Nonprofit Musings

Lessons on Executive Compensation from the For-Profit Sector

I’m going to venture out of the nonprofit world for a moment to share some lessons from how two major corporations – IBM and Intel – are treating their executive compensation. 

Publicly listed corporations are now required by the Securities and Exchange Commission to file a detailed statement (the “Compensation Disclosure and Analysis” or CD&A) describing their executive compensation.  These disclosures can be very revealing, not only about levels of pay but also about the thinking behind them.

In my view, Intel’s most recent CD&A (available here:  Intel CD&A ) is a model of good compensation governance.  It lays out clearly and openly Intel’s compensation philosophy, processes, programs, and results.  While Intel executives are very well compensated, especially when the company is successful, executives are treated no differently than rank-and-file employees.  There are no special employment conditions or severance arrangements for executives.  Executives receive the same benefit programs as all other full time employees, supporting Intel’s objective of providing an egalitarian culture.  Reading this document, you get the strong feeling that this is the kind of company you would like to work for, or invest in.

By contrast, IBM’s CD&A (available here:  IBM CD&A ) is defensive and arrogant.  Instead of simply spelling out what it does and why, IBM begins its statement by patting itself heavily on the back for “putting tremendous effort and rigor into our own executive compensation process over many years.”  Next, it points out that its “unique integrated business model” demands “a senior leadership team of unusual depth, agility, and experience.”  My, aren’t we proud. . .

After describing how it sets salaries and bonuses, IBM quickly gets to another sore point:  executive perquisites, commonly described as “other compensation” in CD&A’s.  Here, IBM says that “additional programs (beyond those for employees in general) that are restricted to senior executive participation amount to less than 1% of their total compensation on average . . . and are limited to services with a direct bearing on individual productivity or security.”  Come on!  What they’re talking about here are things like corporate aircraft.  Saying that only 1% of total compensation goes to perquisites is the same as saying “we’re making so much money that our corporate jets get lost in the rounding.” 

There’s more of this in the lengthy IBM filing, the message being that although you may not like what we’re doing, it’s serving us well.  Maybe it is.  But the Intel filing is far preferable, the message being that this is how we see the world of compensation and our rationale behind it, and we think this serves all our stakeholders – including all our employees – well.

What can you learn from reading both proxies?  My guess:

• Honesty is the best policy.  Distortion of intent is obvious and counter-productive.
• An egalitarian approach to compensation – treating all employees within the same general compensation philosophy – is better than making the rich richer.  
• Giving stakeholders a say in compensation – Intel is among the first to allow a shareholder vote on executive pay – is better than trying to control everything from within.  

More Commentary on Setting Nonprofit Pay Levels

In his Harvard Business Review blog on nonprofits, Dan Palotta has two interesting new posts dealing with nonprofit compensation, Compensation Should Be Aspirational and Executive Compensation, Charities, and the Curse of Proximity. Both these posts and the related comments are well worth reading.  I am not sure I agree with all of Dan's points -- paying executive compensation based on aspirational goals before achieving such goals can be dangerous -- but they are well worth considering and a healthy balance to the many critics who believe that just because you're saving the world you should be making far less than someone running a modest for-profit business.

A Creative Incentive Plan for Nonprofits

One of my clients -- to whom goes full credit for every good idea in this post, but whose identity I am respectfully keeping confidential -- introduced me recently to an highly effective incentive plan design that other nonprofits may want to consider.

This is a fairly large nonprofit -- expense budget well over $100 million per year.  Their incentive plan covers all the key executives reporting to the Chief Executive Officer, about eight in number.  The target incentive is 3% of base pay -- it does not vary by position or level -- and it is an "all or nothing" incentive: an incentive bonus of 3% of base salary is earned or there is no payment.

For each participating executive, there are three performance criteria, all linked to the strategic plan. The first criteria, given a third of the performance weighting, is based on meeting the overall organization's financial operating budget for the year.  The second and third criteria differ based on each executive's responsibility, but each relates to specific strategic plan goals and each is weighted at one third of the total performance rating.

At the end of the year, performance for each executive is ranked against the criteria using a 5 point scale, in which point 3 is meets expectations, 4 is exceeds expectations, and 5 is far exceeds expectations.  An executive's overall ranking must be 4.0 or above to receive an incentive.  If this threshold is met, an incentive bonus of 3% of base salary is awarded.  If not, nothing is paid.

Why do I like this plan?

• It is a true incentive.  This organization sets stretch performance goals, and pays incentives only when performance is truly above average.  To this point, only 3 in 8 eligible executives received awards last year, and it is unusual for any given executive to receive an award more often than one year out of three.
• The target amount of the incentive -- 3% of base pay -- is not so large that it would encourage setting unrealistically low targets or fudging the numbers to achieve goals.  The awards are meaningful -- $3,000 to $6,000 typically, when earned -- but not life changing.  So top management can assess performance honestly, without the pressure that the potential for very high awards can sometimes bring.
• Management at this organization is always focused on what's right in terms of achieving mission, rather than what will produce year-end incentives.  They value the incentive program, but its mechanics and opportunity are not such that it would ever distract them from acting on the best interests of the institution.

I recognize that some nonprofits pay much larger incentives and that others believe that incentive compensation has no place in the nonprofit community, and that both views have merit.  However, if your organization has been considering incentives, modeling a program on the one described in this post would likely be a good way to start.

Equal Pay's a Long Way Away

Having begun my compensation consulting career in the late 1960's, when some employers were still willing to openly defend their rationale for paying women less than men in equal jobs, I would have expected by now that, all things considered, men and women in positions of equal responsibility were generally paid comparably in this country.

Not so.  In a thoroughly researched and well written article, my friend Deborah Eisenberg -- a Visiting Assistant Professor at the University of Maryland School of Law -- demonstrates that pay discrimination is still very much with us, and greatest at the higher levels of management.  The article is well worth reading, and can be found here:  Shattering The Equal Pay Act's Glass Ceiling.

They're at it again!

In a November 30th article in the Boston Herald, reporter Adam Smith (no relation, fortunately) slams Boston area nonprofit executives for "raking in pay and perks" over the past year.  "As the worst recession in decades stripped thousands of Bay State workers of their jobs," he writes, "a small group of people saw greenbacks continue to fatten their paychecks:  the leaders of the state's top tax-exempt organizations charged with aiding the poor, mentally handicapped, and other disadvantaged residents."

The source of Smith's data is of course the IRS 990 forms, which as I've pointed out in previous posts are measuring compensation paid mostly during pre-recession times.  Particularly galling to Smith are executives who earned more than the President of the U.S., six of whom are featured in his article (two of whom, by the way, took pay cuts last year).  

Why observers continue to think the $400,000 the President earns is a benchmark for anything is beyond me.  The salary in no way reflects the enormous responsibilities of the position.  And these compensation critics never factor in little perks the President gets, like a nice mansion to live in, chauffeured limousines everywhere, private aircraft, a bevy of personal chefs, and a $400,000 retirement benefit for life.  The President's position is not an appropriate market comparison.  Can you imagine a nonprofit CEO candidate saying to a Board Chair "Gee, they're offering me the Presidency, and that pays $400,000 -- what are you offering?"  

I have no idea whether the CEO's Smith attacks are paid reasonably, but neither does he.  It would be nice to believe that reporters approached personal subjects like this ethically, but that of course would be naive.

Smith's full article can be found here:   Charity Heads Home

Are Published Compensation Surveys Accurate?

Experiences with two recent clients have raised some red flags about using typical published surveys to evaluate executive compensation.

Both of these clients had previously hired established, well-known consulting firms to evaluate the compensation levels of their senior executives.  Both consulting firms had carefully matched job descriptions to reputable survey data bases and both had used multiple survey sources to support their findings. 

But actual data from IRS 990 forms showed that in both cases, the consultants’  findings were wrong.  Both consultants significantly underestimated competitive market values, especially for top executives. 

Why?  It turns out that the organizations participating in the broad surveys the consultants used were not representative of the organizations with which my clients are in direct competition.  In one case a survey peer group contained 16 organizations with the same type of services as my client and in the same broad geographic region.  But all but one were in lower cost of living areas with salary levels substantially less than a dozen comparable organizations in my client’s immediate market area.

A consultant’s recommendation for another of my clients, an independent nonprofit hospital, was based largely on a compensation survey in which the vast majority of participants are subsidiaries of organizations like Kaiser Permanente and Catholic Healthcare.  Data on the CEO and CFO and other key positions was representative of these positions operating within a larger system, but significantly under the typical compensation levels for leaders of fully independent organizations.

The standard surveys published by firms such as Hay, Hewitt, Towers Perrin, and my former firm – Watson Wyatt – clearly have value.  But if you are going to use them, you should take the following steps:

1. For top positions, check the survey data against the IRS 990 form data for directly comparable organizations.  The 990 data is a bit out of date – but you can update it by 4 or so per year % (maybe 2% for 2009)  and usually get a dependable reading.
2. Obtain a listing of all the organizations in the published survey peer groups against which your data is being compared, to ensure that the group is representative of your organization in terms of mission, structure, size, and geography. 
3. Develop customized peer groups from the participant listings in the published surveys – most of the largest and best known surveys now allow you to do this.  
4. Make sure you understand any assumptions your consultant is using to adjust data from the published surveys.  Common adjustments include aging data to make it current, increasing or decreasing the market values reported for positions that are presumed to be stronger or weaker than positions in your organization, adjusting for regional salary differentials, and weighting data to give more emphasis to surveys the consultant believes are a best match.  These can all be reasonable and useful adjustments, but you should understand them and the effect they have on the conclusions reached.

 

Nonprofit Salary Budgets for FY 2010

A number of clients have asked me recently what to expect for nonprofit salary increases in the coming year.

The short answer is that while no one knows for sure, there is clearly pressure to reduce salary budgets for FY 2010, with a number of organizations freezing compensation.  At this point, my guess is that average salary increases for nonprofit employees will be between 2.0% and 2.5% in 2010, down from the typical 4.0% to 4.5% over the past ten or fifteen years.  And nonprofit executives may get even less.

A quick survey of my clients shows that first and foremost, what organizations are doing with compensation depends very much on how the recession is specifically affecting them.  In organizations that are cutting back on programs or staffing in material ways, none of the top executives are taking salary increases this year, and others are cutting their pay -- a few by as much as 10 or even 20%.  

In most of these cases, the decision not to take a salary increase (or to reduce pay) is being made by the Executive Director, who then informs the Board that this is what he or she would like to do.  This is partially because these individuals believe this is the right thing, and partially because it is a stronger message optically to announce that the ED requested a pay freeze (or cut) than to announce that the Board decided independently to take this action. 

That said, not all organizations are reducing or freezing pay.  Some are in a growth mode and are going ahead with modest increases.  Some are giving lower increases than they originally planned.  In all of these cases, the organization's funding has not been seriously threatened; there have been no layoffs (except perhaps some pruning of weak performers); revenues are continuing to grow.

The situation with incentives is a bit more complex.  One of my clients has suspended bonuses this year -- none will be paid -- and isn't certain whether there will be any payments next year.  But bonuses in this organization are typically 5% of pay or less -- maybe 10% for the ED -- so while they are not unimportant, they are not a highly significant part of total compensation.  The President of another client voluntarily took a substantial cut in a bonus targeted at about 30% of base pay -- even though the Board had evaluated her performance as exceptional.  And a third client, whose financial situation remains relatively strong, is letting its bonus payouts operate normally, with no reduction.

The bottom line here is that compensation decisions should be in line with both financial results and the messages you are sending to your employees and the community.  It's important that employees be treated fairly and that their compensation is sufficiently competitive in your labor markets to reward and retain them.  At the same time, it is vital that the nonprofit community not waste its challenged resources, and that pay decisions are reasonable in light of economic circumstances.

Should Executive Directors Serve On Their Own Boards?

There is one aspect of governance where non-profit organizations are way ahead of their counterparts in the private sector:  in most cases, the board is chaired by someone other than the chief executive.  While there is considerable debate on this practice in the private sector, my view is that separating the powers between the CEO and board chair is highly effective in strengthening governance. 

Some commentators on nonprofit governance argue also that the chief executive should not be a voting member of the board.  Their argument is essentially that full separation between trustees and management strengthens governance. 

I was on this side of the argument until a few years ago.   At a conference on improving nonprofit governance, arranged by Senator Chuck Grassley, the topic of CEO participation on the board came up.  Amidst arguments on both side of the issue, Pat McGuire – President of Trinity University in Washington D.C. – told a story that powerfully demonstrated the value of full board membership.  “Last year,” she said, “our board decided that we were going to have to make some deep staff cuts.  This was tough news for our campus, and it was far better for me to be able to say that we decided to make these cuts, rather than to say that they decided.” 

As full board members, executive directors have only one vote, hardly enough to turn the tables on important decisions.  There are times – such as setting their own compensation – when executive directors need to be excused from the discussion and the voting.  But having a full voice on the board is much more likely to strengthen both their credibility outside the board room and the deliberations inside the room, than to cause any governance problems or conflicts.

A Different Take on Nonprofit Pay

In a recent post, Dan Pallotta makes an interesting argument about non-profit pay.  It's well worth reading.  The blog is here:  The "Psychic Benefits" of Nonprofit Work Are Overrated.  

Good Effort But Misleading Results: the Chronicle's Pay Survey

The Chronicle of Philanthropy has just released the results of its 2009 CEO pay survey (for the full article, click here: Chronicle Survey).   While the Chronicle researchers have made reasonable efforts to upgrade the quality of their reporting, the survey is misleading in some important respects.

The biggest problem is a confusion of years.  The headline says that median CEO compensation rose by 7% in 2008, when in fact the majority of their data is no more current than June 2008, and data from 22% of the 325 respondents is from 2007.  For most people, the impact of the current recession did not really become clear until mid-2008 (the Dow Jones average was above 12,000 on 6/30/08).  So few nonprofits would have been slowing down or eliminating normal annual salary increases during the period for which the Chronicle survey measures salary growth.

Yet in their cover story, the Chronicle states that “the large increase in compensation for nonprofit leaders is especially noteworthy considering the sharp drop in pay earned by for-profit executives” and cites an Equilar study to support this claim.  But the Equilar study covers the full year 2008, which ended with the Dow Jones average at 8,776, down 27% from the June 30 level.  Many corporations’ fiscal years are also calendar years; much of corporate executive compensation comes in the form of stock grants, which of course were not producing expected gains by year-end 2008.  So the Chronicle is trying to compare nonprofit compensation increases given during a period of at least apparent economic prosperity with for-profit reductions occurring during a sharp, deep recession.  This is hardly fair.

As further evidence of the Chronicle’s bias, they claim that inflation during the period of nonprofit increases was “virtually nonexistent”. The majority of these raises (median of 7%) were given between July 1, 2007 and June 30, 2008, during which period the consumer price index rose by 5%. 

In some respects, this survey is done better than others recently published.  For example, the researchers excluded from the comparisons employees whose compensation was inflated due to a one-time payment, such as severance or a pension payout.  They worked to achieve a representative sample, bringing in organizations who didn’t make their size parameters in under-represented areas.  And while I’m not certain of this, they apparently limited the sample only to organizations whose full data was available for both years. 

Further, much of their commentary focused on a supplementary survey seeking information on whether nonprofits were freezing or reducing pay this year.  Reading the entire article, you do get a fairly good picture of what’s going on with nonprofit executive compensation today.

But this survey again demonstrates the problem with combining research with news.  The coverage is more interesting when there are things to criticize – note the photos of 5 well paid executives on page 11 (and Jeff Raikes of the Gates Foundation on page 1) contrasted with the three who took pay cuts shown on page 12.  The media should focus on unbiased reporting, and leave compensation surveying to the experts.

Charity Navigator Compensation Survey Update

I just had a productive phone conversation with Ken Berger, Charity Navigator's CEO.

Following my recent post on some issues with their CEO Compensation Survey, Charity Navigator has amended its publication to clarify that some of the compensation reported, such as that for the President of the University of Delaware, includes cash payouts of deferred compensation and not just salary or other annual compensation.  This is an important improvement in the accuracy of the study.

Charity Navigator is also reviewing its compensation survey procedures and is considering implementing diagnostic procedures to prevent potential inaccuracies in the year-to-year CEO compensation comparisons  

Mr. Berger is clearly interested in further strengthening the metrics with which Charity Navigator assesses nonprofit organizations and reports its research findings.  This is encouraging.  

How much is too much? Assessing nonprofit executive pay.

High compensation for nonprofit leaders, such as the recently reported $1 million pay for Michael Govan, Executive Director of the Los Angeles County Art Museum, often creates a outcry for federal limits on nonprofit executive compensation.  The concern is understandable, but much that’s been written about this is off the mark.

Critics objecting to high levels of nonprofit compensation often hold one or more of the following views:

1. Pay for leaders in nonprofits should be reasonable in terms of competitive levels for similar nonprofit executives,  and the expectations of donors and funders of charitable organizations.   As such, they should almost always be below those paid in the private sector.
2. Pay for nonprofit leaders should be less than some arbitrary standard, such as the salary of the President of the United States.
3. Nonprofit leaders should work primarily for the psychic income of fulfilling important missions; compensation should not be an important factor in recruiting or retaining leaders.
4. The world is full of competent leaders who would work in nonprofit positions for compensation that critics deem reasonable.

The article’s main theses are:

• Except for the first point above, with which I fully agree, most critics of high nonprofit compensation don’t have a good understanding of the dynamics of nonprofit leadership or of the pay required to attract and retain top talent.
• Setting an arbitrary standard to limit nonprofit executive compensation would be a mistake, with damaging unintended consequences.
• Existing controls – board oversight, the threat of fines and sanctions, and public review -- provide sufficient control of nonprofit compensation, even at the top.  But these controls could be strengthened.

This post will attempt to deal with these issues.  It's a long post, so you may want to read it in segments, or you can print a pdf version by going here.  

Managing Nonprofits Can Be Highly Complex

Imagine you are the CEO of a YMCA in a major metropolitan area.  You are responsible every day for hundreds of children in dozens of locations; you need to structure operations and supervision so that none of them are lost or injured or abducted or drowned.  This is in addition the normal responsibilities of ensuring financial health, raising funds, coordinating with city and state authorities, developing and motivating staff, etc.  Few for-profit positions have a similar level of complexity and risk.

The same can be said of presidents of universities, who must combine significant fund-raising expertise with sufficient diplomacy to influence diverse constituencies (faculty, students, alumnae, trustees) to uphold and improve educational excellence.  Ditto for hospital CEO’s, with their financial and regulatory imperatives and diverse constituencies.

Leaders of these organizations and many other types of nonprofits are responsible for much more than revenues and profits – they nurture individual growth and development, heal and comfort the sick, shelter the homeless, protect the battered, and in hundreds of other ways improve our communities.  Yes, almost all of them are willing to do this for less pay than their jobs would be worth in the private sector.  But that does not mean that their pay should be limited to some arbitrary number.

Good Leadership Makes a Difference

One thing I have noticed in my nonprofit work is that there are usually four to five organizations that are considered the leaders in each city’s nonprofit sector and that these leaders vary considerably by type of service provided.  In city A the top charities might include a foundation or museum, in city B it may include the Girl Scouts or an animal welfare charity, in city C it may include a hospital or a homeless shelter or a zoo.

Whether a cause or result of their success, these top charities almost always attract a high level of contributions.  Community leaders want to serve on their boards, where doing so is a badge of honor and acceptance.  These charities usually do a good job of measuring outcomes clearly; they have a strong track record of success; they are financially stable. 

These charities are not the community leaders just because of what they do – there are always equally worthy charities not in the leadership group.  Sometimes their leadership results from a significant economic windfall – the Marin Community Foundation comes to mind.  But almost always, somewhere during the organization’s growth, an inspirational, highly effective leader brought its performance to a level where it’s achievement and value became clearly apparent to the most important and influential individuals in the community.  And their involvement – encouraged by this leader – contributed exponentially to its success.

Now let’s assume you are a trustee of a nonprofit looking for a new leader and you want someone with the potential to build the organization to one of the premier nonprofits in your community.  Or to turn around an organization in trouble.  Or to greatly enhance the organization’s ability to achieve its mission.  The pool of potential candidates includes existing executive directors, nonprofit managers just below the ED level, and for-profit executives, either active or recently retired.   Any of these candidates could be independently wealthy, willing to work for little or even no compensation.  

But why limit your search to those willing to accept below fair pay?  The candidate pool undoubtedly includes qualified people with children in college or other financial needs, without independent financial resources, for whom a decent salary is very important.   The best leaders may come from this pool.

Why capping pay is wrong

For most nonprofits, the type of caps being proposed is immaterial – few pay their top people close to $400,000 or $500,000.  But for the small percentage of nonprofits who do pay this level of compensation, caps would create serious problems. 

First, any pay limit set by the IRS on Congress other governing body would be arbitrary.  The most common suggestions are limiting nonprofit executive pay to the salary of the President of the U.S. (currently $400,000) or the $500,000 base salary limit being applied by the Treasury Department to organizations receiving government funding under the TARP program.  But neither of these numbers reflect the value of the work being performed – they are just politically expedient numbers the public can more readily accept.

Second, any cap would undoubtedly be unfair to nonprofit executives whose scope of responsibilities genuinely reflect greater value than the cap itself.  Limiting pay for university investment professionals or basketball coaches or heads of cardiology in medical schools to $400,000 or $500,000 would result in a unsustainable gap between what they can make in the private sector and what nonprofits could pay.

Third, it is likely that a pay cap would lead larger nonprofits to look for other ways to compensate their top people, through expanded benefits, or added time off, or job sharing, or special fees, in order to keep their best talent.  The government might try to preclude this through legislation beyond the pay cap, but such legislation would be very complex and costly to administer. 

Fourth, the pay cap could actually result in higher compensation for leaders of smaller nonprofits – those below the pay cap.  Even $150,000 or $200,000 is higher compensation than the vast majority of nonprofits should be paying their executive directors today – most charities are very small.   Providing an official ceiling of $400,000 or $500,000 could put pressure on trustees to raise executive compensation more quickly than they would do absent the cap.

Finally, in the largest nonprofits, a pay cap could cause salary compression, with many executives earning close to the cap even though their responsibilities are substantially less than those of the CEO, creating serious inequities in the compensation structure.

There is a Solution

You won’t get rid of excessive pay entirely in nonprofits, no more than in any other sector.  But there are good steps that can be taken to lessen the incidence of egregious pay.

First, the IRS should use existing sanctions more forcefully.  These sanctions (commonly called the “intermediate sanctions”) enable the IRS to fine trustees and tax executives in cases of egregious excess compensation.  But these sanctions apparently are rarely used.  They may be saddled by budget constraints, but I think the IRS should be more aggressive going after apparently excessive compensation.

Further support should come from publications such as the Chronicle of Philanthropy or the Chronicle of Higher Education, and organizations such as the Independent Sector or Charity Navigator.  Some of these organizations may be reluctant to bite the hands that feed them, but as the Chronicle of Philanthropy has shown, pointing out specific cases of potential abuse can create change. 

Most important, the Boards of Trustees should do their homework with a thorough periodic review of top officer compensation.  This review should address these questions:

§  Does the organization have a compensation policy, and if so what is the intended position of the organization’s compensation against the peer groups to which it will be compared?  If the intended position is above average (e.g., 75^th percentile), is this strategy supported by the organization’s size and complexity and/or the background, experience, and performance of the executives being reviewed?

§  Is the peer group against which the organization being compared truly representative, in terms of size, mission, scope, and geography? 

§  How does the top executive’s market position compare to that of other executives and employees in the organization?  If the CEO is the only executive at the 75^th percentile while everyone else is at or below average, is there a clear justification for the difference?

§  How transparent is the entire compensation package?  Are there special benefits or perquisites that apply only to the top officer, and if so is there a justification for this?  Will this justification stand up to public scrutiny?

With strong board oversight, a stronger and more active IRS, and aggressive publicity about questionable compensation, we can strengthen nonprofit compensation generally and reduce the incidents of abuse.

Pete Smith is the President of Smith Consulting.  The former CEO of Watson Wyatt Worldwide, he now provides executive compensation consulting services to the nonprofit community.