By Marc Stockwell.
The tax-exempt sector represents a diverse mix of service- based organizations consisting of health care organizations, charitable/human services organizations, private foundations, trade associations, and rural cooperatives. These organizations compete for the best leadership talent by offering a unique and compelling value proposition that includes a balance of mission served, performance challenges, engagement of diverse stakeholders, and competitive compensation. While each tax-exempt organization is unique in its mission, all face a similar challenge in leveraging the use of scarce resources to best serve the mission and sustainability of the organization. The boards of many of these organizations are increasingly turning to both annual and long term performance pay plans as the most effective method of aligning the interest of executives with those of stakeholders, and providing competitive compensation.
Unique Challenges Facing Tax-exempts in Delivering Compensation to Executives
Tax-exempt organizations face unique challenges and limitations in delivering compensation to executives. These include:
- Performance measurement and funding of awards.
- Statutory and regulatory limits under IRC Section 457(b) and 457(f) on the level and structure of deferred compensation.
- Requirement under IRC Section 4958 to demonstrate a rebuttable presumption of reasonable compensation delivered to disqualified individuals that would include most if not all executives of the organization.
- Maintaining the support and engagement of key stakeholders including employees, members, donors, and the community who may view levels of compensation delivered to executives as excessive despite being prevalent, aligned, and competitive.
- Inability to offer equity based compensation as a “stake” in the growth in value of the organization.
Overcoming Challenges with Effective Design and Favorable Conditions
The constraints and limitations referenced above can be effectively dealt with through careful application of design techniques, access to relevant peer group total compensation data, and most importantly by having in place organizational conditions that are favorable to implementing reasonable and competitive performance based compensation.
Pay Planning Techniques
To comply with intermediate sanctions (IRC Section 4958) and to foster favorable stakeholder optics, the boards of tax exempt organizations must demonstrate the reasonableness and competitiveness of planned compensation for executives. Incentive pay opportunities made available must be evaluated in the context of the total compensation plan (i.e., base salary, incentive pay, benefits, and perquisites) for each executive or disqualified individual. Published industry surveys typically provide reliable market cash compensation values tied to size and scope of the organization, but do not provide the value of other forms of compensation delivered to executives. A useful source that does provide more complete total compensation data, particularly for the executive director or CEO position of peer organizations, is Schedule J of the 990 Return. In addition to providing base and incentive pay awards, the annual value of deferred compensation and nontaxable benefits is reported for each individual subject to the reporting requirements.
Annual Incentive Pay Plans
Incentive pay plans covering executives of tax-exempt organizations typically have the following components:
- Multiple metrics that reflect financial and mission based performance expectations
- Scaled award opportunities expressed as a percentage of base pay and tied to defined performance goals.
- Capped award opportunities
- “Circuit breaker” performance thresholds that must be achieved before earned awards are paid.
Long Term Compensation Plans
Because of the difficulties in measuring and funding value growth in most mission driven not-for-profit organizations, it is generally advisable to stay clear of long term incentive plans which share organizational value. This is in contrast to plans of for-profit organizations which are almost exclusively connected to shareholder value. The objectives are nevertheless similar….to attract and retain key employees by providing meaningful long term compensation opportunities tied to the success of the organization.
As mentioned earlier, the most prevalent form of long term compensation among not-for-profits is SERPs. SERPs can deliver meaningful long term compensation opportunity and, if properly designed, a strong retention incentive. However, SERPs are generally not performance- based and can foster an entitlement mentality. Thus, many Board members in today’s pay-for-performance era are looking for alternative ways to deliver long term performance based compensation.
One approach that is becoming more common is the “performance based” SERP. This combines the planning and techniques used for defined contribution SERPs and the performance measurements of annual incentive pay. A performance based SERP can deliver competitive long term compensation assuming adequate levels of sustained annual performance.
Tax exempt organizations, while structured in a unique way, need to provide meaningful rewards which are aligned with its overall mission. The different stakeholder interests, special tax rules and regulations proscribing rules for reasonable compensation standards present a unique challenge for governance. While arguably the landscape is more complicated than most for profit entities, there are a variety of methods that can be used to provide both short and long term forms of compensation.
Designing and implementing an effective, performance based executive compensation plan for a tax-exempt organization will require:
- Creating and maintaining conditions that are favorable to delivering competitive performance based compensation as summarized above;
- Taking a total compensation planning perspective;
- Action by the board or a designated compensation committee to annually establish a rebuttable presumption of reasonable compensation by following the approval, reliance on comparability market data, and documentation procedures set forth under IRC Section 4958 regulations; and
- Aligning the compensation plan design with the mission and strategies of the organization.