Donor-advised funds (DAFs) are flexible tools which can be used for a number of charitable giving purposes. One increasingly popular use is to use an “endowment-style” DAF in lieu of a private foundation for those with charitable intentions of leaving a legacy that will continue to have an impact on the world many years into the future, given that DAFs are cheaper to operate, more tax efficient, more flexible, and eligible for higher limits on tax deductibility of contributions. However, while much attention has been given to how individuals should allocate a portfolio throughout their own lifespan, considerably less attention has been given to the question of how to best allocate a portfolio if one’s time horizon is “forever”. Especially when it has flexibility with respect to its distributions.
In this guest post, Dr. Derek Tharp – a Kitces.com Researcher, and a recent Ph.D. graduate from the financial planning program at Kansas State University – analyzes considerations when coordinating investment and spending policies of an endowment-style DAF, finding that for donors who have the willingness and ability to be flexible in their distribution policy, investment allocations can be much more aggressive than those commonly adopted by endowments, generating far more income for charitable beneficiaries and build a larger endowment value to sustain giving well into the future.
The traditional approach to investment an endowment is still a well-diversified conservative or moderate growth portfolio – e.g., a 60/40 portfolio – owing in large part to the fact that most endowments have a high need for distribution stability (e.g., university endowment funds that need to fund ongoing operating costs that universities have become highly dependent on). However, in the context of an endowment-style DAF, the reality is that individual donors often have far more flexibility about when and how much they donate. Which is important, especially with the possibility of 100+ year time horizons that allow for immense (and intuitively-difficult-to-grasp) compounding.
In fact, a Monte Carlo analysis (based on historical market returns) of an ultra-long-term endowment-style DAF with a flexible (e.g., percentage-of-assets) distribution policy finds that shifting a fairly modest $100k endowment-style DAF from a balanced portfolio allocation (50/50) to an aggressive allocation (100/0) would result in an extra $13.6 million in inflation-adjusted median endowment account value after 100 years, while also generating an additional $5.6 million in distributions to charitable institutions along the way (albeit with some volatility in annual distributions from year to year)! Further, adopting a simple dynamic spending/distribution strategy (e.g., forego a distribution in years with less than a 2.5% real return), results in an additional $6.1 million boost in real residual value and $1.2 million more in cumulative charitable distributions (as distributions are skipped in some years but made up over time)!
Ultimately, the key point is to acknowledge that willingness to accept some spending instability, coupled with ultra-long-term time horizons to compound, makes it feasible to have a far more aggressive portfolio that still result in substantially more assets going to the charitable institutions that donors care about. Of course, donors must be willing to stay the course, avoid projecting their personal risk tolerance onto the endowment, and be comfortable adopting an allocation that is much more aggressive than the “norm” among prominent endowments… but donors should be cognizant of the tremendous potential of investing more aggressively (and the impact of long-term compounding) if they are willing and able to be flexible!