A Primer In Executive Compensation In Not-For-Profits   by Paul R. Dorf, Ph. D., APD

Upper Saddle River, N.J. – July 19, 2005 - A tremendous amount has been written about Executive Compensation, and lately, most of this information has been extremely unflattering. Much of the criticism has resulted from the gross excesses, misinterpretations of regulations, and the rash of criminal cases brought against the top management of a number of large firms, such as WorldCom, Tyco, Enron, and a host of others. Virtually every day another egregious example of corporate greed has come to light. The effect has been a huge increase in media attention, which in turn has acted as the stimulus for new government regulations aimed at curbing these abuses. While most of the regulations are aimed at publicly traded companies, there has been some spill-over into the Not-For-Profit (NFP) sector. NFPs have their own set of federal and state regulations limiting executive compensation; the most draconian of these regulations being IRC §4958, or what many refer to as “Intermediate Sanctions”.

It is interesting to note that, for the most part, the regulations covering for-profit, publicly traded companies provide few, if any penalties, and certainly none are spelled out for board members involved in the approval of compensation deemed to be excessive. Since in many situations, the only penalty is that companies cannot deduct the amount of an excessive compensation payment, the brunt of the penalty falls onto the shareholders. Conversely, the NFP regulation calls for a 25% excess tax plus a disgorgement of the excess amount. If this does not occur, the fine jumps to 200%. In addition, the board members of the NFP, most of who are not paid for their board service, but are merely acting in an altruistic manner, are subject to individual fines of the lesser of 10% of the excess, or $10,000.

What are the components of the NFP compensation package? There are traditionally six (6) elements that to one degree or another comprise the Total Compensation Package of executives, whether or not they are part of a For Profit or NFP. These are base salary, annual bonuses or incentives, long-term incentives which could include stock options, restricted stock, phantom stock, and a large group of equity and cash based programs, typical fringe benefits, supplemental benefits and perquisites, and lastly various written documents or agreements that spell out the employment and severance provisions. In the case of NFPs, most of these elements are included but often with scaled-down arrangements. One area that is definitely changing is the increased acceptance and use of annual bonuses and incentives. Rather than paying cash compensation in the form of salary only, many NFPs are beginning to introduce variable pay. This not only better aligns the cash compensation with achievement of predefined results; it also allows the Board to in effect “reduce” pay when the NFP’s situation changes, performance objectives are not met, or when there are cash flow issues. It also allows the NFP to provide a more competitive compensation package that better reflects the realities of the market place. The one compensation element, which heretofore has been virtually missing from the Total Compensation Package, is the use of long-term incentives, which typically exists in For Profits in the form of equity. This is one of the major disparities between For Profits and NFPs, and it is one of the areas which needs to be addressed in order to begin to “level the playing field” between the two business groups.

Although it is generally understood that individuals in comparable positions within the For Profit and NFP industries will not necessarily be paid at exactly the same level, there is still a misguided concept held by some individuals, that working at an NFP is rewarding enough, so that their overall compensation should be markedly lower. While altruism is clearly evident, it doesn’t pay the rent. Recognizing the ability of an NFP to pay reasonable levels of compensation, without harming the organization’s ability to carry out its mission, should be a main consideration in determining what compensation elements comprise the package, and in what amounts.

Is it appropriate to provide short-term and long-term incentives? Short-term incentives are generally associated with the achievement of annual financial and/or operational goals. These goals are typically set at the beginning of a fiscal year, and their achievement is part of a tactical plan to advance the NFP’s mission. To ensure that these awards do not become an “entitlement”, the Board must set realistic but stretch objectives, and determine the actual level of accomplishment against those performance measures when granting awards. Paying out bonuses when the performance is not achieved, or the measures are a “slam dunk”, sends the wrong message and defeats the intent of the entire incentive system.

Similarly, the use of long-term goals must relate to the objectives that are more strategic in nature, and related to financial growth projections over the next three to five years. It is at this point that more creativity is needed in the plan design, since NFPs obviously do not have the ability to share wealth or grant equity with members of its senior management team. The award that best fits the requirements should take some form of capital accumulation. The specific design features may vary, but the basics are the same: long-term performance goals are established and monitored. If the performance goals are achieved within the specified period, funds will be set aside into a Rabbi Trust or similar vehicle, which conforms to IRC §457f and 409A. These plans allow monies to be accumulated for the executive until retirement. Although the amounts accumulated under this type of long-term incentive plan will probably not equal the potential value of stock-based plans, it may actually be more consistent with long-term compensation programs in privately owned For Profits, and will certainly go a long way to making the NFP’s executive compensation package more competitive.

What challenges exist in evaluating the NFP executive compensation package for determining reasonableness? An interesting aspect of the difference between evaluation of the NFP compensation package is that elements such as health care benefits, contributions to retirement plans and even the prorated cost of Directors & Officers (D&O) insurance coverage is considered part of the reportable NFP total compensation package, even if it is not taxable to the individual. Among For Profit public companies, the amount and makeup of the executive compensation package is generally available in the various government filings including the proxy reports. Even though SEC regulations require specific items to be reported, preparing these proxies continues to be an art form unto itself; which often masks the true value of the compensation and appears to go out of its way to make reading and interpreting the data difficult, at best. Similarly, disclosure of the comparable required compensation data for NFPs is shown on the IRS Form 990, but is far less definitive and should be carefully scrutinized. The bottom line is that it is much more difficult to accurately make comparisons with other NFPs, which is the main area for judging the reasonableness of the overall compensation package. The regulations currently allow For Profit compensation data to be used when determining the competitive market; this is certainly appropriate since many of the NFP positions are interchangeable between the NFP and For Profit groups. A cautionary note: there are groups in Congress who believe that this “liberal” approach should be curtailed, and only want to allow the use of NFP data in the evaluation of pay.

Why is a Compensation Philosophy important for NFPs? In the world of large For Profits, most have a well-documented Compensation Philosophy that states the company’s intentions vis-à-vis how executives will be paid. This typically includes a discussion of what peers they will use for comparison purposes, the level of competitiveness, the basis for making awards, and the elements to be contained in the executive compensation package. Many mid-sized and smaller For Profits have not yet taken the necessary steps to formalize their pay strategy; this unfortunately is also the case with many NFPs. It is not only important from a business standpoint, but is required in the regulations. One point that needs to be carefully examined is the level of competitiveness that the organization establishes. The most common level for the majority of compensation philosophies and the one that most NFPs strive for is the 50th percentile, or “middle of the pack”. It is assumed that this is a safe place to be, and therefore, the easiest to justify. This may be true, but there is nothing that precludes the NFP Board from selecting a higher or lower baseline, particularly if it is consistent with their philosophy, and justified by the overall performance of the organization. In other words, good performance should earn executives fair and competitive pay, while outstanding performance should earn them above market levels of compensation. It all goes back to setting appropriate expectations and standards, and holding the executives accountable for results; and rewarding them accordingly.