Executive Compensation

Best Practices for the Nonprofit Sector

Regulatory and public scrutiny of executive pay programs has been increasing steadily over the past decade.  Not-for-profit organizations, many of which are charged with advancing the public interest, are arguably subject to even higher standards of conduct due to their particular missions and special, generally tax-exempt status.  The result is that many corporate Boards face significant limitations in designing competitive compensation programs for executives.  Board members and management need to consider best practices in designing, implementing, and communicating executive compensation programs.

Today’s Environment.  Executive pay is being scrutinized as never before.  Boards face calls for increased accountability and transparency.  Today, all aspects of executive pay are being examined, from the actual pay levels and performance leverage to the decision-making processes and decision-makers involved.  During the ‘90s, some nonprofit Boards introduced creative executive reward structures intended to motivate and retain leadership that might otherwise join for-profit ventures.  These and other practices previously considered sound are now under examination.  The Penicle Group predicts that nonprofit organizations increasingly will find that mandates imposed on public companies will be best practices for their own governance processes.

Resulting from this environment, nonprofit organizations now have their own regulatory concerns: the IRS is contacting a projected two thousand charities and private foundations to collect data on their compensation practices.  The IRS program is focused on what the agency views as excessive compensation and benefits at exempt organizations, with particular attention to instances where an executive earns more than $1 million annually.

Stakeholders.  Although a tax-exempt organization may not have shareholders to satisfy, it does have multiple groups that seek to influence its affairs.  Board members and management need to consider the varying interests of many possible constituencies, including employees, donors, organized labor, affected local communities, service recipients, regulators, and the media.  Pressure may be applied by these stakeholders to adopt, voluntarily, reforms for corporate governance and financial matters.  Since many nonprofit organizations are charged with advancing the public interest, even higher standards of conduct can be applied to these employers than to their profit-oriented public brethren.  These enhanced principles create challenges, as organizations often compete for talent with nonprofit entities that may not be subject to the same standards.

Tax Payers Bill of Rights 2.  Over the past decade, the regulatory environment has created additional challenges for tax-exempt organizations in structuring executive compensation.  The “intermediate sanctions” provisions of the Taxpayer Bill of Rights 2 can result in substantial financial penalties for executives and Board members of 501 (c)(3) and 501 (c)(4) organizations, where executive compensation levels are deemed to be excessive – so-called “excess benefits.”  Executives and Boards of tax-exempt organizations can protect themselves from exposure by taking certain steps, including Board oversight, comparability analyses, and appropriate documentation.  The provisions require that all reward elements be considered, including base salary, incentive plans, and employee benefits.

Executive Retirement Plans.  An additional challenge is the complications of designing executive retirement plans.  Federal tax law makes it difficult to design an executive retirement plan that creates value for the executive without simultaneously creating a tax event.  In light of these developments, many tax-exempt organizations have been struggling with how to appropriately reward executives in the current regulatory and public environment.

To avoid current taxation, many organizations previously implemented split-dollar insurance and/or discount stock options on mutual funds.  Recent regulatory changes have largely eliminated the tax effectiveness of these two executive retirement vehicles.

Best Practice Strategies.  Best practices followed by high-performing nonprofit organizations include the following:

• Articulate and Document the Pay Philosophy.  The discussion involved in developing an organization’s pay philosophy provides a timely opportunity for the compensation committee and management to agree on how pay should be linked to the organization’s mission, and what messages the organization wants to send to its external and internal constituents.  The philosophy needs to be approved by the committee and referenced when executive compensation is established and annually assessed.

• Establish an Executive Compensation Committee.  The deliberations of the Board’s compensation committee set the context for executives’ total remuneration, which in turn sets expectations and reward programs for the rest of the organization.  The committee’s decisions on pay for top executives have a real and demonstrable impact on the whole organization.  Additionally,

• the committee facilitates a process that can be documented and thus can be defensible to regulators, the public, and employees.

• Develop a “Total Reward Strategy.”  Total reward includes five components of pay: base salary, annual incentives, long-term incentives, benefits, and perquisites.  While many organizations focus on only one or two components of pay, a holistic view of all five is most important.  First, regulators consider all five components of the “extrinsic” aspects of pay when reviewing appropriateness of executive compensation.  Second, each component plays its own role in facilitating performance, retention, and recruitment, and can be tailored to the needs of different situations.  For this reason, the balance of the components should be customized according to the organization’s philosophy and executives’ needs.  A total reward strategy addresses issues of “Money,” “Messages,” and “Mix:”

   

  “Money” refers to the level at which the committee sets Total Rewards and the market data used to establish that level.  The committee has the ultimate responsibility for identifying appropriate benchmarks and setting pay accordingly.

   

  “Messages” refers to the organization’s expectations of executives, in return for Total Rewards.  For example, committees should expect their executives to reflect the organization’s values and culture, and can build that expectation into base pay.  Building great teams is a way to produce superior results and provide meaningful work environments.  Annual incentives can be powerful vehicles for reinforcing team behaviors.

   

  “Mix”  refers to the emphasis of base salary versus incentives, benefits, etc.  Most nonprofit organizations emphasize variable pay to leverage fixed costs and focus executives on key areas of corporate performance.  Effective variable pay plans and the process by which they are developed provide clarity about what is desired and what happens if the desired results are achieved.

• Link Total Rewards to Performance.  Total Rewards should reinforce priorities and focus executives on the desired behaviors and outcomes for the organization.  High performing organizations that successfully link Total Rewards to performance:

  • Quantify success by developing performance goals and measures.

  • Address relative performance, by comparing results to peers.

  • Ensure that rewards are competitive and motivating to recipients.

• Communicate.  Communication translates leadership decisions about Total Rewards into clear messages for executives.  Secrecy can undermine even thoughtful and well designed programs.  Effective communications helps executives to understand the true value and employer cost associated with each reward element.

• Annual Assessment.  This process can be conducted internally or through independent advisors.  Most organizations prefer outside advisors for their expertise, objectivity, and access to benchmarks.  The process must involve committee deliberation and ultimately, using relevant market data as a basis for setting executive pay.

Conclusion.  All of the above mentioned “best practices” are feasible, given careful thought, time, and resources.  Investments to improve and/or adopt these  practices should more than pay for themselves.  Appropriate and strategic governance today will lead to a healthy, results-driven, mission-directed, documentable, and defensible executive compensation program tomorrow.