Dateline, April 10, 2007, Chicago
Our friends in the for-profit world have been under siege as of late, with the public, regulators, and legislators all asking questions about excessive executive compensation. In hope of avoiding legislatively-imposed limitations and shareholder lawsuits, for-profit boards are trying to improve the process by which executive compensation is set. Nonprofit boards should be paying attention. Obviously, stock options are not an issue for nonprofits, but cash compensation, perks, and other forms of deferred compensation do raise questions, as recent incidents at the Getty, Smithsonian, Museum of Modern Art, and American University aptly demonstrate. That is why yesterday's special section...
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in the Wall Street Journal is worth taking a look at, particularly Joann S. Lublin's lead article, Ten Ways to Restore Investor Confidence in Compensation: What Boards Can Do to Ease Shareholder Anger Over Pay Packages. Here is a summary, with a focus on how these suggestions apply to nonprofit executive compensation.
Eliminate Consultant Conflicts. Lublin's first suggestion is to make sure the board's compensation consultants don't work for management. This clearly goes to the question of independence, something that is worth keeping in mind because of the intermediate sanctions. Rarely will you see management actually paying money to the compensation consultants out of its own pocket. However, compensation consultants do more than just develop and justify executive pay packages. Traditional compensation consultants also design qualified plans and basic pay packages for rank and file employees. If the chief executive is selecting the compensation consultants to do that sort of work, those consultants are beholden to the executive. This is a clear of conflict of interest if those same consultants than develop the compensation packages for senior management.
This can also be a problem for smaller nonprofits that might look to accountants and lawyers to develop compensation comparables for purposes of qualifying the compensation under the intermediate sanctions. Developing those comparables may only be a small percentage of the work that the lawyer or accountant performs for the nonprofit, but unless the inherent conflict is addressed, it could be a very costly piece of work.
To minimize the potential for conflicts, the boards of large nonprofits should be the ones retaining the compensation consultant. That means undertaking an independent review of the consultants, not just relying on a list of names provided to the board by the executive director.
Compare Apples to True Apples. Lublin also warns that boards, when developing compensation comparables, often fail to recognize the differences between their own entity and those used for comparison. She points to Johnson & Johnson and Eli Lilly. In selecting comparables, Eli Lilly indicates it looks to Johnson & Johnson, but Lublin points out that, although both are recognized pharmaceutical conmpanies, Johnson & Johnson's business is much larger and more complicated than Lilly's . Now consider two social service agencies. One runs a Head Start program and provides family counseling services. Another provides both those services, but also has weatherization, housing, credit counseling, employment training, and elderly out-patient-care programs. It probably is not appropriate for the board of the first agency to be looking at the compensation paid to the executive director of the second agency for purposes of setting compensation of its own executive director. In short, the board should make sure it is comparing apples and apples.
Kill Unjustifiable Perquisites. We are big fans of cash compensation, as is Lublin. She advises killing "unjustifiable perquisites." To put this in perspective, just recall your last car purchase. You shop and negotiate hard, arriving at a price of $25,000, which you think is a good deal. Now you learn that the floor mats are $500 extra and there is a $300 dealer prep charge. Perquisites are really no different. Nonprofits should pay their executives cash. If the executive needs a membership in a club, a newspaper subscription, or an automobile, let the executive pay for it. There will be legitimate exceptions, but each perk should be carefully reviewed and the bias should be against granting them. Cash is cash, making it easy to value. Perquisites are harder to value, particulary because they can impose hidden and ongoing costs.
Bonuses Linked to Measurable Outcomes. Lublin also recommends linking all bonuses to performance measurements. it is simply too easy to provide the executive with $25,000 or $100,000 extra at the end of the year when the policy provides for a bonus. At the time the policy is instituted, objective performance benchmarks should be set. Just because a nonprofit hospital generated $2 million surplus last year is not a reason for paying a bonus to its CEO. For all the board knows, the surplus might have been $4 million had the CEO not been so incompetent. It is critical to assess the executive's contribution to the desirable outcome. No organization should be paying a bonus to an executive for outcomes that are tied to environmental factors outside the control of the executive.
Severance for Transition, Not Permanent Lifestyle. Lublin is also against severance packages that pay for failure. It is one thing to provide an executive with two or three months cushion so that the executive can find a new job if the current one doesn't work out. As Lublin points out, it is not appropriate to make sure that the executive's grandchildren can retire to Paris before they finish college.
Lublin doesn't mention these suggestions, but we will add them to the list.
Everyone Can't be Above Average. Boards should avoid falling into the Lake Wobegon syndrome, where "the women are strong, the men are good looking, and all the children are above average." Talk to almost anyone who has served on a nonprofit's compensation committee. They will tell you that their board sets its executive director's pay so that it places him in the 70% percentile. Any board that believes that the executive director is performing at above average levels should be able to support that belief with hard evidence.
COLA Adjustments Should Be the Same for All. If the board justifies a pay increase based on a cost-of-living index, the same index and rate should be used for all employees, including the executive director. There may be instances where a different rate is warranted, but should be a legitimate reasons for the difference. For example, the organization may have offices in New York City and Iowa City, Iowa, meaning that there are geographic disparities in cost of living rates,
Clear Determination of Aggregate Compensation. Too often the board is provided with a thick packet of information before it is asked to vote on a compensation package. The thicker the package, the more likely the board is to grant rubberstamp approval. A thick packet is fine, but the cover page should summarize all aspects and major components of the compensation package. This summary should include cash compensation, deferred compensation (showing present value cost of funding the benefit and expected value of the benefit at time of payment, with investment and discounting assumptions clearly stated), the value of individual fringe benefits that are material, and an aggregate value for minor fringe benefits, together with a list of those benefits. This should be provided to the board before the meeting.
Internal Revenue Service - Circular 230 Disclosure: As provided for in Treasury regulations, any advice (but none is intended) relating to federal taxes that is contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any plan or arrangement addressed herein.
THE FOREGOING IS NOT AND SHOULD NOT BE TAKEN AS LEGAL ADVICE. IF LEGAL ADVICE IS REQUIRED, THE NON-PROFIT OR OTHER PARTY IN QUESTION SHOULD SEEK THE ADVICE OF QUALIFIED LEGAL COUNSEL. If you liked this post, please review the links in the lefthand column for a description of our training and consulting services. You will also want to acquire a copy of Jack Siegel's book, A Desktop Guide for Nonprofit Directors, Officers, and Advisors: Avoiding Trouble While Doing Good."
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