Executive Compensation: The Process, Pitfalls And Opportunities

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Executive Compensation: The Process, Pitfalls And Opportunities

The National Association of Independent Schools recently mailed an important notice about benchmarking executive compensation using “Stats on Line” for members and how this resource can help to satisfy IRS reporting requirements. This article complements the NAIS memo.

Most non profit boards are now familiar with the requirements of the Intermediate Sanctions Act which applies to US based 501c (3) organizations. If they have established 457(f) non qualified deferred compensation plans for their heads or CEO’s, they must learn now about Section 409 A of the Internal Revenue Code. (See www.JLittleford.com for information and articles on these regulations.) Section 409 A has made non qualified plans less attractive except for the younger and mid career head who is likely to stay for a few years.

The NAIS Bulletin did not focus upon the importance of the PROCESS of compensation decision making; the key patterns observed among boards and heads engaging in this process; and the various “buckets” of compensation among heads and other top executives of non profits.

Today most non profit boards have appointed a compensation committee whose annual charge is to obtain information about the current market “value” of their head of school or CEO and to benchmark and decide upon his or her compensation package accordingly. If they have not formed such a committee, it is time to do so.

Compensation committees appropriately are taking more and more time to ensure that they have up to date “safe harbors” documentation that complies with IRS requirements on head/ CEO and key employee compensation packages. “Key employees” are usually defined as the top five highest paid individuals in the organization, and in some schools this even could be a senior teacher. For safe harbors purposes besides the Head and/or President, the CFO and perhaps the Assistant Head would be of greatest interest.

This article points out some of the nuances and “tricky” aspects of safe harbors analysis and the behavioral patterns which this consultant has observed and perceived in facilitating over 2500 compensation reviews of heads of independent and international schools and CEOs of other non profits and charitable foundations. Those patterns and observations are not simply interesting, they are informative, important and often powerful tools from which to learn. Boards need more than just raw data to comply with the latest IRS regulations. This includes international school boards who are not worried about IRS requirements but want to benchmark their heads’ compensation packages. All boards need EDUCATION about what lies behind compensation data and how to use that information to attract, retain, motivate and retain their heads.

    1. The Compensation Committee

The compensation committee should be comprised of three to five board members-usually the board chair, the compensation committee chair, the finance chair, and a past chair and/or vice chair. The larger the committee, the more complicated the process and thus the more difficult it may be to reach a clear, concise and prompt conclusion. This is because each member of the committee would like “buy in” to the final decision and wants to feel a degree of personal ownership for some aspect of the process and the outcome.

The professions of those serving on the committee can have a dramatic effect on the outcome. We all act from our personal background and experiences. Those with corporate CEO and COO experience and those in the venture capital and investment management fields tend to be the end to pay less, again largely stemming from how their own compensation is delivered, i.e., usually by billable hours, project management or civil service standards. They see the world of compensation very differently. Educators, those with personal wealth, and homemakers also tend to influence pay toward the lower end. For these reasons, the mix of committee members is important in order to ensure all perspectives are represented.

Regardless of the mix of personalities or professional and personal backgrounds, according to this consultant’s experience, 99% of professionally facilitated contract discussions can and do reach closure within four hours. Complications may arise when a committee member fails to observe the rules of good governance, i.e., allowing a personal agenda, such as an incident involving the head and his or her child, to influence his or her thinking or not wishing to give way to the majority view in the room.

    1. Charter and Board Approval

While it seldom occurs, and most committees tumble over this topic, the compensation committee should have prior board approval to act on the board’s behalf to set the compensation and oversee the annual evaluation process of the head of school. Compensation and evaluation are parts of the same process and should be entrusted to one committee.

In this consultant’s experience, almost all such committees at some point in the process question their own scope of authority and whether they must take their recommendation back to the full board for discussion and approval or whether the committee is empowered to act on behalf of the Board. It is preferable to make this determination in advance by having a simple and clear charter in place. In any case, legally the entire board has the right to know the head’s compensation.

    1. Conflicts of Interest

In this day and age, those with a potential conflict may not serve on this committee. That includes all potentially “interested” parties, especially employees, relatives, and VENDORS. Vendors include architects, project managers, lawyers, insurance agents or any others whose firms are conducting business with the school. While the conflict of interest issue may be skirted in some way to allow these individuals to be board members (although not advisable), they cannot serve on a compensation committee. Their participation could invalidate the process.

    1. “Tricky” and Political Issues

What constitutes a potential violation of “safe harbors” from the point of view of the IRS? What compensation disclosure might draw an audit resulting from a complaint by a parent, alum, teacher, or newspaper article? What might prompt the imposition of penalties as called for under the Intermediate Sanctions Act?

There are tricky elements to safe harbors analysis. In one state in which this consultant has many clients, there is a cluster of highly paid heads whose total packages are clearly in the 95th percentile or higher nationally. They are all within about $50,000 to $70,000 of each other. Generally, it APPEARS that it would be acceptable for a package to be number one in its category and/or region for safe harbors purposes, as long as it was not substantially ahead of the close competition. How does the organization or school, and ultimately the IRS, judge what is “too far ahead”? This question goes to the core of why the integrity of the database used to benchmark the package becomes so critical and why it is risky to rely solely upon published statistical data that may be inaccurate, incomplete or and quite often inconsistent.

What if, in this example, one or two of the higher paid heads in this cluster retire and a head who was in the fourth position in the group before NOW rises to the top position? What if that new placement was also significantly above the next highest? NOW, what constitutes “safe harbors?” MIGHT it be necessary to REDUCE that head’s salary or pay it out differently to ensure compliance with safe harbors limits? Most likely, yes. This is why annual updates based upon accurate data are so important-the dynamics change constantly as new packages are negotiated and heads relocate or retire.

Potentially the composition of the compensation package, that is, the “buckets” or types of compensation paid, could attract IRS attention as well. In Littleford & Associates’ analyses, we ask client schools to consider eighteen possible different kinds of compensation. The more unusual the practice, the more risky it is. One school built a stock option plan similar to the business world. What made this practice unwise was that a safe harbors comparison would find few, if any, other schools providing the same compensation structure.

Another school provided unusual education assistance for the head’s children, and another provided several club memberships, some in locations that to an outsider would appear to have no reasonable connection to the school’s interests. All of these schools were trying to meet the head’s needs. But again, the key is obtaining expert knowledge about what would be considered an aberration in the realm of most generous in pay, responding to their sense of a leader adding value to the bottom line. Professionals, from lawyers to doctors to accountants, independent school compensation patterns, and thus possibly be considered an “excess benefit” in the eyes of the IRS or even the charitable trust division of a state attorney general’s office.

Can you compare a head of school’s salary with the position of a college president? There are a number of independent school heads who were college presidents, or moved from schools to the college president’s role. There are others who are frequently solicited to put their hat in the ring for a search for a college president. Our sources tell us that small colleges then become a reasonable and fair comparison for purposes of safe harbors analysis. Having letters of interest from a college or university would be important to retain.

One School found itself the object of an alumni attack, and its ferocity prompted a “seeded” article in a national newspaper. That in turn caused the State Attorney General’s Office to undertake a review of the School’s practices on a range of compensation and governance issues mentioned in the article. Every state has different rules and interpretations of excessive compensation for non profit executives, as determined by its own charitable trust division. These can be influenced greatly by local politics, culture and history.

In this particular case, the State opined that the Head was overpaid and required the Board to reduce the package and to keep all future percentage salary increases in line with that of the faculty going forward.

In making this determination, the State used for comparison only other independent schools within that state. Within that State the Head was paid about $100,000 more than the next highest paid Head. Among similar schools nationwide, the Head’s package ranked among the top five but not at the very top. In its defense, the School was national and international in nature and caliber with significantly more resources than other independent schools in its state, and it would always seek a national candidate. A file of detailed written evaluations of the Head’s performance would have greatly helped the School’s case. To no one’s surprise, the Attorney General’s audit lead to an IRS audit.

An IRS audit of another School was prompted by newspaper articles, picketing and general union agitation about the school not using union labor for a construction project. The union zeroed in on the head’s compensation to attract attention. No change in compensation occurred as a result of this audit, as far as we know, but the aggressive attack on the School’s Head over an issue of economics and savings and its carryover to the federal tax authorities caused considerable stress.

In another case, a parent in a fury over a tuition increase organized other parents who researched 990 forms. While the parent group had no idea how its School and others fill out 990’s and what the compensation numbers listed really represent, they found, in their minds, a correlation between a tuition increase and an increase in the Head’s salary. The tuition and the head compensation increase probably had nothing to do with one another, but the Head’s tenure did not last much beyond this organized attack. There is much variation from school to school on how data and information are reported and this is another reason why these forms, readily available on the Internet, can be dangerous in the hands of the misinformed.

    1. Comparables and the Importance of Evaluation

What constitutes a comparable group of schools or institutions for purposes of safe harbors analysis for IRS and state charitable trust standards? While this may differ by state, and even by interpretation of agent or official, the following factors are generally taken into consideration: location and region tuition levels, enrollment, budget, physical plant size, endowment, and mission.

However, for comparison purposes, compensation committees should not just consider schools in the same area or of similar enrollment or endowment size. Why? Few schools would limit their search for a new head to a narrow geographic region or only to schools with an endowment of $X, for example. Thus safe harbors limits relate not only to what similar organizations are paying but what it would take to hire and retain a replacement head or CEO of similar experience and caliber.

What about the head’s age, experience and performance? If a head is very senior in age and experience, cannot the school pay at the higher end of “safe harbors?” One would suppose the answer is a guarded “yes” IF the Head has a proven DOCUMENTED track record of achievements relative to clear established goals.

Performance is important, more important than most boards realize. It is wise to have a clear, transparent (but not bureaucratic or overly “democratic”) annual review in place. The head evaluation process should be based upon a manageable number of goals; driven by a compensation committee which analyzes and summarizes the input; and involving at some level the entire board both in the initial goal approval process and the confidential evaluation at the conclusion.

Many schools do not undertake such a process at all. On the other extreme, our Firm has found “360” evaluation to have serious political pitfalls. In one school, both the Head and the compensation committee felt that the head evaluation process could be improved. Several board members suggested incorporating aspects of a 360 model which had worked well in their corporate settings. The Head was only in his second year, and felt anxious about soliciting faculty and parent feedback about his performance. His predecessor had lasted only two years. The head before that one had lasted three years.

This consultant raised transition and governance issues which the board had not considered at all. The 360 evaluation model is always risky in school cultures, which behave in very different ways from corporate ones, but it is potentially even more so in transition situations where the head has had insufficient time to build political capital with key constituent groups.

While there is certainly no absolute rule, our analysis of the compensation patterns of mid size to larger independent schools of national and regional reputation shows that this pattern tends to hold true: The highest paid administrator below that of the head is paid double that of the highest paid teacher; the head is paid double that of the highest paid administrator not including housing.

  1. The Head’s Role in the Process and Patterns of Behavior

A head compensation review should, whenever possible, not be limited just to data gathering. Every process of a head compensation review should provide an opportunity for a head of school to express an opinion about future compensation and aspirations for a change in structural terms.

Having witnessed over 2500 of these presentations over 25 years, Littleford & Associates has been struck by these patterns:

Most heads have not assessed correctly the tone and direction of the board members who comprise the compensation committee. During these discussions, board members will make comments that tend to surprise a head in a major way. Sometimes these are pleasant surprises, such the conservative frugal board member who supports a major salary increase or the seemingly critical chair who becomes extremely complimentary of the head’s performance in this venue. At other times the board members are far more critical of the head in his or her absence, and were the head present, he or she would be hearing these criticisms for the first time.

  1. Often the committee is surprised by the head’s “reflections” about the job and its pressures.
  2. Heads often want to be compared to a named list of similar schools. Sometimes the committee members do not consider this list the appropriate one or do not wish to include some of the higher paying schools. This is a normal response by both parties.
  3. Most committee members want to be sure that they can defend the compensation decision if the 990 data becomes public.
  4. Almost no chair or board member present in these meetings has ever seen a 990 form much less seen their own school’s 990 form before or after it is filed. This is an unfortunate situation that can come back to “bite” the school. Board chairs, finance chairs and heads should always review it and understand the rationale behind the numbers.
  5. Most board members are surprised to learn that about one third of schools do not file 990 forms. That is because many are or claim to be affiliated with a church organization and are thus exempt from filing. Others just do not file for no apparent reason.
  6. Some schools and nonprofits list the head or CEO’s name and salary among the board members rather than among the top five paid officers. Others choose to report the head’s compensation with another entity, such as a foundation managing the endowment assets. While some of these appear to be subterfuges to avoid public scrutiny, some seem to reflect genuine auditor or business office confusion about the rules.
  7. Most committee members have never seen the head’s contract until the committee meeting.
  8. Most contracts are fair to both parties. A few are stacked against the head, usually in the termination language. In those instances when the contract clearly favors the head’s interests, one almost always finds a situation where the head exerts more power than the board.
  9. About 95% of all heads today have written multi-year contracts.
  10. Most contracts are not sufficiently clear on provisions for termination, if other than for “cause.” A school might terminate a head with no further pay and cite “cause” where “cause” in that contract might include “lack of performance.” This is a risky definition of “cause” as any new set of board members can change expectations for performance.
  11. Within four hours, most board committees can review a compensation analysis for safe harbors purposes; reach a compensation decision; and close the feedback loop by conveying that decision to the head and receiving his or her reaction.
  12. Boards find the head compensation process fascinating, informative and eye opening, and almost always will convey that to the head when he or she reenters the room for the final discussion.

Summary

Many schools and other non profits still have not formed compensation committees, and the head evaluation process is still an informal conversation between head and chair. The formalization of such processes is important yet need not become bureaucratic or overly legalistic.

The head compensation process is an important facet of hiring, retaining, guiding, evaluating, developing and caring for a head of school. It is also a process with follow up documentation that is now mandated by law. The documentation ideally should include not only the Rebuttable Presumption of Reasonableness Checklist” recommended by the IRS also but a supporting “Safe Harbors” letter from a compensation consultant.

Littleford & Associates undertakes the compensation review process on behalf of nonprofit boards worldwide. Our firm works exclusively for boards on this topic, not heads/CEOs. However, both heads and boards find the process open, healthy, reinforcing and to a great extent, a marriage renewal process that meets the needs of both parties and covers the legal bases as well. Our data comes from benchmarking schools and non profits for over 2500 schools and similar entities for the past 24 years and from updating that data through personal feedback and communications with heads and chairs as well as analyses of the 990’s.

John Littleford
Senior Partner