Essays on People, Place & Purpose

Investing in What Works for America's Communities

Pay for Success: Innovating our Way out of Poverty

by Ian Galloway

Despite the many great examples of community transformation highlighted in Investing in What Works for America’s Communities, deep poverty persists—20.4 million American’s live below half the poverty line—in neighborhoods across the United States. In my view, this is partially because we have become too conservative with our approach, too afraid to try new things for fear of losing scarce public (and even scarcer, private) funds. Instead, we should encourage bold prototyping, supported by a public-private finance system that emphasizes innovation, lifts up strategies that work best, and jettisons those that don’t. Specifically, an approach that rewards positive outcomes and encourages reasonable risk taking and experimentation among social sector service providers.

Consider the social impact bond (SIB).The SIB is a new funding structure designed to save government money (in the prison system, for example) by paying for successful improvements in social outcomes (such as reducing gang violence).  The SIB’s “Pay for Success” model has two main components: 1) a performance-based contract; and 2) bridge financing. The performance-based contract commits a funder (usually government), to reward a service provider (usually a nonprofit), for delivering a verifiable social outcome. Then, on the basis of that potential reward, the service provider secures an investment from a foundation, bank, or impact fund—the bridge financing—to pay for its operations until the outcome is achieved and the reward is secured, at which point the investor is repaid with interest. The rest (mostly) is left up to the service provider, including identifying what partners they need to succeed, their strategy for achieving the goal, what it will cost, and how to raise the money to fund it for the duration of the agreed-upon timeframe. The result: a system that uses private-sector financing to support service delivery innovation driven by performance-based contracts tied to public sector payouts for success.

“Paying for success” isn’t new. In fact, it has been used many times in the past to catalyze technological innovation. For example, the X-Prize Foundation used this approach in 1996 to develop suborbital commercial spaceflight. The foundation committed to pay $10 million to the first company to send three people to the edge of space (100 Kilometers) twice in two weeks and bring them home safely. Twenty-six companies from seven countries competed for the prize, with Scaled Composites (SpaceShipOne) eventually capturing it eight years later. But the story doesn’t end there. Incredibly, the competing companies collectively spent $100 million to win the $10 million prize. That innovation was the true goal of the prize and is now the basis of a $1.5 billion public-private space travel industry.

Likewise, we should reward social sector organizations for solving difficult poverty-related challenges, such as closing the academic achievement gap, shrinking over-crowded prisons, reducing neighborhood violence, and increasing employment.  Such an approach—paying for an outcome instead of a promising program or a theory of change—would unlock enormous creativity and innovation in the social sector, just as the X-Prize did for the aerospace industry. Community organizations would compete for public contracts tied to measurable social outcomes enforced by impact auditors and underwritten by socially-motivated investors. Entrepreneurial, results-based organizations would rise to the top and funding would, over time, flow towards success and away from failure.

Understandably, market-based solutions (even a quasi-market solution, like this one) raise caution flags—and for good reason. Like many others in the community development industry, I would much prefer to just pick “proven” organizations/approaches/models, etc. and scale them successfully all over the country. But we’ve tried that before with disappointing results (consider the tired trope: there are no silver bullets). Every low-income community faces its own unique set of challenges. Innovation and adaptation will be, by necessity, the only way to address these challenges everywhere. Pay for Success approaches scale good ideas and put us in a position to innovate our way out of poverty.

Ian Galloway is a senior research associate at the Federal Reserve Bank of San Francisco and the issue editor of a recently-published Federal Reserve journal on Pay for Success financing. He was also a contributing editor of Investing in What Works for America’s Communities. His views are his own and may not reflect those of the Federal Reserve Bank of San Francisco or the Federal Reserve System. 

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Investing in What Works for America’s Communities is a joint project of the Federal Reserve Bank of San Francisco and the Low Income Investment Fund.

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