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Executive Compensation in Non-Profits – Risky Business

How times have changed. In the past eight to 10 years, there has been a significant shift in the general public’s attitude about compensation.

The meltdown of the financial markets and market turmoil that followed provided an unusually stark background against which some spectacular instances of executive compensation excess were spotlighted for all to see. These few instances of “lottery ticket winners” in the midst of the general public watching their own economic situations horribly erode may not have been just the most recent insult to sensibility, they could be the last.

Significant new disclosure requirements and mandatory shareholder votes (non-binding at least to this point) on executive pay were included in the Dodd- Frank financial reforms. The Occupy protests further solidified sentiments against corporate greed, excess, etc. Finally, the 2012 general election campaign exploited the public’s hostility toward the “top 1 percent or 2 percent.”

These developments in the for-profit world have largely been responsible for conducting more and more of executive compensation in full view of shareholders and the general public. At least one commissioner of the SEC observed that these changes are to “ affect the behavior of companies and boards rather than to provide information that investors would find useful.”

Over the years, the nonprofit sector has adopted many pay practices found in the for-profit sector. The focus on being competitive, more sophisticated approaches to pay, etc., have become a routine topic of boardroom discussions. Outside board members have undoubtedly introduced some of these changes and the competition for management talent has also prompted these developments. Similarly, changes to Form 990 requiring more disclosures about executive pay as well as instantaneous access to these forms online have provided a window for the public to see almost as much as any publicly held company would reveal in its proxy.

I’m observing what I believe is an end to some of the similarities for the nonprofit group and that is what prompts the “risky business” title to this short article. As noted in several of my previous Nonprofit Standard articles, I believe that nonprofit organizations have long been held to a different and higher standard than those in the for-profit sector. The general public believes that the “nonprofit” designation means more than simply exemption from tax. Many believe it implies low or no compensation regardless of the complexity of the organization and accountabilities associated with its management.

So, you might ask “What’s risky? What’s my point?”

I am referring to some developments and potential developments at the state level that set limits or a “cap” on pay for executives. Often in response to the same types of bad examples we’ve discussed here in the past, some states have enacted or proposed to enact legislation that will place a limit on how much an executive may be paid and even a prohibition on any compensation for a board member.

While Florida, New Jersey and Massachusetts have proposed limits on compensation for certain nonprofit executives in their states, New York has enacted legislation that sets a cap of $199,000 in New York state funds for all forms of compensation paid to any executive in a social service organization receiving the majority of its funding from the state or by virtue of being state-certified. (On Mar. 13, New York announced yet another postponement of the implementation of this legislation until July 1, 2013.) The regulations make provisions for higher compensation in some situations, but the process for doing so is complex and will require annual activity on the part of the organization to continue the higher pay.

In New York and the other states mentioned, a fixed cap amount has been set as a limit for pay with little or no consideration of the size, type or complexity of the organization nor the requirements of an individual qualified to capably manage it. Where the specific amount comes from is not clear; perhaps it is some other reference point like the highest paid appointed official in the state or just a number (e.g., $200,000) which is “all that anybody needs to be paid.”

The risk here might not be obvious to state officials or many in the general public. Placing a cap, especially an arbitrary one, on executive pay impedes an organization and, in extreme cases, I would submit could harm the organizations the government aims to “help.” Past experience and human nature generally suggest that the introduction of any new regulation imposes time and cost pressures on those organizations affected as they assimilate, apply, interpret and in some cases develop ways to escape or minimize any inconvenience or impact that might be produced.

Another type of risk that might be encountered is a limitation on the type or caliber of individual that can be attracted to an organization to manage it. Please understand, I am not suggesting that compensation is the only consideration when an individual makes a decision about joining an organization. It is not. Nor am I suggesting that paying more always attracts individuals that are more qualified or more capable. It does not. There is, however, some correlation between pay and qualification that cannot be overlooked. There are those highly accomplished and well-to-do individuals who can work for a “dollar a year,” but they are few and far between. I have also seen organizations with impassioned employees dedicated to their mission start to experience high levels of turnover as “maturity” and family responsibilities start to make financial demands no longer satisfied by low pay.

One state, Massachusetts, has proposed legislation that no board member of a nonprofit organization be allowed to receive compensation. When the state’s largest health insurance organization, a multibillion dollar organization, resumed paying its board members, the message from the state was that no “public charity” should pay its board.

Hospitals and higher education institutions are also being cited more frequently as examples of organizations with leadership pay levels viewed by some as excessive for a nonprofit. Both types of organizations are under considerable scrutiny for increasing costs. Pay becomes an easy target for those looking to find causes or scapegoats for them.

It is not unreasonable to believe there is a demand for capable management in the nonprofit sector just as there is in the for-profit sector. And these capable individuals distinguish themselves in their ability to achieve better results by delivering more or higher levels of service from similar resources and innovating new and different ways to accomplish objectives and fulfill the mission. There is competition for these individuals and, at some point on some level, reasonable expectations about compensation must be met.

The risk here is that arbitrary caps or onerous regulations on pay will eventually cap the caliber of talent that can be attracted to manage the organizations upon which so many people depend to do good. The governing bodies of all nonprofit organizations must be ever more diligent in their stewardship of the organization’s pay practices, especially for leadership positions. Compensation is a critical component of the organization’s management system and must be managed as diligently as any of the organization’s key systems. The board needs to create a tailored program for compensation that is fully aligned with and supportive of the organization’s mission.

Compensation committees and board meetings are excellent forums for discussions of how to structure pay and how much to pay for leadership positions. Outside advisors and information sources offer a good context for deciding what is best or right for a particular organization to do. Detailed meeting minutes and explanations in Form 990 offer excellent opportunities to communicate the rationale to interested parties outside the organization. Organizations that make the best use of these will assuredly fare better in their efforts to manage pay well.

Simply trying to pay the most is no more defensible than paying the least. Competitive conformity, doing what everyone else does, is equally reprehensible. Rest assured, those who do not thoughtfully manage their pay practices will have it managed for them as the government is always “willing to help”.

This article is written by Michael Conover, Senior Director, Specialized Tax Services at BDO.

This article originally appeared in BDO USA, LLP’s “Nonprofit Standard” newsletter (Spring 2013). Copyright‚© 2012 BDO USA, LLP. All rights reserved. www.bdo.com

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