generation).
This last point starts to push us up against the moral ground explored by Peter Singer in his new book The Life You Can Save: Acting Now to End World Poverty. You can also get a taste of Singer’s moral reasoning from an extensive op-ed he wrote for the New York Times Magazine in 2006 titled What Should a Billionaire Give – and What Should You?
Singer’s line of reasoning offers a challenging argument that all of us must do much more to end global suffering. Right now.
It is well worth the read.
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5 Comments
Pete Manzo says:
March 10, 2009 at 3:12 pm
Great post, Sean. I’ve always found discount rates and the time value of money very intriguing when applied to philanthropy. In Porter & Kramer’s landmark article on strategic philanthropy, they use the time value of money to argue that foundations must be many times more effective than typical donors to justify the fact that they only spend as little as 5% of their portfolio values each year in grants, by pointing out that it can otherwise take 100 years in giving out $5 each year to match the value of a well placed $100 gift today. I’ve often thought that, perhaps accidentally, the time value of money is a comparative strength of United Ways, for example, which raise and distribute almost all their funding ever year. (Full disclosure: I now work for United Ways of California.) Doesn’t the discount rate argue for Chuck Feeney’s “give while you live” approach?
Let’s hope we’re not headed for a deflationary spiral, but even if we were, I actually think the argument for spending more philanthropic dollars gets even stronger.
Singer’s argument seems to be that we can all afford to do more to save lives in being today, and it is very compelling. The counter argument is usually based on the notion of intergenerational equity – the concept that funding should be available for our children to use to solve the problems they want to address in the future. This argument really only makes sense for institutions, not for individuals. The point you’re making seems to be, though, that by spending more today, we may in fact be helping avoid problems our children would otherwise need to address, and I agree. – I’ve always thought that really undercuts the intergenerational equity issue. Also, if we’re optimistic, we believe that more wealth will be created and put into foundations in the future, so with that, plus the time value of money, plus an assumption that we make smart giving decisions, why wouldn’t we want to spend more in the current day?
Sean Stannard-Stockton says:
March 11, 2009 at 7:19 am
I agree that negative discount rates argue for giving more now. So does the (unproven, but probably true) idea that social problems compound (grow) faster than asset prices appreciate.
But the problem is that if endowed charitable entities give at levels higher than 5%, they will extinguish themselves. That’s not automatically a bad thing. But it would be terrible if they all adopted this mindset.
Imagine a gun slinger in a battle, no matter how bad things get you don’t want to use your last bullets.
But individual giving (non-endowed) is different. An individual’s main source of new income is through working, so they can give at high levels and still replenish their ability to give. But endowed entities endowments are both their fuel for giving and their only source of new income. This creates a tension that I think too many people ignore when they announce support of a higher payout requirement.
Renata Rafferty says:
March 11, 2009 at 9:17 am
Are there any studies available that evaluate the relative efficacy and financial “health” of foundations that regularly exceed the 5% requirement?
Sean Stannard-Stockton says:
March 11, 2009 at 9:55 am
Not that I’ve seen. But there’s tons of studies that look at the more generic question of how much can you withdraw from an investment account without risking depleting the account (this is the exact same issue foundations face).
The rule of thumb is 5% (which is where the payout rate comes from), but lots of studies suggest that only 3% or 4% is viable if you look at longer term asset price performance instead of focusing on the relatively strong returns from the 1950-2000 period.
It is basically a probability question where the more you take out, and the longer you take it out for, the higher the chance that you deplete the account (spend down).
Here’s a collection of studies. Here’s a bunch more links.
Aaron Dorfman says:
March 12, 2009 at 2:43 am
This is a great discussion. There are many foundations that seek to exist in perpetuity yet who choose to pay out above 5%, and there are also studies that show this is possible. Reasonable people disagree about this, and the various studies are contradictory. But it is critally important that leaders of foundations consider these discounting issues you raise when making their payout decisions. There are real costs to keeping payouts low.
In NCRP’s recently-released Criteria for Philanthropy at Its Best, we devoted a whole section to this issue and we call for foundations to pay out 6% in grants. We trace the policy history of payout, and we cite the various relevant studies. It’s chapter IV of the book–pages 81 to 100–for anyone interested. (Full disclosure — I’m the ED of NCRP.)
Free downloads at http://www.ncrp.org/paib
