Getting Paid — Part III (The Final Chapter… For Now)

[Note: Raising the issue of excessive CEO salaries prompted a lot of comments from readers, most off-line, and additional posts from me. But here are my final words on the subject, at least for a while. A friend, knowing that I was having knee surgery during these weeks, and noting the tone of my critiques on executive compensation, told me the pain must be making me cranky. There’s some truth to that. Here’s one last blast – then on to other things next week.]

In my last post I talked about how CEOs of private foundations get paid too much. I didn’t say that the president of a particular private foundation was overpaid – simply that, as a rule, CEOs of private foundations receive much higher salaries (a median of $466,500 for large foundations) than the demands of their job would seem to justify.

So how did these extraordinary salaries come about? One driver, ironically, seems to be the set of instructions from the IRS designed to ensure that the salaries of nonprofit CEOs did not climb out of control.

The IRS tells nonprofits that they need to have a structured process for determining executive compensation; that those in charge cannot have a conflict of interest (in other words, the CEO’s spouse or the CEO’s number two person shouldn’t be on the compensation committee); and that the organization needs to use data that indicate “the amount that would ordinarily be paid for like services by like organizations in like circumstances.” That all seems well and good. But we’re still looking at extremely high salaries for private foundation CEOs. How did that happen?

Here’s what I think is going on. When a foundation board is setting the compensation for its CEO, it looks at what comparably-sized foundations (some of which may be located in communities with a higher cost of living) are paying their CEOs. Because most boards are either fond of their CEO or at least highly dependent upon him or her (and not at all eager to search for a new one), they tend to pay above the average for comparable organizations. The other foundations respond in kind. Up and up goes the CEO compensation. Salary inflation at one institution leads inexorably to higher salaries at all.

There’s a similar dynamic among CEOs of nonprofit hospitals. There was a bit of a kerfuffle recently here in New Hampshire thanks to a report on the salaries paid to the CEOs of the state’s 23 nonprofit hospitals. The total CEO compensation at one hospital exceeded $1.3 million, with CEO salaries and benefits of $600,000 to $800,000 being the norm for the larger hospitals. I will openly admit that running a hospital is an almost mind-numbingly complex job – far more difficult than running a private foundation. These CEOs work hard and most seem to be doing an excellent job. And yet: the compensation levels seem out of proportion to what constitute top salaries in the area and what other staff are paid at their institutions.

There was a very good editorial about this issue in the Concord Monitor, which cited a study showing that no hospital boards want to pay their CEO less than the average for an institution its size – and that they commonly start their compensation discussions at the 50th percentile and shoot for a salary that’s in the range of the 75th to 90th percentile. As the editorial notes, “That creates a ratchet effect that only moves upward. “

That “ratchet effect” is the key: if every hospital board wants its CEO to be in 75th to 90th percentile, then every CEO’s salary will go up, steadily and relentlessly. It’s like Garrison Keillor’s Lake Woebegone, “where all the children are above average.” After a few years of matching and beating the average compensation level, you end up with a situation where the CEO is earning a salary that’s out of whack for what other top professionals earn in the community – and hugely more than what the average employee in the hospital is earning.

When scrupulous adherence to best practices leads to such severe salary distortion, perhaps we should start questioning the best practices themselves. Even when the decisions reached by the compensation committee seem frugal, they’re really not. For example, one hospital touted that its CEO earned only a 4% average annual raise in recent years. That small percentage translates into a large average salary increase (4% of $660,000 is $26,400) that only distanced the CEO farther and farther from what the nurses and physicians’ assistants and other frontline staff earn.

Nonprofits need to be cognizant of how people will react to the news of large CEO salaries. There is a corrosive effect on staff morale and the image of the institutions (and, therefore, their ability to attract donations) if they pay their chief executive an amount so out of proportion with the community norm. And simply because other institutions in nearby cities do the same thing does not make it right.

I’ll go back to the point I made in my first post on the subject of salaries: most nonprofit staff members are underpaid. In my practice I work primarily with community-based nonprofits, and I don’t know a single one that couldn’t use additional revenue. These organizations are balancing their budgets on the backs of staff members (including the CEOs) who are overworked and paid very modestly.

So when CEOs in certain sectors attract attention for the unjustifiable incomes they receive, it hurts both their institutions and the nonprofit sector in general.  I suggest that foundation and hospital boards freeze the salaries of their CEOs for the next few years, not as punishment, but in recognition that executive compensation has gotten out of hand. (I doubt that any of the CEOs would suffer materially if they were to forego a raise.) Moreover, the CEOs should consider making meaningful financial donations back to their institutions. And in setting executive compensation, boards in the future should pay significantly more attention to the community and institutional context of the salary levels, and a bit less attention to what similar organizations in other cities are paying.

Copyright Alan Cantor 2012. All rights reserved.

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