October 28, 2014

Donor-Advised Funds Let Wall Street Steer Charitable Donations

The unveiling of The Chronicle’s Philanthropy 400 sadly confirms what many of us have feared for the last several years: an inexorable takeover of the charitable sector by Wall Street.

Three of the top 10 fundraising organizations on the list are donor-advised funds affiliated with financial firms: Fidelity (No. 2), Schwab (No. 4), and Vanguard (No.10). A fourth organization in the top 10, the Silicon Valley Community Foundation, is also primarily a sponsor of donor-advised funds. Money is flowing into advised funds, rather than to nonprofits that provide actual services. This accelerating trend of warehousing philanthropic dollars is a deeply troubling trend for American philanthropy.

To understand why the extraordinary growth of DAFs is a problem, we should first review how donor-advised funds work.

A donor creates an advised fund by making a contribution to an account held within a large organization that has charity status under Section 501(c)(3) of the Internal Revenue Code.

Historically, these sponsoring organizations were community foundations or religious federations, but in recent years all sorts of organizations have gotten into the act, most notably financial-services firms that have created affiliated nonprofit donor-advised fund entities. Though donors give up legal control when they make their gifts to the advised fund, they (and often their heirs) retain the right to make recommendations about which charities will benefit from the eventual distribution of the funds.

The role of the donor in this arrangement has always been treated with a wink and a nod. Donors technically give up absolute control of the funds once they establish their DAFs, which is why they can claim a full charitable tax deduction. But donors understand that they can essentially distribute the funds to any charitable causes they choose and the sponsors will almost always accede to their wishes. A donor can have this de facto control over the charitable distribution without the hassle and expense of creating a private foundation. Moreover, unlike a private foundation, which must distribute 5 percent of its assets on average each year, there is no requirement for any annual distribution whatsoever.

None of this would matter much were if it not for the stunning success of commercial donor-advised funds in attracting donations. Now people are suddenly paying attention, and we need to ask ourselves: How did these Wall Street-related donor-advised fund operations come to dominate such an enormous swath of the philanthropic landscape?

The progenitor of the 50 or so commercial gift funds was Fidelity Charitable, which received the blessing of the IRS to function as a charity in 1991, a decision that in retrospect did to American philanthropy what the Citizens United decision did to American politics: It opened the floodgates for the wrong kind of money.

Fidelity is not only the first of the commercial gift funds but the biggest, with total assets as of June 2013 of $10.2-billion. Officials at Fidelity Charitable and similar entities bristle at the label "commercial gift fund," saying that their organizations are fully independent charities with their own boards and charitable missions—that there’s nothing "commercial" about them. But given that nearly all DAF dollars are invested in the mutual funds of the affiliated financial firms, and given the constant cross-selling between the for-profit and nonprofit entities, that notion of independence is little more than a legal fig leaf.

There are many commercial gift funds beyond the big three of Fidelity, Schwab, and Vanguard. Nearly every prominent financial services firm has its own DAF, though there are some variations on how they are structured.

For example, the National Philanthropic Trust (No. 24 on the Philanthropy 400) serves as the legal entity and back office for the private-label donor-advised funds of several financial services firms such as UBS. The American Endowment Foundation (No. 147 on the Philanthropy 400) allows funds to be invested in whatever financial firms the donors—or, more accurately, their financial advisers—choose. More firms seem to be jumping into the DAF rodeo every year, and several of their funds are rising rapidly in the Philanthropy 400 charts, including those affiliated with Bank of America and Raymond James.

So why is the flood of money into DAFs so bad?

First, if donations to donor-advised funds were dollars that otherwise would not have gone to charity—that is, if the funds facilitated a net plus in donations—then the rise in giving to DAFs would be a positive development.

But there’s no indication that that’s the case. "Giving USA" reports that charitable giving from individuals in recent decades has consistently hovered at around 2 percent of disposable personal income. While overall giving to charity as a percentage of income has remained flat, dollars flowing to DAFs doubled from 2009 to 2012 (reaching $13.7- billion), according to the National Philanthropic Trust’s 2013 Donor-Advised Fund Report, and the percentage of charitable giving going to donor-advised funds also doubled (to 5.7 percent of the $240.6- billion of all giving from individuals, as reported by "Giving USA"). It’s largely a zero-sum game: Money going into DAFs is essentially subtracted from other charitable giving.

In my work as a consultant to nonprofit clients, I frequently find examples of donors diverting their donations from operating charities to donor-advised funds. I recently asked a man who historically was a top donor to one of my clients if he would support its new campaign. His answer was no: His new charitable priority was to build up his donor-advised fund to pass along to his children. He is not alone. With more money going to advised funds, less is going directly to charity. Fidelity’s gain is other charities’ loss.

Second, when money goes into DAFs instead of to operating nonprofits, the charitable impact is deferred for years, perhaps forever. Even as nonprofits are struggling to survive, and even as they are dealing with enormous unmet needs, ever more money is being warehoused for future distribution. This is described by DAF advocates as a long-term commitment to the community; I see it as exacerbating the chronic underfinancing of today’s critical needs.

Third, because there is no requirement that donor-advised funds spend all their money, there is no guarantee that the money will ever be directed to charitable purposes. DAF advocates point to the overall spending rate (some 15 percent a year), and they note how that compares favorably to the 5 percent spending rate of most foundations. But the comparison does not hold.

Contributions to DAFs provide much greater tax benefits to donors than contributions to private foundations. Meanwhile, though the 5-percent foundation distribution rule is inadequate, at least it applies to each and every private foundation. That’s not the case with donor-advised funds. Bragging about the overall DAF spending rate skips the awkward truth that many DAF accounts go years without making a single distribution. And, finally, the fact that the law governing private foundations is flawed does not justify the continuation of badly conceived rules governing other entities.

That’s why I support the proposal by Ray Madoff, a professor at Boston College Law School, to require money contributed to a donor-advised fund to be distributed within seven years. Rep. Dave Camp, chair of the House Ways and Means Committee, goes one better, suggesting that the all the money be given away within five years of the gift. This time-based distribution requirement strikes me as utterly reasonable.

The advised-fund industry thinks otherwise, and its outraged opposition shows that this sort of reform is striking home. DAF advocates must realize that providing donors a full charitable deduction for giving to a vehicle with no payout requirements makes no sense from a public-policy or philanthropic viewpoint. So they bluster about how this proposed reform is a threat to the American way. I don’t buy it, and neither should you.

Fourth, there are ethical issues. Commercial gift funds provide commissions to the donors’ financial advisers, thereby essentially paying them for facilitating charitable gifts.

Moreover, the brokers and DAF organizations are incentivized to have the donors keep the money invested rather than distributing to charitable causes. If you think this commission structure is a violation of fundraising ethics as prescribed by the Association of Fundraising Professionals, it is. Strangely enough, that didn’t stop the association from awarding its 2014 Outstanding Fundraising Professional of the Year Award to Eileen Heisman, chief executive of the National Philanthropic Trust, an organization whose success has been based in part on financial advisers receiving commissions for their clients’ gifts to donor-advised funds.

I often hear how donor-advised funds are a means of democratizing philanthropy. Foundations, this line of reasoning goes, are a tool for the ultrawealthy, and DAFs are a way for the rest of us to be philanthropic. To which I say: People can be philanthropic by giving directly to charity. They don’t need an entity, whether a foundation or a DAF, to serve as a holding tank.

This is particularly important to understand as we see more and more money—billions!—diverted from outright giving into donor-advised funds. I understand how donors enjoy having these utterly flexible and lightly regulated charitable tools at their disposal. I certainly know that Wall Street is delighted by the fees they produce. But the cost to society is enormous.

Alan Cantor is a consultant to nonprofits on fundraising, strategy, and other matters.