A Practical Guide for Investing Money to Donate Later

post by Chris_Webster · 2020-07-05T20:01:49.659Z · score: 16 (7 votes) · EA · GW · 3 comments

Contents

  Introduction
  Summary of advice for US donors
  Ways to invest for the future
    Savings Account/Certificate of Deposits (CDs)
    Mutual funds in a standard mutual fund advisor
    Mutual funds through a traditional (non-Roth) IRA or 401(k)
    A private foundation
    A donor-advised fund
    Best investment vehicle: DAFs
  Increasing returns: fees and asset allocation
    Fees: index funds are your friends
    Asset allocation
  Choosing a provider
  Final comments
  Notes
None
3 comments

Introduction

In this post, I’ll be discussing the practical steps needed for a donor to invest their money and then donate it later. This was inspired from the 80,000 hours podcast with Phil Trammel.[1] In the podcast, Phil explains the reasoning behind saving to invest for the future. I found this argument compelling, and went to research some of the practical steps to invest for future donations. Along the way, I realized that the research I did in this process would be useful for others in the EA community, and hence set out to write this post.

I will not be discussing the arguments for or against saving one’s income for donating in the future as opposed to donating it now. Rather, this will be a practical guide for those who have already decided that they would like to save a portion of their money for future donations. I will cover different ways to save for the future, why I believe Donor Advised Funds (DAFs henceforth) to be the best vehicle for saving, and what I believe to be the best asset allocation for those investing in DAFs for the long term ( ≥100 years or so).

The advice in this post is aimed at those in the United States, as it’s where I live, and thus what I had already done research about for my own sake. Plus, I found it much easier to find information for US donors. That said, much of what I cover will apply internationally as well, and I will write a few words for those in other countries at the end.

Finally, a disclaimer: I have no formal expertise in any of the subjects I’m discussing. Everything in this post is the result of searching the internet and reading books on retirement planning. I will also note that all investing carries risk and that I am not a certified financial advisor in any shape or form. If you’re saving money for the future, it makes a big difference whether you have your funds in a high-return, low-cost vehicle or a low-return, high-cost vehicle. I therefore encourage you to do your own research for your own situation when making any financial decisions.

Summary of advice for US donors

To invest money for future donations, I recommend the following. I’ll discuss my confidence in this advice for each step where appropriate.

  1. Open a DAF with Fidelity Charitable. (I’m very confident that DAFs are the way to go for the majority of people. I am less confident that Fidelity is the absolute best provider.)
  2. Make contributions to the DAF, particularly in years when you are in a high tax bracket. (Very confident.)
  3. Allocate your assets as follows: 70% Total U.S. Market Equity Index, 20% Total International Equity Index, 10% U.S. Bond Index. (I would put my 95% confidence interval for these numbers as +/- 20 percentage points each.)
  4. Set these allocations to automatically rebalance several times a year, or do so manually. (Very confident: I have never read anyone suggest otherwise.)
  5. Make donations from the fund in accordance with your personal donation strategy.
  6. If you wish for the fund to continue after your death, set this up with your DAF provider - you can give the fund to someone else, potentially restricting donations with certain criteria. (Less confident: these steps probably depend more on your specific DAF provider’s policies, and how they change in the future.)

Ways to invest for the future

Here I present all the reasonable ways I could think of to invest for the future, and why I think DAFs are the best vehicle for one’s savings.

Savings Account/Certificate of Deposits (CDs)

These are FDIC-insured vehicles offered by banks.[2] CDs usually have 1-5 year terms. I do not recommend these, for two major reasons: returns and tax liability. Savings account and CD yields are low, with nominal rates for 5-year CDs currently around .5%, and having never been above 3% in the past 10 years.[3] This is compared to typical stock returns which can easily give 5% nominal annual rates of return. Plus, they offer no tax advantages: you are not able to claim tax deductions when you deposit money into them. This makes it difficult to effectively avoid taxes, as you’re likely to withdraw money to donate at sporadic intervals rather than on a yearly basis. The biggest advantage to these accounts is that they are insured by the federal government for up to $250,000, and as such they are risk-free up to that amount.

Mutual funds in a standard mutual fund advisor

This avenue is good in the returns aspect, as you are able to gain access to the world stock market, typically the highest-return investment vehicle over the long term. Further, Vanguard and its competitors offer very low fees and a wide variety of funds to invest in, both of which can help to increase long-term returns. However, once again the issue of taxes arise: these funds offer no special tax incentives, and you will be on the hook for any capital gains that these funds incur. (Capital gains taxes are 0, 15, or 20% (depending on your income) if the assets are held for over 1 year, and treated as taxable income for assets held less than 1 year.[4])

Mutual funds through a traditional (non-Roth) IRA or 401(k)

Once you are over 70.5 years old, you can donate up to $100k per year tax-free from your IRA.[5] Further, once you pass away, you can donate the assets remaining in your IRA to charity, or pass the IRA itself along to someone else. One downside of this approach is that there is a maximum contribution limit per year for these accounts: currently, $6k for IRAs. In addition, it is not possible to donate assets from a 401(k) account, which is unfortunate because 401(k)s have higher contribution limits (currently $19.5k), and often have employer-sponsored matching benefits. However, you currently are able to roll over a 401(k) into an IRA, which you can then donate assets from. [6]

A private foundation

A private foundation is an organization that gets its funds from a single source family or donor, and typically gives money to other charitable organizations.[7] The foundation must pay taxes on its investment income (currently 1.39%), and must pay out 5% of their assets every year. For these two reasons, a foundation seems like a poor method for an individual to save their money for the long-term. 1.39% is a high tax, and required donations of 5% really hamper one’s ability to save for the long term.

A donor-advised fund

You can think of a DAF like an IRA, except you get a tax deduction for putting money into them in addition to your tax savings on the assets’ growth. You put money in when you please, and then when you wish to distribute the money, you tell your provider where to donate the amount you choose. This ensures that you can put money into them when it’s most advantageous for you, i.e. at times when your marginal tax rate would be highest. They are very low-cost, typically around .5% + whatever fees are on the funds that you invest in, for a total of less than 1%. They have no minimum distribution requirements or maximum donations per year. (They do have a minimum starting asset requirement, which I will go over for different providers later.) The only restriction on giving is that the money must be donated to an eligible 501(c)(3) organization (or foreign charities that meet the equivalent requirements for a 501(c)(3)). This is the standard requirement for any sort of tax-deductible donation account.

There are a few downsides with DAFs. One is that they offer a relatively limited range of investment options, without the variety one can find in typical retirement accounts or mutual fund accounts. That said, all provide access to the major asset classes (international equity, domestic equity, domestic fixed-income), and some provide a few extras for those seeking exposure to different types of assets (more on this later).

Another potential downside of choosing a DAF is that once you put money in, you cannot withdraw it without donating it to a charitable organization. While the intent is obviously to save money to donate later, it’s conceivable that the optimal donation at a certain time may not be a charitable organization, but instead an individual person (e.g. a prodigious researcher that needs cash quickly) or a private company (e.g. a startup trying to manufacture a new vaccine). Yet, the irrevocability of funds in a DAF may also be an upside, as it could prevent you from taking out cash in something like a "moment of weakness." In this way, DAFs may provide some insurance against value drift, something not provided by any other investment vehicle.

Best investment vehicle: DAFs

Going over these options, I believe that the clear winner for saving for the long-term is a DAF. Their low fees, tax status, and access to equity markets mean that they very likely offer the best return for your money over the long run.

Increasing returns: fees and asset allocation

Before discussing the best mutual fund providers, I will go over the two main options we have in increasing our returns: how much is paid to the provider, and how to allocate among asset classes.

Fees: index funds are your friends

Fees are straightforward. DAF providers charge a percent of the total assets under management every year. This is called the expense ratio. One’s return is thus the normal rate of return minus this expense ratio. Due to the laws of compound interest, it cannot be understated how important fees are to your overall return. As a simple example: suppose there are two funds. Both earn 5% per year, but one charges no fees, while the other charges a 1% expense ratio (a high, but common, level among mutual fund fees.) After 100 years, an initial $5,000 investment in the fee-free fund will be worth $658k, while the same amount in the fund with a 1% fee would be worth $253k. This is a staggering difference, and the gap will only grow as our timeline grows longer.

The best way to reduce fees is to choose index funds, (also known as passively managed funds), as opposed to actively managed funds. Index funds decide what securities to hold by tracking an index, like the S&P 500 Index, for example. In an S&P 500 Index fund, the fund will constantly seek to mirror the composition of the S&P 500. This is relatively easy to do from an operational standpoint, compared to people actively choosing the allocation of securities in a fund. This relative ease gets passed to you in the form of much lower fees: often in the range of .05%, compared to ranges of .5-1.0% in actively managed funds.

Of course, one might think that the fees would be worth it. Surely, paying humans to pick the right stocks would increase your returns. As it turns out, this is not the case. Very few mutual funds beat out index funds consistently, and fewer still have low enough fees to make it worth it.[8]

Asset allocation

Once we have decided to invest in index funds, our next question is which index funds? Or, more specifically, how much money should we put into different classes of index funds, such as international stocks, US stocks, bonds, and the like? This is obviously an enormous area of study, with a huge academic literature. My analysis is primarily based on Modern Portfolio Theory, and in particular the fantastic All About Asset Allocation, by Richard A. Ferri.[9]

Our ultimate desire is to maximize returns while minimizing volatility. Note that we care about minimizing volatility even in the long run: decreasing volatility while keeping simple average return constant increases compounded return. For a simple example, consider a fund that has a 5% return two years in a row: its average return is 5% per year, and its compounded return is 5% per year. Next consider a fund that returns 20% one year, but loses 10% the next. Its average return is 5%, but its compounded return is only 3.9% per year .[10]

There are two major ways to decrease volatility: rebalancing and finding low correlations. Rebalancing is straightforward, and simply means selling and buying assets periodically to return to your target allocation. If you want a 75/25 mix of stocks/bonds, and in one year stock prices double while bonds stay the same, you will end up with a roughly 86/14 split after that year. Rebalancing will sell stocks and buy bonds until you’re back at your target mix. The simple way to realize why this is useful is to think of it like buying low and selling high: if stocks have just doubled relative to bonds, it’s probably a decent time to sell stocks and buy some bonds. The frequency of rebalancing is not as important: once a year is standard advice, but once a quarter or bi-yearly works fine too. Many DAFs let you set this up automatically.

The other way we can decrease volatility (and thus increase returns) is to seek anticorrelated assets. The best way to explain the reasoning for this is an example from Ferri: Imagine we are going to evenly divide our money between two asset funds. The funds A&B are positively correlated, C&D are negatively correlated, and E&F have a correlation of 0. Each fund has an average annual return of 5%, but the returns are distributed differently over time. The following table shows the return of a 50/50 allocation in each pair of funds, re-balanced every year:

CAGR is the Compounded Annual Growth Rate, a measure to compare how each fund does.[11] As the table shows, the ideal combination is the negatively correlated funds, followed by the 0 correlation funds, with perfectly correlated funds in last place. In reality, it’s difficult to find negatively related funds with the same simple average return, but we can do our best to find funds with low correlations.

With all of that explanation, where does that leave us? We know we want to select funds with low or negative correlations that have high returns, and we want to re-balance between these funds yearly. Because DAFs typically offer only a few different asset classes, we really only have to decide between our allocation in a handful of major buckets: US stocks (sometimes broken down into large and small companies), international stocks, and bonds. Historically, U.S. stocks have offered the highest returns over time, so they will comprise the majority of our portfolio. International stocks have had lower returns, but they provide an important diversification benefit, because they usually have had a low correlation with U.S. stocks. Finally, bonds have much lower returns than stocks, but they have an even lower correlation with U.S. stocks, so it is important that a portfolio has at least some bonds.

Ferri takes this analysis further, and computes historical portfolios with different ratios of each of these types of assets. He calculates the tradeoff between different allocations and how those allocations performed in the past. From his analysis, and from the general ideas I laid out in the preceding paragraph, I suggest the following portfolio: 70% U.S. stocks, 20% international stocks, and 10% U.S. bonds. I think there is a pretty wide margin on these numbers, perhaps +/- 20% for each: asset allocation is by no means a settled science. In other words, perhaps you could do your own research and find evidence that you want no international stocks or no bonds, but I would be surprised at any portfolio that looks drastically different than the 70/20/10 split I recommend.

Choosing a provider

We know that we want a DAF, and we have a decent understanding of how to allocate our assets in the DAF. The next step is to choose a provider. I found a wonderful reddit post [12] with a table summarizing some key figures for the main three U.S. DAF providers, which I’ll reproduce here.

An important thing lacking from this table is the funds and expense ratios offered by the providers, which I’ll add here. I only list the index funds, as the actively-managed funds are significantly worse, as I explain above. Some accounts offer lower fees for assets over a certain amount, but I will just list the standard fees here. The fees are listed in percentage points (i.e. .17 is .17%, not 17%).

I’ve included the three main investment classes in their own column.[13] Note that Fidelity has the lowest expense ratios for the 3 core funds we were considering [14], that should make up the bulk of your portfolio. Also note that Fidelity has the lowest minimum balance to open an account, along with a lower minimum donation amount. For these reasons, I believe Fidelity to be the best of these three accounts.

Final comments

While I think all of the information I've shared here is correct and my conclusions valid, there are several subsets of people for whom this information does not apply.

First, those residing in non-U.S. countries. The three providers I listed above are only available to U.S. donors, and the tax-specific details I've written about are for the U.S. only. I have not done the exact same research for other countries, but a few things from my advice should stay the same:

For the U.K., I did find a few things that may prove useful. I found a few U.K. DAF providers: NPT UK and the Charities Aid Foundation. If anyone has found other vehicles in the U.K., or has experience with investing to donate later in the U.K., I would love to hear their thoughts in the comments.

Another group for whom this advice may not apply are those with large amounts of wealth. If you have upwards of hundreds of thousands of dollars to donate every year, you are potentially better off investing in unique opportunities that are only available to those with that much money (some hedge funds or venture capital funds, for example.) Or, a foundation may be your best bet to achieving your donation goals. That said, I still think a DAF is a low-risk and tax-smart for an individual to invest their money, even in very large amounts.

Finally, the advice here seems good for managing wealth to donate in your lifetime, but things get murkier after death. From my research, I have not found any evidence that you could control the DAF after your death (e.g. directing the DAF to disperse a certain amount to a certain charity every 10 years.) This may be possible, but would probably require some special arrangement with your DAF provider. The best that you could do otherwise is either 1.) donate the assets to a nonprofit before your death, or 2.) leave the DAF to a trusted individual to manage.

I hope this has been helpful for those donors looking to save their money to donate in the future. If you want to know more about asset allocation or mutual funds, I once again recommend John Bogle's Common Sense on Mutual Funds and Richard A. Ferri's All About Asset Allocation. Reading both will give you an excellent sense of the nuts-and-bolts of picking mutual funds, and how you potentially could tweak the ratios I've suggested to improve your long-term returns.

If you disagree with anything I've written, or have more information that would be useful for long-term donors, I'm happy to discuss in the comments and include other knowledge in an edited post.


Notes


  1. How Becoming a “Patient Philanthropist” Could Allow You to Do Far More Good - 80,000 Hours. ↩︎

  2. FDIC: Insured or Not Insured? ↩︎

  3. Federal Deposit Insurance Corporation. “National Rate on Non-Jumbo Deposits (Less than $100,000): 60 Month CD.” ↩︎

  4. Kagan, Julia. “What Is Capital Gains Tax?” ↩︎

  5. Fontinelle, Amy. “Can I Use Money From My IRA to Donate to Charity?" ↩︎

  6. Rollovers of Retirement Plan and IRA Distributions | Internal Revenue Service. ↩︎

  7. “What Is a Foundation: Definitions, Types & Rules.” Foundation Source. ↩︎

  8. For further details, I recommend the classic Common Sense on Mutual Funds, by John Bogle. Citation: Bogle, John C. Common Sense on Mutual Funds. Fully updated 10th anniversary ed, Wiley, 2010. ↩︎

  9. Ferri, Richard A. All about Asset Allocation: The Easy Way to Get Started. 2nd ed, McGraw-Hill, 2010. ↩︎

  10. See this page for details on calculating compounded returns. It's the best way to compare performance across different funds. ↩︎

  11. Again, see this page for details. ↩︎

  12. Post can be found here. ↩︎

  13. "ESG" Stands for Environmental, Social, and Governance funds. These funds only invest in companies that meet a pre-defined set of criteria, like those that emit less than a threshold carbon dioxide level. ↩︎

  14. Note that the absolute level of all of these fees are quite low, often well below the 1% level. This means that there are potentially advantages to be gained from investing in these asset classes. I generally think that the gains from lower fees will outweigh the gains from better asset allocation, but you may decide otherwise. In this case, you may prefer a provider that offers more unique funds. ↩︎

3 comments

Comments sorted by top scores.

comment by Andy_Schultz · 2020-07-21T16:29:43.525Z · score: 3 (2 votes) · EA(p) · GW(p)

Thanks, this was useful! A few comments:

  1. There was some more discussion on this topic in the following question: https://forum.effectivealtruism.org/posts/iyPQ9fSBGrweXAMLL/investing-to-give-beginner-advice [EA · GW]

  2. You write that money should be added to DAFs in years when your marginal tax rate is high. What should we do with money earned in other years? I believe the answer is to invest in taxable accounts (i.e. your section "Mutual funds in a standard mutual fund advisor"). Then in years when you want to contribute to the DAF, you can move money from your taxable account to the DAF. Donate shares that have increased in value to the DAF to avoid capital gains taxes, and sell shares that have decreased to tax-loss harvest and then contribute the cash to the DAF. In fact, some people may wish to consider starting off investing in taxable accounts and waiting to open a DAF at a later time.

  3. The section "Mutual funds in a standard mutual fund advisor" discusses capital gains tax, but this should not usually be an issue since you can donate appreciated shares to charity or a DAF. Instead, the taxes to look at are from dividends. These are taxed at the capital gains rate that you cite, and are additionally taxed as ordinary income in most states.

comment by MichaelDickens · 2020-07-06T23:30:40.810Z · score: 3 (2 votes) · EA(p) · GW(p)

I think this is good advice for the most part.

Allocate your assets as follows: 70% Total U.S. Market Equity Index, 20% Total International Equity Index, 10% U.S. Bond Index. (I would put my 95% confidence interval for these numbers as +/- 20 percentage points each.)

Would you be willing to bet your $500 against my $100 that VTI (US total market ETF) outperforms VXUS (total international ETF) over the next 10 years? Or would you hypothetically accept this bet, even if you don't want to in practice? I realize there's a difference between being 95% confident that an investment is a good idea and being 95% confident that it will outperform over a particular time period, so I understand if you wouldn't want to take this bet.

(If it's not already obvious, I strongly disagree that investors should overweight US equities relative to the global market portfolio. I wrote more about this here. I think a better default investment allocation is the global market portfolio, e.g., see section 3 here.)

comment by Chris_Webster · 2020-07-07T00:31:52.370Z · score: 3 (2 votes) · EA(p) · GW(p)

Thanks for the comment!

The bet you propose is great for getting me to think about U.S. vs international equities. I've been sitting here proposing different variations of that bet to myself, and I keep flip-flopping on the specifics of the next 10 years and how equities will perform over the period. I think I would take the bet at something more like 3:2 or 2:1 over the next 10 years (if I had no liquidity issues or risk aversion.) Like you mention, however, I think that specific question doesn't play a ton into my more general recommendation of 70/20/10 for the next ~100 years or so.

Thinking on the pieces you've linked, however, has made me question my credence in the 70/20/10 split. My reasoning for the majority in U.S. funds was primarily based on my reading of John Bogle, who was rather famous for advocating 0% international holdings. The reasoning he gave is that many large U.S. companies draw much of their income from markets in other countries. Thus, being invested largely in U.S. stocks already exposes you to international performance. This, plus the fact that international index funds typically have higher fees, was enough for Bogle to recommend never holding international stocks, and at the very most having 20% of ones portfolio invested internationally.

But, the income-diversification point mentioned in the piece you've written, combined with the pretty tiny difference in fees (a difference of .02% for Fidelity), has encouraged me to think that something like 60/30/10 or 50/40/10 might be more desirable. I will read up and think about this more - I think I was holding on to Bogle's conclusion without really thinking through his reasoning and other viewpoints.