PAY FOR PERFORMANCE FOR EXECUTIVES IN TAX-EXEMPT ORGANIZATIONS By Marc Stockwell and Eric Chapman, Findley Davies

Transcription

1 The Magazine of WorldatWork PAY FOR FOR EXECUTIVES IN TAX-EXEMPT ORGANIZATIONS By Marc Stockwell and Eric Chapman, Findley Davies In the face of unique challenges, boards of tax-exempt organizations get creative with executive compensation. The tax-exempt sector represents a diverse mix of service-based organizations, including 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 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. 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. These constraints and limitations 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 2012 WorldatWork. All Rights Reserved. For information about reprints/re-use, copyright@worldatwork.org

2 TO COMPLY WITH INTERMEDIATE SANCTIONS AND TO FOSTER FAVORABLE STAKEHOLDER OPTICS, the boards of tax-exempt organizations must demonstrate the reasonableness and competitiveness of planned compensation for executives. and where provided is delivered in the form of either: Cash awards tied to performance measured over multiyear performance period (i.e., surveys indicate 10 percent to 15 percent of larger organizations with sophisticated performance planning processes tied to strategic plans) Performance-based SERPs with annual contributions tied to performance (long-term performance-based compensation; see Figure 2). to implementing reasonable and competitive performance-based compensation. (See Figure 1.) Prevalent Forms of Performance-Based Pay and Delivery Strategy Surveys of tax-exempt organizations across the United States indicate that: Approximately 35 percent of all tax-exempt organizations, without taking into account size, deliver annual incentive pay to their executive group. (See Figure 2.) Approximately 85 percent of larger, more complex organizations, such as health-care systems, deliver annual incentive pay to their executive group. These organizations tend to have more conditions favorable to incentive pay. Incentive pay tends to be much less prevalent in smaller human services organizations that do not have conditions that are favorable for performance-based incentive pay. Pay for executives of these organizations is generally limited to base salary. (See Figure 2.) The most prevalent form of longterm compensation provided by a wide range of tax-exempt organizations, regardless of size, is delivered in the form of supplemental executive retirement plans (SERPs) with fixed contributions or benefits tied to future service. This form of compensation is often provided in circumstances where conditions are not favorable to the delivery of fully competitive cash compensation or annual incentive pay (i.e., long-term fixed compensation strategy.) (See Figure 2.) Performance-based long-term compensation is much less prevalent, Pay Planning and Incentive Plan Design 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 provides more complete total compensation data, particularly for the executive director or CEO Figure 1 Conditions Favorable to Performance-Based Incentive Pay INTERNAL EXTERNAL Value proposition to management talent is both mission driven and success sharing. Measurement-based management and assessment processes in place. Highly engaged, sophisticated board with compensation committee structure. Formal strategic plan developed, documented and communicated to employees. Performance culture with defined accountabilities and goals that are aligned with the strategic plan. High-quality services that create competitive advantage and influence growth and financial performance. Incentive pay is prevalent within industry and peer organizations. Prospective talent have skills and knowledge that are marketable across industry segments that offer annual and long-term incentive compensation. National industry network and support structure in place as source of prevalent practice information. Reliable funding sources exist. Favorable stakeholder optics are prevalent. 38 workspan october 2012

3 Figure 2 Direct Compensation Delivery Strategy SHORT TERM (ANNUAL) LONG TERM (STRATEGIC) FIXED Service-based SERP -BASED Annual incentive opportunity Annual incentive opportunity Performance-based long-term compensation Figure 3 Total Compensation Elements and Target Mix B A S E PAY ANNUAL INCENTIVE PAY LONG-T E R M (Annual Earned or Accrued Value) NONTAXABLE BENEFITS PERQUISITES TOTAL MARKET $300,000 $90,000 $45,000 $25,000 $20,000 $480,000 PLANNED $300,000 $75,000 $65,000 $30,000 $10,000 $480,000 Figure 4 Incentive Plan Award Schedule DIMENSION FINANCIAL CUSTOMER ORGANIZATIONAL GROWTH WT. 50% STRATEGIC FOCUS Revenue growth and long-term financial sustainability Provider of choice Expand needed services that enhance financial sustainability F Y TARGET Increase net revenue by 8% Customer service rating of 90% or better Launch new service line at budgeted financial targets; meet service standards with credentialed staff 20% Assumed performance (organizational growth) 30% Assumed performance (financial) 35% Assumed performance (customer) 40% WEIGHTED EARNED AWARD 15% 8.75% 6. PERCENT OF BASE SALARY PAID 30% october 2012 workspan 39

4 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 THAT SHARE ORGANIZATIONAL VALUE. 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. Figure 3 on page 39 illustrates median market total compensation for an executive position, determined from access to peer group pay data and published surveys, and planned compensation targets for each pay component. In this case, the organization s total compensation philosophy and strategy is to: Target compensation to the executive at median market total compensation. Deliver performance-based pay in the form of annual incentive pay and performance-based deferred compensation. Relative to market pay, greater weight is placed on long-term compensation. Deliver modest perquisites compared to market value. Deliver supplemental nontaxable benefits in the form a flexible pool of dollars that can be spent on available nontaxable benefits that meet the needs of the executive. Annual Incentive Pay Plan 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. Figure 4 on page 39 illustrates where award opportunities (i.e., percent of base pay) are tied to performance levels achieved relative to target or planned performance results. Earned awards under this structure are conditioned on operating income or surplus after bonus being at or above a defined level, and maintaining all accreditation standards. Long-Term Compensation Plan Because of the difficulties in measuring and funding value growth in most mission-driven notfor-profit organizations, it is generally advisable to stay clear of long-term incentive plans that 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. While SERPs can deliver meaningful long-term compensation opportunity and, if properly designed, a strong retention incentive, they are generally not performance-based and can foster an entitlement mentality. Therefore, many board members in today s payfor-performance era are looking for alternative ways to deliver long-term performance-based compensation. One approach that is becoming more common is the performancebased SERP. This combines the planning and techniques used for defined contribution SERPs and the performance measurements of annual incentive pay. Referring back to the planned compensation illustration (Figure 3), the executive would be provided an annual SERP contribution at target of $65,000 pursuant to the overall compensation plan. The contribution would be earned through annual performance, perhaps pursuant to a schedule similar to Figure 4. Once determined, the annual contribution would be deferred into the SERP subject to a vesting schedule requiring future service. Some of the attributes of this type of plan are as follows: An account balance is maintained on the books of the organization in the name of the executive. The account represents a liability of the organization to the executive. Assets are set aside each year equal to the performance-based contribution and invested in marketable securities, potentially under the direction of the executive. Assets set aside remain the property of the organization and subject to claims of creditors (this is required to preserve the tax deferral). On a regular basis, the value of the executive s account is adjusted to reflect the value of the marketable securities. A legal plan document details the design of the plan, vesting provisions, timing of contributions and distributions, etc. The document specifies 40 workspan october 2012

5 compliance with key tax provisions Sections 409A and 457(f). As portions of the account become vested, the executive will be required to recognize taxable income pursuant to section 457(f). The plan may accommodate this by distributing either the taxable amount or the applicable taxes on the taxable amount leaving the remainder to accumulate tax deferred in the plan. At retirement, termination of employment or other date provided, the vested deferred compensation will be paid to the executive. All taxable amounts paid are reported on Form W-2. A performance-based SERP can deliver competitive long-term compensation assuming adequate levels of sustained annual performance. Conclusion Tax-exempt organizations, while structured in a unique way, need to provide meaningful rewards that 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 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 here Taking a total compensation planning perspective Taking 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 Aligning the compensation plan design with the mission and strategies of the organization. Eric Chapman is a senior consultant at Findley Davies in Toledo, Ohio. He can be reached at echapman@findleydavies.com. Marc Stockwell is a principal at Findley Davies in Toledo, Ohio. He can be reached at mstockwell@findleydavies.com. resources plus For more information, books and education related to this topic, log on to and use any or all of these keywords: Pay for performance Executive compensation Long-term incentives. october 2012 workspan 41