DAFs: The best worst idea in philanthropy

Donor-advised funds, or DAFs, are the duck-billed platypus of the philanthropic world: a very weird creature that shouldn’t, by rights, exist. When described, they make very little sense, and it’s easy to get angry about them as a result. But you shouldn’t. Because, weirdly, for all that they are bad things in theory, they turn out to be good things in practice.

If you want to know why DAFs are considered evil, look no further than an article which appeared in the New York Review in 2016, by Lewis Cullman and Ray Madoff, entitled “The Undermining of American Charity”. As Cullman and Madoff explained, quite correctly, DAFs “give donors all of the tax benefits of charitable giving while imposing no obligation that the money be put to active charitable use.”

A plutocrat can take a million dollars today, or even a billion or more, put it into a DAF, invest it in the stock market, watch it grow, control how it’s invested, and never give a penny to charity – all while taking a massive up-front tax deduction. If the charitable tax deduction is supposed to encourage and reward the donation of money to charitable causes, it’s perverse to see it used in a context like this, where the primary beneficiary would seem to be the big asset management companies (Vanguard, Schwab, Fidelity, and the like) who get to manage the funds.

And yet.

For all that no one would have deliberately designed a system which worked like this, the rise of the DAFs has turned out, improbably, to be good, not bad, for America’s charitable sector.

To understand why, let’s look at Helaine Olen’s recent attempt at picking DAFs apart. The big argument is a pretty simple one: DAFs act like dams in the stream of funds flowing to charitable causes. Instead of the money going to straight to actual charities, it gets backed up into rapidly-growing reservoirs, where it does no good for anybody really except the people managing the funds. If you look at the money donated to charity every year, a growing chunk of it is going into those socially-useless reservoirs, instead of irrigating the genuinely charitable sector.

On the other hand, it’s impossible to know the counterfactual here. The amount given to charity every year has been going up impressively, even excluding the sums being sent into DAF reservoirs. There’s no particular reason to believe that charities would have received more money absent the DAFs, and it’s even possible that they would have received less. (After all, they are beginning to see significant flows from DAFs, now.)

What’s more, DAFs haven’t really been tested in an economic downturn. Reservoirs exist for a reason, after all: they supply liquidity when it’s needed most. Right now, during an economic boom with a soaring stock market, people are giving record amounts to charity. But booms come to an end, and when the bull market becomes a bear market, charities will naturally expect their income to fall. But the DAFs will still be flowing, and that money might help make up some of the shortfall. In lean years, it’s entirely predictable that DAF outflows will exceed DAF inflows – and that makes them a useful countercyclical smoothing mechanism.

After all, the normal way that a DAF works is that a donor funds it with some kind of windfall, and then withdraws money from it, at an average rate of about 20% per year, to give to charities over time. There have been a lot of windfalls in recent years, so DAFs have been growing quite quickly. But during an economic downturn, windfalls happen much less frequently, while there’s no reason for the withdrawals to decline very much. (If the DAF is invested in the stock market, and the stock market goes down, then that might reduce the amount available for charitable gifts, but they’ll still keep on flowing at some level.)

DAFs are, in large part, a way of gaming the US tax code so as to maximize the amount that Uncle Sam contributes towards your charitable giving. Here’s how Olen puts it:

These funds allow people who earn more money in one year than another to time their deduction, depositing money in the donor-advised fund in years when their earnings permit them to receive a greater tax benefit, and then donating the money to charities over a period of years. Those who are in favor of donor-advised funds suggest this incentivizes people to donate more than they otherwise would; detractors say it’s just another tax advantage for the wealthy.

Well yes, all tax deductions are tax advantages for the wealthy; poor people don’t itemize their taxes. But most DAF detractors don’t oppose the charitable deduction in general, just the DAF version of it in particular. The one thing everybody agrees on is that the DAF mechanism increases the size of the charitable-deduction tax expenditure – the amount that the US government is effectively giving to charities in the form of taxes it would otherwise have collected for itself. To be sure, in the short term, a lot of that money ends up in the stock market rather than in the pockets of charities. But over time, charities will surely be net winners, rather than net losers.

From a public-policy perspective, there are lots of reasons not to like the charitable tax deduction. I’d happily see it abolished, or scaled back. But that would be bad for charities, and if your main concern is the income of charities, then you should want it to be as big as possible. And that means encouraging DAFs, not fighting against them.

There’s another reason why DAFs are good at maximizing charitable giving, which has nothing to do with the tax code. It’s simple behavioral economics: the longer you’ve had a certain amount of money, the more normal it feels to have that much and not less. When people get a windfall (their company gets sold, perhaps, or they get an inheritance, or they sell their house at a large profit, something like that), they’re not used to having so much money, and they often feel that they should share some of their good fortune with those needier than themselves. A couple of years later, by contrast, that good fortune has just become a base-level amount of money in a bank account somewhere, and giving it up means giving up something they would normally possess.

As a result, a good way of maximizing charitable giving is to provide incentives to donate a large lump sum immediately when you receive a windfall, even if you don’t know exactly where or how you want to give it away. And that’s exactly what DAFs do.

But why do DAFs allow people to give no money to charity? Even foundations are required to disburse a pretty paltry 5%. Shouldn’t DAFs be required to do the same?

The answer is: they are, but they are only required to give out 5% on an aggregate basis, and they’ve never had any trouble meeting that bar. The problem with a mandated minimum is that it acts as an anchor: people start feeling weird about giving more than that. Just look at the world of foundations, where a vast majority give out almost exactly 5% of their assets every year. Then look at DAFs, where the amount given out is closer to 20%. Left to their own devices, it turns out, people are much moregenerous than they would be were they instructed to give away a minimum amount.

Olen raises a couple of other objections to DAFs. One is that they make it easier for donors to give anonymously, and that in turn makes it harder for charities to pester those donors for further gifts. Personally, I consider this to be a feature, not a bug: while it’s easy to drop a few anonymous banknotes into a collection bucket or a donations plate at church, it’s harder to give bigger sums anonymously, and people do, for many reasons like to give anonymously sometimes. I’m sure the charity would prefer it if they knew who the donor was, but ultimately it’s a good idea to honor donor intent. Anonymous giving has a long and honorable tradition, and if DAFs make it easier, that’s great.

Certainly there’s no indication that anonymous giving reduces the total amount that donors give; just that it reduces the amount they get pestered by the recipients of their largesse, and possibly helps them spread their giving around more than they otherwise might. That’s all fine by me. The charities which get my dollars shouldn’t be the ones which pester me the most.

Olen’s other objection about anonymity is that there’s a public purpose served in knowing who the donors are to certain charities, especially charities which align themselves with political causes. But in this she’s confusing two different things. DAFs allow donors to be anonymous to the charity; but even if the charity knows exactly who its donors are, it has no obligation to make that information public. The Form 990 tax filings that all non-profits need to make public give a lot of information about where charities’ money goes, but none about where it comes from. Changing the rules about DAFs would have no effect on that.

So don’t worry too much about DAFs. Indeed, they’re one of the few areas where unintended consequences seem to have worked out very well.

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