A Primer In Compensation In Not-For-Profits 2009 Update

Upper Saddle River, NJ – April 28, 2009 –There has been a virtual avalanche of media attention on executive compensation, mostly involving large publicly-traded financial institutions.  Many of these issues involve excesses resulting from greed, apparent ignorance, and arrogance.  We are now in the throws of a global recession, which has resulted in plant closings, layoffs, and bankruptcies, as well as considerable pain and anxiety for much of the populace.

The negative reaction to the seemingly continuous examples of egregious executive compensation and heightened media attention has acted as a stimulus for new government regulations aimed at curbing these abuses.  Some of these regulations have already been approved, while a host of others are anticipated, particularly as the new administration moves forward.  It appears that most of these will be aimed at companies in the publicly-traded sector; however, it is expected that there will be 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 significant of these regulations being IRC Section 4958, or what may be referred 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 any excessive compensation payment, the brunt of the penalty actually falls onto the shareholders.  Conversely, the penalty for excess benefit transactions within NFPs levies a 25% excise tax, plus disgorgement of the excess amount on the executive who received the excessive compensation.  If the executive does not make these restitutions within a stated period, the fine automatically jumps to 200%.  In addition, the Board members of the NFP, most of whom 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 $20,000, per transaction.

The IRS has promulgated the rules for its new Form 990, which is to be completed for Fiscal Year 2008 filings.  This new Form requires submission of enhanced and very detailed compensation data, as well as questions relative to the process utilized by the independent Board members to make their pay determination.  In addition, the Form delves into other areas of compensation and policies, in order to collect data as part of the IRS’ evaluation into pay practices that the IRS may flag as problem issues in the future.  To relate this to the For-Profit world, disclosures under the new Form 990 are similar to those mandated by the Securities and Exchange Commission (SEC) within the Compensation Discussion & Analysis (CD&A) section within the proxy statement.

Recent activities related to executive compensation as a result of the financial crisis have caused many Boards to examine their governance practices, particularly in the areas of determination and approval of executive pay.  Many Boards, particularly among NFPs who are now required to provide specific disclosures on their executive compensation processes, have taken steps to ensure that they can respond appropriately to the IRS and outside scrutiny relative to the manner in which they pay their top people.  NFP Boards are becoming better educated and more versed in the mechanics involving the Total Compensation Package.  As a refresher, we have detailed the main areas of executive pay that Boards should understand.

What are the components of the NFP compensation package?  There are traditionally five (5) components that typically comprise the Total Compensation Package of executives, whether or not they are part of a For-Profit or NFP.  These are: (1) base salary; (2) annual bonuses or incentives; (3) long-term incentives, which includes both equity and cash based programs; (4) fringe benefits, supplemental benefits and perquisites; and lastly (5) various employment 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 variable compensation in the form of annual bonuses and incentives.  Rather than paying cash compensation in the form of salary only, many NFPs are beginning to introduce variable pay programs.  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.  A side benefit to the organization is the establishment of SMART goals and objectives, the accomplishment of which becomes the basis for earning awards.  The use of incentives and bonuses allows the NFP to provide a more competitive compensation package that better reflects the realities of the marketplace and is justified by results. 

The one compensation element which has been virtually non-existent from the Total Compensation Package among NFPs 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 is just beginning to be addressed as a way 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 misconception 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, which in turn will enhance 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 stretch, but realistic 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 when the measures are a “slam dunk”, sends the wrong message, defeats the intent of the entire incentive system, and will probably be considered as inappropriate.  Plan designs can include "toll gates" or "circuit breakers", which are specific financial or operational indicators which must be attained; otherwise, no awards are payable, regardless of performance achieved on assigned performance measures.

Similarly, the use of long-term goals must relate to the objectives that are more strategic in nature, and related to performance over an extended time period.  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 Sections 457(f) 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 even if it is not taxable to the individual, 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.

The details surrounding the amount and types of compensation elements are slowly but surely becoming more transparent among For-Profit public companies due to recent changes in SEC reporting requirements.  Similarly, the new Form 990 for NFPs is expected to bring about greater transparency by identifying the details of the executive compensation package.  The regulations currently allow For-Profit compensation data to be used when determining the competitive market for NFPs; this is certainly appropriate since many of the NFP positions are interchangeable between the NFP and For-Profit groups.

A cautionary note:  there are individuals 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 will be used 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 extremely important from a business standpoint, but is also 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 at the market average, 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 its pay 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 allow them to earn above market levels of compensation.  It all goes back to setting appropriate expectations and standards, holding the executives accountable for results, and rewarding them accordingly.