A Primer In Executive Compensation In Not-For-Profits - www.netgamblinghouse.com - Aug. 7, 2008

A Primer In Executive Compensation In Not-For-Profits

www.netgamblinghouse.com/archives/2008/08/10/a-primer-in-executive-compensation-in-not-for-profits/

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–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.

Compensation Resources, Inc. provides compensation and human
resource consulting to mid-size and Fortune 500 clients as well as
public, private, family-owned and emerging companies. CRI specializes
in Executive Compensation, Salary Administration, Performance
Management, Sales Compensation, and expert witness services. Our
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