An Analysis of Inflationary Costs of Capital in Impact Investing & Community Investments
Sandhya Nakhasi
Executive Director
Community Credit Lab
Executive Director
Community Credit Lab
How do rising interest rates and sky-high inflation affect the rates that borrowers pay? We get this question a lot lately at Community Credit Lab (CCL).
For CCL, the short answer is simple: given our emphasis on affordable credit as a mechanism for reversing historical extractive pricing in communities that face financial discrimination (i.e., the poverty premium), the interest rates we work with our partners and other stakeholders to establish for loans extended to borrowers aren’t tied to the inflation rate, or base interest rates like the Secured Overnight Financing Rate (SOFR) or Prime Lending Rate. The long-term answer is more complex as it involves understanding CCL’s cost of capital and how foundations, family offices, impact investor funders and advisors think about inflation, as these stewards and advisors of wealth are CCL’s primary sources of capital for resourcing our lending programs.
This analysis focuses on how foundations integrate inflation into their total portfolio return requirements, and at the individual investment level (i.e., the required interest rate expected to be earned from their fixed income / private debt investments which comprises community investments). The purpose of this analysis is to question the status quo of practices and assumptions around setting target returns for endowments and to increase transparency into how incorporating inflation impacts the cost of capital in mission related investments, impact investments, and community investment allocations, especially fixed income or debt allocations. By shedding light on how inflation, fees, and payout requirements are typically established, our hope is to ultimately move towards deeper interrogation of the status quo and build new approaches together.
In providing this technical analysis and the case for rethinking foundation target returns, our goal is to continue acknowledging systemically unjust sources of wealth and power, and the related need to reverse these injustices by not requiring “return on capital” based on conventional risk metrics and assumptions. Further to understanding the below analysis around inflation and how investment parameters were originated by the IRS, conscious decisions to shift power and wealth must ultimately be taken as financial analysis alone under standard calculation methodologies will not build towards an equitable society.
So how do foundations and advisors incorporate inflation?
With respect to inflation, our experience and research suggests that most foundations factor inflation in as a component of the total target return they set on their endowments. But, instead of incorporating short term inflation rates (which often fluctuate dramatically as we’ve seen lately), foundations typically use a proxy for expected long term inflation rates. A typical foundation investment return target is 5% to cover annual grants and operating costs, plus a proxy for long-term inflation that is around 2-3%. Typically, the investment return target is stated as 5% net of investment fees and taxes (both are captured as a component of spending; taxes on investment returns are 1.39% of net investment income), with inflation added to arrive at a total return target. In short, total endowment return targets typically begin at 5% (for annual grants and operating costs) plus 1-2% (for investment fees and taxes) plus a proxy for long term inflation between 2-3%, for a total of 8-10%.
Today, this calculus is the cornerstone of most foundation investment policies and minimum investment return targets. Examples of this standardized approach—with the assumption that investment fees and taxes are not included—are below (with emphasis added):
- Excerpt from the Investment Policy of a private foundation with a $3 billion endowment: “The primary Investment Objective of the Foundation is to achieve a long-term rate of return in excess of the rate of inflation plus spending in order to preserve purchasing power of Foundation assets and support the perpetual nature of the Foundation’s mission. Stated as a Financial Return Target, this is 5% plus expected long-term inflation.”
- Guidance for foundations from a registered investment advisor with $30 billion under advisory: “Performance assumption estimates an average 7% long-term rate of return…which aligns with a typical spending policy of 4-5% and a long-term inflation forecast of 2-3%.”
According to Pacific Foundation Services, the IRS mandated 5% payout figure “was agreed upon to ensure that private foundations would, in theory, be able to exist in perpetuity…the calculation was based on historic market returns of approximately 8% which, after accounting for 3% average historic inflation, leaves 5%.” Based on this, it’s interesting to recognize that the widely adopted 5% payout stems from historical market returns and historical inflation calculations with the primary goal of ensuring that foundations can exist in perpetuity. This strategy was assumed and standardized by the IRS and continues to be frequently adopted by foundations as proverbial wisdom.
How much are we talking about?
In practice, this means that if a foundation has an endowment of $100 million in any given year, the typical investment strategy targets 5% in investment returns (i.e., $5 million) to cover annual grants and operating costs plus an additional amount to account for long term inflation (i.e., 2% = $2 million) plus investment fees and taxes (i.e., $1-2 million, inclusive of both advisory fees and underlying fund manager fees). The latter, however, is typically incorporated into advisor and fund management targets, rather than integrated into investment policy statements directly (since policies state targets net of fees). All in all, a $100 million foundation endowment is likely targeting a minimum average return of $8-10 million each year.
U.S. private foundations have over $1.3 trillion in endowment assets which means that total annual required investment returns start to add up quickly: based on the above investment targets, this would equate to a minimum total required annual investment return of over $100 billion dollars per year for private foundations, assuming total return targets of 8-10%. This assumed range and estimated dollar return correlates with actual average returns for private foundations: according to a 2019 study from Candid, “three-year returns for the hundred and seventy-eight private foundations in the study rose to an average of 9.2 percent.”
Under current approaches, even impact-first and mission related investments are often expected to drive returns in foundation portfolios. This means that an increasing portion of a foundation’s overall return targets are meant to be derived from mission related investments and impact-first investments, including private asset classes like community investments.
Simultaneously, calls for increased allocations to community investments continue to grow. For too long we have underinvested in solutions designed by people closest to the challenges created by systems designed to extract, rather than support communities. As a result, disparities in wealth and social outcomes across race and other demographic factors continue to expand. Based on these increasing calls to action, there is growing awareness that communities need to be designing solutions for themselves and that these solutions need to be appropriately resourced via impact investments.
However, we can’t call for increased allocations to community investments without simultaneously calling for a reduction in foundation target returns and a reduced cost of capital in impact investments. If we do, we’d only be extracting further from communities by transferring interest and fees from people with fewer resources to cover a larger proportion of the target returns that foundations currently expect to earn each year—this approach clearly wouldn’t be a path to an equitable society. To put this bluntly, if all private foundations shifted 100% of $1.3 trillion in endowment assets to community investments while maintaining typical minimum annual return targets of 8-10%, over $100 billion dollars would be extracted from communities with fewer resources as a result (assuming community investment intermediaries would accept an 8% cost of capital).
So how does inflation affect foundation endowment pricing?
There are two levels at which inflation and prevailing interest rates get priced into foundation endowment returns:
- at the total foundation endowment level;
- at the individual investment allocation level.
Addressing both is critically important to ultimately integrate mission related investment strategies that achieve foundation mission goals and investment goals together effectively. Otherwise, investment goals and mission goals will forever remain in tension.
In addition to total foundation-level target returns incorporating inflation, we must reconcile how individual investment decisions are predicated on traditional, outmoded mechanisms for establishing security-level expected return targets. Once foundations set a return target, whether that’s 5% or 10%, they turn to finance staff and consultants to figure out how to build a portfolio that has a good chance of meeting the return target. To do this requires the pricing of individual investments and securities and the traditional tools for this are tied to inflation. Traditional risk-adjusted target return frameworks incorporate a risk-free rate (often pegged to prevailing U.S. Treasury Note yields), which includes inflation expectations. A risk premium is then added to the risk-free rate based on the perceived “riskiness” of who and what the funds will be invested in. As a result, even if foundations reduced their endowment return requirements to 5%, specific allocations would still need to be evaluated through a common framework that acknowledges which allocations should be return drivers (e.g., public equities and bonds) and which allocations shouldn’t be (e.g., community investments) to truly optimize for the foundation’s mission.
The target rate of return foundations expect to receive via community investments translates to community investment intermediaries’ cost of capital and then, typically with a mark-up, equates to the cost of capital for communities (i.e., people and small businesses). However, traditional investor-centered return targets fail to properly account for many systemic factors including the poverty premium and other costs borne by communities: inadequate access to health insurance and health care, education, childcare, wage gaps, and historically discriminatory policies, laws, and regulations. Based on this, we reject pricing mechanisms like the risk-free rate and traditional risk premium estimating methods when determining equitable target return rates, especially within community investment allocations.
Something needs to change—and it needs to start with mission and strategy, not 5%
As we have demonstrated, when inflation rates rise, under traditional investment approaches with the above parameters, foundation target returns will also rise and, therefore, the cost of capital will rise across investment allocations, often including community investments and private asset classes that are classified as mission related or impact investments. With this in mind, a few things are important to note as we continue to think about how to enable affordable community investments and mission-first investments together:
- Foundations typically set their spending policies and investment target returns based on IRS mandated payout requirements, not mission alignment or strategy rooted in mission first and foremost. While this continues to be a historical carryover, it is worth noting repeatedly since it also continues to be a major barrier to impact-first investments that can unlock affordable capital and resources for communities that face discrimination.
- Although foundation costs are covered in the IRS payout requirements (i.e., the first 5%), target returns are then topped up by long term inflation. The typical justification for this would be that the goal is to include inflation across the endowment to ensure that the purchasing power of its assets remains constant and the foundation as well as grantees have resources to cover rising costs associated with inflation. Yet, this argument drives us back to where we started: deferring to the IRS to dictate a strategy of existing in perpetuity, rather than designing a mission-driven strategy and then determining the ideal relevant payout and investment strategies that adhere to IRS requirements. One positive example we’ve heard of lately is a foundation ring-fencing a portion of assets for operational continuity and leaving the remainder of the endowment available for return agnostic allocations that seek to achieve mission-related goals.
- IRS 5% payout requirements also include grants and other grant-related expenses (administrative costs, fixed assets, etc.); however, investment expenses incurred in managing the endowment don't count towards the payout requirement and those fees are typically between 1-2% inclusive of both Registered Investment Advisor (RIA) fees and fees charged by underlying fund managers. It’s important for foundations to see that these fees often equate to an increased cost of capital as it relates to their community investment portfolios (since advisors are tasked with delivering the return target net of these fees) and increase transparency in public Investment Policy Statements, rather than assuming targets are simply “net of fees and taxes” and that this doesn’t have a downstream effect on their cost of capital and communities.
What’s the real disconnect?
Under current standards, foundations typically arrive at total return targets by setting their spending budget first, often dictated by the IRS 5% rule, and then tasking in-house investment teams or external advisors to achieve financial return targets accordingly. The frequent disconnect is that all of this is grounded in IRS regulations and traditional finance, without regard to externalized costs, including the social costs of economic inequality.
Regardless of how we do the asset/liability math, or our assumptions around notions of belonging, the “cost of capital” is based on a system that prices in investment risk, fees, taxes, and inflation and leaves little room for empathy and shared humanity. Stewards of wealth have been trained to maintain their wealth and the power that comes along with stewarding it by demanding returns that cover perceived risks and costs. If foundations and other impact investors desire to be more equitable and supportive of affordable community investments by accepting 0-2% asset level returns on their capital, it won’t be possible to get there by reducing risk, fees, taxes, and inflation assumptions. Instead, we must shift mindsets together to demand that portfolios don’t set a primary focus on earning enough of a return to maintain wealth and power in perpetuity. Accepting that the perpetuation of the current wealth and power structures shouldn’t be the primary goal will continue to be an ongoing journey that ultimately gives primacy to stated social and environmental missions—in the end, this can and should be fundamentally freeing.
Moving onwards together by centering people and mission
Let’s assume that the shared goal for foundations is to make a combination of grants and impact first investments under a reasonable cost structure that includes diverse, professional staff and effective intermediaries to build relationships, structures and terms that are fair and just to all and rooted in applicable social and environmental justice principles. If that’s the case, as a starting point, foundations should recognize that community lending and other impact-first allocations should not drive returns in investment portfolios given that there's no way to get to an affordable cost of capital using conventional capital market and economic components including risk premium, inflation, investment fees and taxes.
Financial intermediaries should reduce the cost of capital to borrowers because of how historical practices in the financial sector have exploited and extracted capital from these same individuals and communities. At Community Credit Lab, we know that moving from a typical interest rate of between 8-30%+ (that CCL’s borrowers would find elsewhere) to 0-3% will not fully reverse historical discrimination and extraction. Yet, we also know that rethinking financial pricing practices is a necessary step in recognizing how capital can be used differently. Together, we can begin to address the harm that the financial sector has inflicted historically—and continues to inflict on communities with the least resources who face the highest levels of discrimination.
We all can work together to reduce the cost of capital for people and communities, and we see many foundations, advisors, and intermediaries leading the way with new economic thinking and a willingness to disrupt the status quo. We also know that much of the above traditional calculus is not the work of individuals, but the downstream effects of a larger system of how capital is controlled, advised, and ultimately allocated to best serve goals that relate more to perpetual existence and less to mission alignment and strategic decision making for the benefit of others. Whether or not foundations continue to choose to modify or eliminate return targets entirely, we believe it’s important to be transparent about how and why investment priorities are made and who’s deciding, because these decisions affect the communities that we all seek to support together and often present extreme barriers to unlocking affordable capital for all through impact-first allocations.
What are recommended prompts for action?
In addition to shared learnings and reflection, we advocate for action based on our own experiences navigating a balance between learning, reflection, and a bias towards action. In support of this, we are sharing the below recommendations that we believe can serve as prompts for larger conversations around how foundations can steward resources more effectively.
- Continue asking the first-principle question, “who are foundation endowments for?” and further question “is our strategy aligned with the desires of those we seek to support?”
- Consider the cost of capital that is often pushed onto people and small businesses via traditional approaches to community investment allocations;
- Have discussions internally (or with advisors) about how inflation does or does not change endowment investment strategy, especially as it relates to community investment allocations;
- If there is established trust and relationship, bring in community members to help inform and guide the design and target returns of the Investment Policy with the ideal goal of weighting these recommendations as heavily (if not more heavily) than recommendations from financial advisors;
- Transparently share about this journey to realign target returns to encourage and provide tools for others to also embark on this journey.
