Compensation In Nonprofits
Compensation In Nonprofits: Why Variable Compensation Is An Important Consideration In The Design of Effective Compensation Packages
There is a long held belief by many people that because of the charitable mission of nonprofit organizations, providing market competitive or higher levels of compensation would merely be draining resources away from their mission. Since the history of many nonprofits can be tracked back to religious roots, this may have had some validity since social, medical and humanitarian purposes drove many of the original charitable actions of nonprofits. The argument in this situation is that the individuals who devote their lives to work at a nonprofit do not need any compensation beyond the barest of minimums. In other words, there is still a group, including some of the media, which believes that executives and employees working for a charitable organization should only have adequate compensation, since the individuals receive psychic remuneration for the good they do.
This may hold true for those that have devoted their lives to a religious cause, in which they are able to live in a protected and funded environment, but for the majority of individuals who are working at nonprofits, this is not practical or realistic. They must live in a secular world in which virtually everything costs money, and bread, milk and housing costs are the same, regardless of how the money is derived. Few individuals are independently wealthy to the point that they are able to perform work without some level of compensation. Put another way, when people are involved in a job search, they are not only looking for the opportunity to join where they can use and improve their skills, but are also seeking good pay and benefits, all of which will satisfy their individual needs. When an organization is recruiting new employees, the amount of compensation that they offer versus another organization is therefore one of the key factors that comes into consideration.
Many continue to believe that nonprofits should not attempt to go head to head in competition for qualified candidates with for-profit organizations within the labor market. This infers that those who work for nonprofits are of a lesser quality or capability, and therefore unable to get a job in the for-profit world. Although not every nonprofit will have the resources to compete at the same level of pay, this doesn’t mean that they should knowingly provide below-market compensation, or that they cannot be more creative in how their compensation arrangements are structured. Neither the Board of a nonprofit, nor its top management, will knowingly seek less qualified people to staff their organization, in order to save a buck! Nonprofits, like any other organization, for-profit or not, are running a business, and the success of its business is based on the most valuable asset of any organization - its employees.
Although many are driven to work for nonprofits in a desire to give back to the community, a properly constructed compensation package that provides fair compensation, with potential for rewards based on superior performance, will help tie these individuals to the organization, particularly in the case of high performers and qualified executives. Turnover of trained and qualified employees is a huge expense from three perspectives: the actual cost of recruiting and training, the lost opportunities related to not being able to get the “job done”, and the emotional burden placed on the other employees who have to shoulder the responsibilities for those who have left. In an nonprofit where every dollar counts, retention is a key consideration in the design of its compensation program.
Many perceive, by virtue of the name itself, that nonprofits do not make any profit, therefore, there would be nothing to “share” with employees, so there is a limited, if any, focus on the compensation program. Unfortunately, there are some nonprofits that have trouble sustaining themselves from a financial standpoint, and as a result, are less capable of supporting their mission and very existence. The reserve (profit) that is left over after payment of all operating expenses provides the funds with which to carry on their charitable role. nonprofits cannot offer a portion of this reserve as compensation for growing the reserve; this is referred to as private inurement.
However, there is nothing prohibiting the organization from crafting an incentive program where specific rewards are identified for achieving pre-established performance objectives relating to financial and/or operational results. For more sophisticated nonprofits, this becomes one of the means by which they help to achieve the main objectives of compensation: Attract, Retain, Focus, and Motivate. When these compensation objectives are achieved, there is a good chance that the organizational performance objectives are achieved as well, and will result in a healthy, successful nonprofit. Employees who succeed in this environment are the ones that grow with the organization, become its future leaders, and continue to contribute to the nonprofit’s on-going mission.
From a historical standpoint, nonprofits and government entities have been accused of providing low pay but very generous benefits. Previously, this was probably not far from the truth; good benefits were a cost effective way to raise an organization’s competitiveness without the greater expenses associated with higher pay. For many reasons, now this is no longer true. First, benefit costs have grown exponentially, whereas compensation costs have raised modesty in comparison. Second, the growing complexity of nonprofits have necessitated that they hire the technical skills required to operate and they have, therefore, had to compete directly with the private, for-profit sector. Another consideration is that many jobs are similar if not exactly the same as they would be in a for-profit company. Since the jobs are virtually the same, why should those in the nonprofits sector be paid differently, or less? Certain professional areas, most notably, Finance and Accounting, IT and Systems, Human Resources, as well as clerical and support positions, are very much in demand. In order to attract and retain these positions, the compensation that the nonprofit provides must be similar to, if not equal to that paid within the For-Profit marketplace.
The necessity of comparing pay levels and compensation components is critical, not only for the purposes of being able to hire employees in the general marketplace, but also in their retention. The issue of determining comparability has been made much easier and more realistic, when the IRS indicated that for-profit data could be used in determine comparability for Intermediate Sanctions requirements. Intermediate Sanctions specifically address disinterested parties, which generally refers to the paid senior management of a nonprofit; these are the individuals who are identified in Form 990 filings. However, it can be argued that the concept of recognizing for-profits as peers for pay determination really extends to all positions. Certain jobs have traditionally been the exclusive domain of nonprofits, but this separation has been blurred as for-profits have entered into traditional governmental and nonprofit areas, including healthcare, education, social service, operation of highways and airports, and even prison facilities. Similarly, nonprofits have ventured into territory once exclusive to for-profits, including insurance, transportation, hotels, restaurant and bars, plus a multitude of other non-traditional areas.
Another issue affecting the types of pay programs found in most nonprofits is the lack of a sophisticated Human Resources (HR) function. This is not meant to cast any dispersion on HR. Their role has generally been more administrative in nature, which includes handling a wide variety of typical personnel functions, including staffing, recruiting, record keeping, training, safety, payroll, general employee issues, policies and procedure, pay and benefits, and much more. In most instances, as the organizations have grown, they have often deviated from the standard ratio of HR professional to staff, from 1 to 100, to staffing ratios that leave time only for the basics of pay issues and prohibit dealing in the intricate aspects of compensation and incentives. There is a shift in the general HR community to become more strategic by providing critical thinking in the areas of employee recruitment, retention, compensation plan design, and pay-for-performance. A well groomed HR function will serve to meet the challenges that the competitive market places on attracting and retaining key individuals, through compensation programs that reward these individuals for their efforts, commitment, and leadership capabilities.
For a variety of reasons, many of which are neither no longer relevant nor correct, recognition and reward programs within nonprofits have been pretty basic, and not necessarily competitive. However, Boards of nonprofits, in conjunction with HR and senior management are now taking a much more aggressive look at their pay practices, and changes are occurring which in turn have necessitated the design and adoption of new and more main stream compensation programs.
WHY THINGS ARE CHANGING
The Board members of nonprofits have traditionally been made up individuals who have a strong belief in the mission and value of the religious, philanthropic and/or charitable nature of the organization on which they serve. In some bylaws there is actually a requirement that there be a defined relationship (i.e., users of the nonprofit’s services). However, because of recent legislation, the drive for good governance, and growing awareness by the Boards themselves, there is a significant increase in the desire to retain some Board members who possess strong financial and accounting skills, as well as successful business experience. This change has resulted in membership on nonprofit Boards that have become increasingly sophisticated from a business sense, including compensation acumen and knowledge about the value of jobs and trends in pay.
As the nonprofit industry matures, there is a greater recognition on the part of many Boards that nonprofits have to compete in a more aggressive labor market for top talent that includes both nonprofits and for-profit companies. There is no evidence that any Board would knowingly recruit for key leadership positions based on the applicants seeking lower salaries, particularly since lower pay infers less qualified individuals. Many positions within a typical nonprofits are not exclusive to nonprofits, such as a Chief Financial Officer or Chief Technical Officer, since the skill sets and experience of these and many other jobs are easily transferred to for-profit companies.
This is even recognized by the Internal Revenue Service, which provided for the use of compensation data from for-profit companies when calculating the competitive market value of nonprofit executive positions. The Intermediate Sanctions regulations contained in IRC §4958 established the tacit recognition by the federal government that compensation within NPs could consider the for-profit world. Having the IRS recognize the use of for-profit data in setting compensation levels goes a long way to “legitimize” this concept for use at both the federal and state level.
One significant impetus for the increased interest in nonprofit pay programs rests with the recently enacted requirement for transparency of compensation arrangements contained in various federal regulations (IRC § 4958, 457(f), etc.). The regulations require, among other things, that there is complete documentation covering all compensation arrangements, with no unwritten side deals. In March 2007, the IRS issued a report on executive compensation1, in which it provided an interesting insight into the need for complete documentation. Contained within the summary was the statement: “Although high compensation amounts were found in many cases, generally they were substantiated based on appropriate comparability data.” It is interesting to note, that one of the stated objectives of the IRS’ Executive Compensation Compliance Initiative is to “Increase awareness of compensation as a compliance issue with the charitable sector and establish an IRS enforcement presence in this area.”2 These statements from the IRS are very powerful: balance actual compensation levels with performance, and provide transparency to avoid issues of compliance.
WHY NONPROFITS SHOULD PROVIDE VARIABLE COMPENSATION
There is an overwhelming, growing, and recognizable need for nonprofits to actively compete in a “real world” labor market for the transferable skills of its labor force. This need requires that nonprofits not only recruit from that marketplace, but also be able to stand up to this market to which they may potentially lose their key staff. It is a rare organization that knowingly serves as a training ground for the rest of the labor market; in other words, expending the time and resources to recruit, train and then lose qualified employees to its competitors. This becomes particularly important for current and future leaders of the organization; qualified and talented individuals who are in a position to successfully fulfill the mission of the nonprofit, are key to its continued operation, and a well-structured rewards package along with a supportive work environment will serve to motivate and retain these individuals.
The use of variable compensation has a number of distinct advantages from a retention standpoint. The use of bonuses and incentives can raise the overall level of pay to competitive levels, making it less attractive to move elsewhere. Often, the variable compensation element is applied only to the top management positions. In reality, if properly constructed, variable pay consisting of bonuses and/or incentives can be used effectively at all levels within the organization. At lower pay levels, a small difference in pay between the organization and the marketplace can cause dissatisfaction, making a job with a 25 or 50 cent per hour difference seem like a lot. On an annual basis, this equates to approximately $500 to $1,000, which could be the difference it takes to aid in retention. Increase the difference to $1.00 and this is approximately $2,100 for the year or 10% to an individual paid $10.00/hour.
Bonuses tend to be much more subjective with the determination of individual awards based on a look back at an individual’s past performance and contribution. On the other hand, incentives require the establishment of goals and planning beforehand. This planning provides an added value to the organization, while giving the employees a road map of what is expected of them; specifically the goal setting process supplies the individual’s need to know what is expected, as well as requiring the organization to review performance at the end, and close the loop to indicate how well the expectations were met.
The typical compensation package within the nonprofit world consisted of two major elements; base salary and benefits. However, in order to successfully compete with the for-profit sector and in an effort to attract skilled business professionals and management, nonprofits have had to adopt executive compensation programs that more closely resembled those found in the for- profits, in variety, if not in total value. This compensation package now more commonly consists of five distinct elements, which include base salary, short-term incentives and bonuses, longer-term incentives, benefits and perquisites, and finally, employment and change of control agreements. As nonprofits begin to explore each of these components of the executive compensation package, the Board must not only consider the specific plan design issues, but also funding issues, and where appropriate, identification of performance measures upon which awards will be based. Even for non-management level positions, the use of variable compensation can be extremely effective for three reasons: 1) to enhance the nonprofits ability to attract and retain highly qualified talent; 2) to raise the amount of overall compensation, but tying it to the achievement of specific goals; and 3) recognize both individuals and teams for their contribution and performance. This last factor is consistent with everything we have learned about providing feedback and managing expectations of employees.
A word of caution is warranted, however, since if meaningful objectives are not established and awards are paid when not warranted, the program could become an entitlement. Should employees and executives be entitled to an award every year? Probably not, since this may be indicative of goals that are not enough of a stretch. Setting meaningful objectives is a critical ingredient of the variable compensation process. In effect, the question that is raised is: Are the goals worth paying for? Whereas objectives are often though about only in terms of financial measures, they can also be of an operational nature. Clearly, the nonprofit must have sufficient funds with which to operate and pay the variable compensation; however, meeting certain operational goals is of such importance that the funding can be considered as an investment towards their achievement.
DISCUSSION OF COMPNESATION ELEMENTS
For-profits and nonprofits swim in the same labor pool, and thus, nonprofits should provide compensation programs that contain similar, if not the same components, while offering something of value within the overall compensation package. The typical cash components often sought by executives coming into an organization, regardless of for-profit or nonprofit, include the following elements:
Competitive base salary that is commensurate with the executive's experience and predicated on the market value of that position.
Short-term incentives that act as the primary motivators of performance and provide a clear link between performance and ultimate rewards.
Long-term incentive compensation. that couples a retention device for key executives with a long-term capital accumulation opportunity.
THE SHIFT TO VARIABLE PAY PROGRAMS
Pay decisions in many nonprofits, as well as in many for-profits, have traditionally been based on length of service and, in some instances, the level of education of the employee. This system is still prevalent in many nonprofits; and is most evident in educational institutions and collective bargaining environments. Other common approaches to salary adjustments have been Across the Board Increases (ATB), Cost of Living Increases (COLA), and Step Systems in which the increases were tied to the length of service. In all of these salary increase methodologies, virtually all employees received increases, with the possible exception of a limited number of poor performers; virtually no system is provided to recognize and reward high performers. The “Holy Grail” of salary increases was to develop a method to allow companies to reward employees based on defensible and significant differences in their individual performance; in other words, a method to consistently reward them based on their contribution and evaluated performance. The concept known as Pay for Performance requires that the organization have the ability to accurately and consistently measure performance. As nonprofits have embraced the concept of performance management programs, this has provided the means for them to also Pay for Performance. Although this concept may not be universally accepted, it has become very mainstream for organizations to strive to reward based on performance and contribution. According to the American Society of Association Executives, 58% of responding organizations reported that job performance is the primary determinant of salary increases. With the capability to measure performance, nonprofits are now able to apply the performance factor used for the determination of base salary increases to short-term bonuses and incentives, and longer-term awards.
The shift from a compensation program consisting of salary only to a combination of salary (fixed pay component) and bonuses (variable pay component) is due to the recognition by many organizations that they need to be competitive within the labor market, while at the same time, controlling fixed costs. By tying a portion of the pay package to the achievement of specific financial and/or operational objectives, it is easier to justify paying the additional money needed to remain competitive.
Short-term incentives act as the primary motivators of performance. Linking the achievement of critical performance objectives to awards that vary based on the level of performance attained provides nonprofits with an opportunity to achieve its primary objectives of compensation (Attract, Retain, Focus, and Motivate), while rewarding those individuals who play a key role in the organization's leadership success with commensurate incentives. In order to achieve the full impact of short-term incentives, they must be just that - incentives. There should be no expectation on the part of the employee that the awards are automatic and irrespective of the level of performance achieved. Successful executives and employees realize that performance is a key driver of many compensation plans, and those that ultimately contribute to the on-going operation of the organization are those often recognized by the Board and the organization itself as its leadership team.
IMPORTANCE OF LONG-TERM INCENTIVE PLANS FOR EXECUTIVES
It is not intended that nonprofits should always compete head-to-head with the private, For-Profit sector. It may be difficult, if not impossible, to do so in most instances. For example, the largest portion of many executive pay packages, particularly in publicly-traded companies, involves the potential increase in the value of stock based long-term incentives. Although the value of the stock derives from increases in market value of the company, the actual money when the stock is cashed in comes from the marketplace, not out of the operating capital of the company. Since nonprofits do not have equity, and certainly not any marketable stock, the funds for such a long-term program obviously must come from the organization itself. This traditionally has been seen as a prohibition to any nonprofit organization that wants to offer a longer-term incentive. The real difficulty lies not only with the funding of such a program, but also with identifying appropriate performance metrics upon which to base the attainment of such awards.
Many nonprofits have instituted Supplemental Executive Retirement Programs (SERPs), a form of deferred compensation, as a means of rewarding their long-service top executives. Since these are considered to be non-qualified deferred compensation plans, they are required by the IRS regulations to contain a forfeiture provision, in which they are subject to forfeiture if the executive terminates prior to their regular retirement. In addition, the funds, even if set aside; remain an asset of the organization, subject to claims of creditors. Because of the risk of forfeiture and the prohibition on vesting prior to retirement3, SERPs also act as a Golden Handcuff since they offer a strong financial deterrent against early termination, thus further serving to tie the leadership team to the organization and motivating them to maintain a financial stable organization.
SERPs in general provide additional post-retirement income, and since they are not required to comply with Employee Relations Income Security Act (ERISA), they are provided selectively to members of senior leadership. As such, they have become an important part of the total executive compensation package. Traditionally, most of the SERPs that have been adopted by Boards provide a flat percent benefit (i.e., 70% of the executive’s highest salary for the last three years); these are known as a Defined Benefit (DB) plans. The amount of the benefit usually is based on competitive trends among peer organizations, rather then being based on any specific formula. Since the IRS tends to look favorably on compensation arrangements that are formulaic (as long as the formula does not lead to excessive compensation), some organizations utilize a standard methodology that takes into consideration years of service of the executive, with the higher level of SERPs being provided to the longest service executives. This formula provides for greater amounts of income replacement, based on the total number of years served. There is typically a cap or maximum, which sets the upper limits of the benefit. Since the tendency for most organizations is to implement the SERP towards the end of an executive's career, in most instances it does not matter which positions the executive held during their career with the organization, so that they receive credit for each year of service but at their highest pay level.
Based on recent trends however, there is a desire by Boards to move from the traditional Defined Benefit (DB) plan to a Defined Contribution (DC) type of approach in which the funding is spread over the career and the amount of the SERP is the sum of annual contributions and interest, rather than a fixed percentage of the executive's ending salary. It should also be noted that in many instances, Boards are now providing the SERP benefit to additional senior management participants, rather than only to the Chief Executive Officer or top executive. Under these DC plans, the size of annual contributions takes into consideration not only the years of service, but also the position level of the individuals in the organization, so that higher-level positions receive larger contributions (e.g., 10% annual contribution for Vice Presidents, 15% for Senior Vice Presidents, and 20% for the President). The main advantage of the DC over the DB type plans is that the organization has eliminated the requirement to provide a large and often underfunded amount associated with a defined benefit, and can alter the annual contribution, based on the organization’s annual financial capability.
To better meet changing needs, DC plans can be structured to provide a DC contribution along with the opportunity for participants to earn additional contributions based on achieving specified annual performance targets. Since this plan contains a performance element, it has the attraction and retention advantages previously mentioned, as well as providing an extra level of incentive. This makes this hybrid arrangement more like the long-term incentives typically associated with For-Profit companies, which are considered to be so attractive to executives.
Regardless of its exemption status, the ability of an organization to utilize a variable compensation tool to drive performance and retain employees is based on a systematic process for plan assessment, design, and administration. The following six-step approach may be utilized for a systematic approach to plan design.
Step 1 – Clarify the Organization’s Mission and Strategy:
There must be consensus among the Board and Top Management as to where the organization's focus should be, which performance goals to emphasize, and in some cases, what the role of the executives and staff should be. In order for the plan to be effective, these focus items must be identified and prioritized from most to least important. This strategy should be used in defining the concepts for the new plan.
Step 2 - Determine the Desired Mix and Amount of Variable Compensation:
The basis for the design of the executive compensation plan should begin with a determination of what the reasonable and appropriate compensation package is for the company’s executive positions. This is particularly important for nonprofits in light of the Intermediate Sanctions rules. Reliance on relevant and appropriate market data, including data obtained from comparable peers, is an important step in this process. In addition, the degree of variability should be defined, i.e., what will be the mix between fixed pay (salary) and variable elements (consisting of short- and longer-term incentives). A similar exercise should be undertaken for determining variable compensation for non-executive positions.
Once the compensation package mix is determined, the Board should define its Compensation Philosophy, to serve as the baseline for designing a new plan.
Step 3 - Develop a Draft Plan:
The various plan components are combined to create a plan that will achieve the organization's mission and Compensation Philosophy, with sufficient flexibility to adapt to changing internal and external conditions. The parts include, among other items, definitions of:
· Participation and eligibility
· Basis for payment of awards (performance metrics and weightings)
· Size and level of awards for different executive levels.
· Timing of awards (current year, defined performance period, career-based, or deferred)
· Establishment and measurement of performance targets and thresholds
· Award determination and funding
· Administrative rules
A key element of success is to design a plan that clearly relates rewards to performance. Once the Board and Compensation Committee approve the draft plan, it should be appropriately documented in a written format.
Step 4 - Model the New Plan:
To anticipate how the plan may operate once implemented, the organization should conduct a cost/benefit analysis to determine how the plan participant will be rewarded under different performance scenarios. Performance at target will relate to a reward that is typically at market. Not only will sufficient modeling help to highlight the organization's key performers, but may have the effect of spotlighting and ultimately eliminating the weaker members of the team.
Step 5 - Implement and Administer:
Communication is a key component to proper plan implementation and administration. This helps to ensure that participants understand the organization’s commitment to the plan’s success. The participants have a special interest in the new plan; the organization must clearly link the rewards to the desired performance objectives to be achieved. Care should be exercised when implementing a new or changed plan to avoid demotivating participants.
To ensure smooth implementation and to continue to focus the executive’s attention on the desired results, on-going communication and feedback are critical. Top Management, the Compensation Committee, and the Board should be active participants in this process and should be able to take immediate corrective action when performance falls below standards. Such a system continues to reinforce the organization's commitment to the plan’s success and can enhance the motivational effect on the participant to perform. It is critical that the rewards reflect the actual performance so that the plan's benefits do not merely become an expectation.
Step 6 - Monitor and Correct:
Periodic, on-going examinations of the plan's mechanics, implementation, and administration should be undertaken to ensure that the plan continues to meet its original objectives. If the results don’t match up with the expectations, the organization needs to examine why not, and take remedial action.
The success of any nonprofit is tied directly to its ability to meet the mission and goals of the organization. Having a motivated and focused team that embraces the organization's ideals, and benefits from their performance through a well-designed and meaningful reward system, will enable it to operate more effectively and foster the current and future leaders of the organization. Variable compensation can be a key element that enhances a nonprofit’s ability to attract and retain the right talent to do the job, and helps the organization to compete for employees among for-profit companies.
Report on Exempt Organizations Executive Compensation Project—Parts l and ll, March 2007bid. 2006 Association Compensation & Benefits Study, ASAE & The Center for Industry Research. Internal Revenue Code Sections 409A and 457(f).
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.