Increasing the Charitable Disbursement Quota – Well Meaning, but Wrong

For those that don’t know, the DQ is the minimum amount that a registered charity must spend on providing charitable programs each year. It is calculated by multiplying a fixed percentage rate, currently 3.5%, by the value of an organization’s investment portfolio. The objective of the DQ is to balance the need of putting charitable money to work to benefit society against the need for capital to be retained by the charity and allowed to grow. For many charities that find fund raising a challenge, the portfolio’s value can only be sustained in real terms with future capital growth. To state the obvious, successful capital growth in real terms is driven by future returns, not past experience.

The impetus for the government review is the uncomfortable contrast between (a) the visible and immediate social needs caused by the severe impact COVID-19 has had on Canadian society, and (b) surprisingly high recent investment returns. It appears to us that the charitable sector is divided. Although the urge to mandate higher payouts is well-meaning, we believe that now is not the time to be making such a change. Procuring donations is hard and future investment returns will almost certainly be lower than recent experience.

History of the DQ

The DQ, introduced in 1976, was intended to ensure that a significant portion of a charity’s capital was directed towards its mandated charitable purposes. At that time, the minimum expenditure requirement for private charities was 5%. It was subsequently lowered to 4.5% and extended to public charities in the 1980s⁽¹⁾. In 2004 the federal government reduced the DQ to 3.5%, on the basis that the 4.5% level was high relative to long-term real returns that could be earned on a charitable investment portfolio. In fact, the government mentioned the following in its budget plan:

“Budget 2004 proposes to replace the fixed 4.5% disbursement quota rate with a new rate that is more representative of historical long-term real rates of return earned on the typical investment portfolio held by a registered charity.”

Now, after many years of solid returns and the DQ remaining at 3.5%, the Government is contemplating whether a revision higher is appropriate. Let’s look at whether that makes sense.

Capital Market Expectations

Historically, a typical charitable investment portfolio was comprised of stocks and bonds with the objective of earning a real return capable of maintaining the purchasing power of the portfolio after making the annual DQ. In addition to stocks and bonds, some larger charities may also incorporate so-called alternative investments, such as private equity, in the asset mix. It is on the basis of future expected returns that an appropriate DQ should be based. So let’s take a look at market returns leading up to the last change in 2004, as well as recent returns, to see if an increase in the DQ is warranted.

Looking first at equities, over the long term, equity returns have been remarkably consistent. The table below compares the 10, 20, and 30-year annualized returns of the TSX over the period leading up to 2004 with the returns leading up to April of this year.

The conclusion? Equity returns may vary year-over-year, but they have been remarkably stable over long time periods. Therefore, over the long term, a charitable investment portfolio can expect equity returns to be around 7%.⁽²⁾

Can the same thing be said about fixed income? The extraordinarily strong bond returns over the past 40 years have brought yields to historic lows. In contrast to returns in the equity market, this virtually assures that future fixed income returns will be uninspiringly low. At present, the best forecast of the next 10-year return in the bond market is today’s yield to maturity of 10-Year bonds. Let’s look at what yields were like in 2004 and compare them to the present day.

In 2004, when the government concluded that a 4.5% DQ was not in line with the historical long-term real returns earned on a charitable investment portfolio, the Government of Canada 10-Year bond yielded 4.8%. Today, with the current DQ set at 3.5%, the 10-Year bond yields 1.3%. Counterintuitively, what’s up for discussion is whether to increase the charitable DQ from 3.5% to 4.5%. If aligning the DQ with realistic expected future returns is the impetus for making a change, consideration should be given to lowering, not raising, the percentage.

Today’s ultra-low level of interest rates that is at the core of monetary policy will have all manner of unintended consequences. We know low rates penalize savers to the benefit of borrowers. They also encourage investors that have a limited capacity to take risk, to pursue riskier investments. Similarly, there is a temptation for charitable organizations to re-allocate their portfolios away from cash and fixed income to riskier asset classes, such as alternative investments, in an effort to generate better returns. However, what’s commonly overlooked is that these alternatives often lack transparency, are illiquid, and almost always carry higher fees. Incorporating them into an investment policy requires a degree of investment sophistication and size that is beyond the scope of many charities. Inevitably, a higher DQ combined with low interest rates will encourage charities to pursue riskier investment strategies. Instead, the DQ should be set at a level that allows charities to maintain their capital base on a sustainable basis without undue risk. In fact, back in 2004, the government acknowledged this and wrote the following in its 2004 budget:

“Given the ongoing nature of charitable activities, it is appropriate to allow charities to maintain their capital asset base on a sustainable long-term basis. Accordingly, the disbursement quota rate on capital assets should be set at a level that can sustain the real value of a charity’s capital assets over the long term.”

Charity Longevity – the Challenge gets Harder

Not every charity is designed to exist in perpetuity. Those that can fundraise easily or are prepared to spend down their capital can always pay out more than the minimum. However, for those charities that see their mission as helping a cause for a very long time, raising the DQ in the current environment will present a real challenge. At Nexus, we’re well aware of how difficult this is for charities that have a limited capacity to raise funds. In 2013, my colleague Geoff Gouinlock wrote a white paper titled “The Perpetuity Challenge of Small Foundations – Managing in a World of Low Returns”. In that piece, Geoff wrote that it was lower future returns that would be troublesome for charities. Today, the challenge is double-barrelled: potentially lower future returns, and the contemplated increase in the DQ. Taken together, the odds will be stacked against charities that desire to provide charitable support for the long term.

Conclusion

The motivation to increase the DQ arises from trying to help others in a time when needs are high. A time may come when it is appropriate to raise the DQ, but that time is certainly not now. Increasing the quota at a time when Canadian charities face the prospect of lower capital market returns might provide a temporary benefit now. However, over the long term it will negatively impact charities and the beneficiaries they are meant to serve.