Ethics of Discounting
(Added 2/10/2011)
I know we need to discount gifts to calculate remainder values; but, from what I can tell, it's not black and white, even though I always thought the IRS method was an absolute valuation process. When we aren't valuing the present value of a unitrust, annuity trust, or gift annuity, however, how should we discount expectancies? My financial director says we should use a high discount rate because that makes the present value conservative. I understand that an amount due in the future must be discounted but I always thought it should be connected to inflation. How should we discount future values?
Unfortunately, most people think that when a mathematical process is involved, if the formula is correct, the result is certain. In fact, most of the time the opposite is the case. While it may seem difficult to discount a value by, say, 10 percent a year for five years, that process is actually quite simple. We can all agree on the number that emerges 59 percent. But who's to say everybody agrees on the factors - in this case, 10 percent and five years? The IRS's calculation takes into account actuarial tables for one of those factors life expectancy - and no one seems to have much problem with those assumptions, but what about the discount rate? (Ever wonder about what's being discounted, especially as the deduction is higher when the discount rate is higher? Short answer: for annuities, the income value; unitrusts and pooled income funds work slightly differently.)
The bone of contention lies in the discount rate. The IRS dictates the rate we use for split-interest gifts, but nothing guides us when discounting values for other purposes. Should we discount at the rate of inflation (which has been rather low lately)? Or a charity's actual increase in spending (which is often higher because the cost of programs has traditionally been higher than inflation)? Or what about something called "opportunity cost" (the amount the charity does not earn because the amount is not being invested, often the highest rate of the three)? Deciding the rate to discount an expectancy is fraught with subjectivity, and, if the result steers anyone into analyzing the success of a planned giving program and certainly if salaries become dependent on it the process is very much ethics-based.
I once had to deal with a finance person who insisted that the entire planned gift expectancy portfolio be discounted by the average market growth over the past five years. This was in the mid-1990s, when the stock markets were soaring. And you are right: the higher the discount rate, the lower the resulting present value. The difference between using the inflation rate and the opportunity cost rate was a whopping (and disheartening) $50 million. That is, the finance person claimed that the planned giving effort resulted in $50 million less than everyone thought. And this was already a fairly sophisticated group.
That story ended with the charity using a rate something above inflation and below its annual cost rise. The staff documented why and how the rate would be determined, which is most of the battle when it comes to making subjective decisions. It also mattered to the trustees if not to the finance person - that using the opportunity cost made no sense because the money was never available to invest in the first place. Some finance officers think that a deferred gift is an option, that the donor merely chooses not to give the whole amount outright, that if fundraisers were really doing their job donors would just give it all at once, now.
But that can go the other way, too. If you don't like 59 cents on the dollar, just use a discount rate of five percent: your work is all of a sudden worth 77 cents.