As I wrote in my Letter From the CEO, one of the foundation's goals for the coming years is to make sure we tell our partners and the public what we're doing, what we're learning, and what impact our grants are having. This Management Discussion, the first in an annual series, is one attempt to live up to that goal. I want to answer some of the questions that people ask me and my foundation colleagues. Because many of those questions are about the inner workings of the foundation, this letter is more internally focused than the rest of this year's annual report.

Structure and Governance

In 2005, our grantmaking programs were organized into four main areas: Global Health, Education, Global Libraries, and Pacific Northwest. (As we explain in the Other Initiatives section of this report, we also made grants in additional areas, including microfinance; agricultural development; and water, sanitation, and hygiene.) In 2006, we reorganized the foundation to allow for growth and greater impact in the years ahead. In part, this reorganization involved creating three new high-level positions: presidents who will oversee our work in the United States, in Global Health, and in Global Development. You can read about these changes and our new leaders in this statement on our Web site.

I'm often asked: Why doesn't the Gates Foundation have a board of trustees? The answer boils down to the fact that Bill and Melinda—our two trustees—are deeply involved in the foundation's work. They want to keep learning as much as they can and shaping our strategies so their wealth can do the most good for the most people. They want this foundation to be able to act quickly, responding to the problems that we've identified and to new ones as we learn about them. And they feel that they're best able to do that by maintaining control themselves.

Yet Bill, Melinda, Bill Sr., and I have served on many boards ourselves, and we know they play a crucial role by bringing in outside voices and raising tough strategic questions. Because we don't have a board, we need to find other ways to do the same thing. That's why, throughout the organization, we actively seek out input and ideas from the outside. All of our programs involve a variety of highly credible outsiders who are close to our issues in program development, strategy development, and grantmaking.

For example, when we established our $450 million Grand Challenges in Global Health initiative, we appointed a scientific board—with 20 out of its 22 members from outside the foundation—to reach out to the entire global scientific community in order to help define a list of challenges for exploration that, if solved, could bring about enormous health benefits for people in the developing world. The initiative is benefiting enormously from this extensive outside input.

We also brought in outside advisers to help our Global Libraries program explore working with new countries. These experts, who were leaders in library development and public access computing, helped us revise our methods for choosing countries and our approaches to working with them.

Because we have gained so much from outside experts in the past, we've been thinking carefully about how we can get that advice in the most consistent and effective way. In the next few months, we plan to establish a more formal advisory system; when we do, we will announce it on our Web site.

Grants

Another question I'm often asked is: "Who approves grants?" Not surprisingly, the answer depends on the size of the grant. While I don't want to publish the details of who can approve which grants, I will say that our spring 2006 reorganization gave significant grantmaking authority to the presidents of our three major programs (the U.S. Program, the Global Health Program, and the Global Development Program). Most grants are now approved by directors within the programs, by the president they report to, or by me. This will decentralize authority and make us able to respond more quickly. Very large grants are still approved by Bill and Melinda. But we believe the best way for them to spend most of their time on foundation business is to help us formulate and refine our strategies and bring attention to the issues we care about.

Endowment

A third area I'm frequently asked about is the foundation's endowment. Who manages it? What kind of returns do we get?

The foundation's portfolio is managed by an external investment team called BGI, which also manages Bill Gates' personal portfolio. BGI is based in Seattle and led by Michael Larson. Bill and Melinda donate BGI's services to the foundation, as well as the cost of third-party investment managers hired by BGI to manage part of the foundation's portfolio. Bill and the foundation are BGI's only clients.

Our investments are designed to ensure that the foundation has a stable financial base with which to make grants and pursue its mission for the long term. Because they intend to donate more of their own money to the foundation over time, Bill and Melinda feel that the endowment does not need to grow aggressively through investments. Therefore, they have asked BGI to manage it fairly conservatively, aiming for a 5 percent nominal return each year. Since 1999, the portfolio has earned more than that goal—an average of 8.53 percent a year.

We maintain a strict wall between our programmatic work and BGI's management of the portfolio. BGI is not involved in decisions about grants, and the foundation's program staff is not involved in decisions about investing the endowment.

Payout

The Internal Revenue Service requires private foundations to distribute at least 5 percent of their average endowment over the course of a year. We generally exceed this requirement by a small percentage. As a result, from 2000 to 2004, the foundation distributed $376,049,274 more than was required by law.

Grants Paid

The table below shows the grants paid by our different program areas for 2004 and 2005, followed by a brief explanation of the increases and decreases from one year to the next.

Global Health
Several factors contributed to the 90.9 percent increase in Global Health grants between 2004 and 2005. In 2005 we made the first payments in our second $750 million commitment to the Vaccine Fund. We also made more grants related to the priority health conditions we've identified. Finally, the work we're supporting to develop a new malaria vaccine proceeded faster than we expected, so we made more payments in that area than we had planned.

Education
The decrease in Education grants between 2004 and 2005 is slightly misleading. In 2004 we made the final grant payment to the United Negro College Fund for our $1 billion commitment to the Gates Millennium Scholars Program. Grants in our U.S. high school program actually increased by more than 30 percent from 2004 to 2005.

Pacific Northwest
The growth in our Pacific Northwest program in 2005 resulted entirely from our one-time $30 million grant to Bill Gates' high school alma mater, the Lakeside School in Seattle.

Other Initiatives
This category consists mostly of grants made by our Strategic Opportunities team, which explored potential new program areas, though it also includes one-time grants that didn't fall into one of our other areas of giving. It increased in 2005 as the Strategic Opportunities group made initial grants in three areas: financial services for the poor; agricultural development; and water, sanitation, and hygiene. Our Global Development program, which we created in 2006, grew out of the work done by the Strategic Opportunities group.

Stewardship

The past few years have seen some high-profile cases in which foundations and other nonprofits have violated the public's trust and failed to live up to their responsibilities. At the Gates Foundation, we have followed these stories with great interest. They serve as a constant reminder that we have to ask ourselves: How do we make sure we are spending our resources responsibly?

First, of course, we're intensely focused on getting, and sharing, results from our grantmaking. We have established a small internal team at the foundation to help all of us concentrate on results and be self-critical as we develop program strategies, measure the impact of our grantmaking, and become more effective grantmakers.

We also have reviewed and updated our internal policies and processes, and we've implemented new systems as well. For instance, information about each of our grants is available in a searchable database on our Web site. And our travel policy now requires all employees to fly coach on all domestic flights. (Like other nonprofits that do a lot of work internationally, we do allow employees to fly business class on overseas trips of more than five hours so they can make the most of their travel time.)

Our conflict-of-interest policy requires employees to disclose any connection with a potential grantee or vendor. This helps ensure that no one who has a conflict of interest makes a final decision about a grant or contract. We have also created a database that checks every grant and contract so we can identify any potential conflicts.

Our whistleblower policy prohibits retaliation against any employee who reports inappropriate behavior in the workplace. It's important for employees to feel comfortable raising concerns directly with the foundation's leadership, but we have also provided an alternative that lets them make an anonymous report by calling a toll-free number or visiting a Web site run by a third party.

Beyond these two key policies, we have adopted a set of guiding principles that describe how we focus our work. They also set standards for how we want to act. All new employees get a copy of these principles before their first day on the job, and they are expected to live up to them in their daily work.

You can view the guiding principles as well as the whistleblower and conflict-of-interest policies on our Web site.

We also want to be good stewards when setting compensation and benefits for executives. The foundation needs experienced leaders who can manage an organization that is changing and growing. On the other hand, executives' compensation has also become a hot-button issue in the nonprofit sector—especially when it's seen as excessive. I'm also keenly aware that the nonprofit sector is not the same as private industry, and if we pay too much, other nonprofits could have a hard time attracting talented people.

When we're setting an executive's compensation, we work with an outside consulting firm that analyzes the compensation for similar jobs at peer foundations and non-profits. As our executive positions become more complex, our executive compensation will go up accordingly. That said, many of our employees—executives included—could make more in the private sector, and they choose to stay at the foundation because they're passionate about the work they do. (I am not paid a salary.)

Growth

I'm often asked how much the foundation will grow in the next few years. While it's hard to predict the future, we are definitely hiring more employees as we learn more about the areas where we're working and look for ways to have a bigger impact.

This growth isn't steady—it comes in fits and starts, as our mission dictates. For instance, as we have wrapped up the first phase of our U.S. Libraries program, the number of employees in that group has dropped, to 10 at the end of 2005 from a high of 132 in 2001.

But on the whole, we are adding to our staff. In 2005, we grew from 197 full-time employees in January to 247 in December. This may still be too lean; in the next few years, we could have as many as 500. While this growth is considerable, and while it presents real challenges for our management team, I think it's the best way to manage our resources responsibly and make sure they have great impact around the world.

Because of this growth, we're running out of room at our current headquarters in Seattle, a space we've been renting since 1999. To accommodate our long-term growth, and to give us a permanent space in our hometown, we are building a new campus in Seattle. It will be located near Seattle Center, the city's cultural heart, on property that belonged to the City of Seattle.

2005 saw several major milestones for the project. We created IRIS Holdings LLC to handle buying the property from the city as well as planning, design, and development. The City Council approved the sale and purchase agreement for the property. We started meeting with the local community to get to know our future neighbors and get their feedback on our design plans. We also received a key permit for the first construction project on the site—a parking garage. (Seattle Center will own and operate the garage, which will accommodate the foundation's employees and guests as well as Seattle Center visitors.) Construction of the garage should begin at the end of 2006. Many more details about the new campus are available on our Web site.

The Gates Foundation has changed a great deal in the past five years, and it will grow and change even more over the next 10. The organization we put in place in 2006 will help us manage that change. When I think about the decade ahead—the opportunities we all have to improve millions of people's lives—I couldn't be more excited.

Patty Stonesifer
Chief Executive Officer