A DISCUSSION OF EXECUTIVE COMPENSATION IN NOT-FOR-PROFITS

05/29/13
By: Paul R. Dorf, APD, CRI

Upper Saddle River, NJ – May 2013 –Over the last few years, there has been a virtual avalanche of media attention on the excesses of executive compensation.  These “revelations” include all companies for which data is publicly available, and include large publicly-traded companies, as well as many non-profit organizations.  Many of these potentially excessive compensation matters result from greed, apparent ignorance, and arrogance.  We are slowing recovering from a global recession, which has resulted in plant closings, layoffs, and bankruptcies, as well as considerable financial 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 federal and state government regulations aimed at curbing these abuses.  Some of these regulations have already been approved, while others are anticipated.  While many of these are aimed at the publicly-traded sector, most notably, the Dodd Frank Act, we have also seen a number of state governments, including New York, New Jersey, New Hampshire, and others issuing regulations that are targeted at the Not-For-Profit (NFP) sector.  NFPs already have their own set of federal and state regulations limiting executive compensation; however, more are being created and implemented in an attempt to stem what is viewed as egregious excesses.

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 restitutions within a stated period, the fine automatically jumps to 200%.  In addition, the Board members of the NFP, most of which are not paid for their board service, are subject to individual fines of the lesser of 10% of the excess or $20,000, per transaction.

The constant media reports about excess executive compensation have caused many Boards to examine their governance practices and issues related to the determination and approval of executive pay.  NFP Boards have recognized that they are being held responsible to provide disclosure of their executive compensation process, have taken steps to ensure that they can respond appropriately to both the IRS and outside scrutiny concerning how 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 must 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.  These are: (1) base salary; (2) annual bonuses or incentives; (3) long-term incentives and deferred compensation; (4) fringe benefits, supplemental benefits and perquisites; and (5) various employment agreements that spell out the employment and severance provisions.  Within 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 both annual incentives, as well as longer-term deferred incentive compensation.  Rather than paying cash compensation in the form of salary only, many NFPs are beginning to introduce variable pay programs.  This better aligns the cash compensation with achievement of predefined results, and it allows the Board to “reduce pay” when the NFP’s situation changes, performance objectives are not met, or when there are cash flow issues.  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.  Although it is generally understood that individuals in comparable positions within the For-Profit and NFP industries will not necessarily be paid at 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 the amount and what components the Total Compensation Package (TCP).

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 and defeats the intent of the entire incentive system, as well as being 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 to members of its senior management team.  The award that best fits the requirements should take some form of deferred 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 a future date, often their retirement.  Although the amounts accumulated under this type of long-term incentive plan will probably not equal the potential value of stock-based plans at publicly-traded companies, it may 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 evaluations of the NFP compensation package is that even if it is not taxable to the individual, components of the TCP 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 TCP.

Why is a Compensation Philosophy important for NFPs?  In the world of For-Profits, most are required to 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 companies have not yet taken the necessary steps to formalize their pay strategy; this unfortunately is also the case with many NFPs.  One point that needs to be carefully examined is the level of competitiveness that the organization establishes.  Most NFPs set their Compensation Philosophies 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.  There is, however, nothing that precludes the NFP Board from selecting a higher or lower baseline, particularly if it is consistent with its culture, mission and justified by the overall performance.  In other words, good performance should earn executives a 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.