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Trusteeship Magazine

Setting Presidential Compensation: What Board Members Need to Know

By Joseph S. Johnston
January/February
2015

An improperly handled decision on executive compensation can put individual board members—and presidents—at legal and financial risk.

Many boards defer and delegate too much, abdicating their collective responsibility for setting compensation to the board chair or a small group of board members. High-performing boards will develop a compensation philosophy statement and authorize an appropriate group to take the lead in recommending presidential compensation for the full board’s approval.

Two aspects in federal law and regulation are particularly important when setting executive compensation for nonprofit, charitable institutions: intermediate sanctions and the rebuttable presumption of reasonableness.

Do you know the total amount and elements of the compensation package provided to your college’s or university’s president? Do you know the rationale for the decision to provide the particular compensation and benefits chosen? Was the final compensation package discussed with the full board before approval? Did you take part in the approval of the president’s compensation and benefits? If you are a member of a governing board and would answer “no” to any of these questions, your institution may not be achieving best practices in governance.

If yours is an independent institution, you may even be out of compliance with Internal Revenue Service (IRS) regulations and guidance. And you, personally, as well as your president and fellow individual board members, may be at some legal or financial risk.

Setting executive compensation in a fair and effective manner can be a daunting challenge. It resembles the task that Homer’s Odysseus faced in the Strait of Messina of navigating between the two sea monsters, Scylla and Charybdis. At all costs, Odysseus had to avoid both features—menacing shoals and a deadly whirlpool. Today’s board members must likewise strive to avoid two evils. They cannot, on the one hand, fail to attract and retain the best candidates to lead their institutions, fail to remunerate their presidents fairly for their efforts and market value, or fail to motivate them fully. On the other hand, they must also be prepared for the inevitable scrutiny of compensation packages by the government, the news media, and various stakeholders.

Boards, however, have an important advantage over Odysseus. Avoiding Scylla meant passing too close to Charybdis, and vice versa. Boards, by contrast, have at their disposal a proven way of navigating their perils—a process we set out in the remainder of this article. That process can go a long way toward ensuring that decisions about compensation will produce good results. It can also protect institutions and boards as a whole—and, importantly, presidents and board members as individuals—from bad ones.

Key Laws and Regulations

Two aspects in federal law and regulation, in particular, speak to setting executive compensation for nonprofit, charitable institutions: 1) intermediate sanctions and 2) their compliance safe harbor, the rebuttable presumption of reasonableness.

Intermediate sanctions first appeared in the Internal Revenue Code in 1996. They are penalty taxes that will be applied to certain tax-exempt organizations (including nonprofit colleges and universities, but generally not public institutions) determined to have paid an “excess benefit”—a benefit exceeding the intrinsic value of what was received by the charity. Such penalty taxes will be levied on any insider, or “disqualified person,” who receives an excess benefit and on any organizational manager who approves such a benefit knowing it to be excessive. These sanctions are termed “intermediate” because, while imposing penalties, they stop short of completely revoking tax-exempt status. (It does happen!)

The IRS defines a “disqualified person” as someone in a position to exercise substantial influence over the affairs of an organization, a definition that may include board members, executive officers of the organization and their family members, founders of the charity, substantial contributors, those with sway over its expenditures, and others. “Organizational managers” potentially include members of governing boards and any committees that approve compensation. These are the types of people who are at risk of any finding that they either benefited from or approved “excess benefit transactions.” Paying an institution’s president what the IRS deems excessive salary and benefits could clearly represent an “excess benefit transaction,” subject to intermediate sanctions.

Intermediate-sanction penalties aren’t trivial. A president on whom they are imposed would be personally subject to an initial tax of 25 percent of the excess benefit. In addition, he or she would be required to repay the excess benefit to the institution. Much steeper penalties come into play for the president if those taxes aren’t promptly paid.

Of concern to board members should be the IRS stipulation that any board member who knowingly approves such a transaction is personally subject to an initial tax of 10 percent of the excess benefit, up to a tax of $20,000.

What exactly is “knowing participation”? A board member knowingly participates if he or she has actual knowledge of sufficient facts that indicate the transaction confers an excess benefit. Even silence or inaction or abstention can be participation.

Also of importance is the transparency around violations of the law. An independent institution must disclose on its IRS Form 990—a public-record document— whether it has had an excess-benefit transaction and paid the penalty tax. An indication that it has is certain to draw the public’s and key stakeholders’ attention to the governance of the college or university.

Establishing the rebuttable presumption of reasonableness is another key regulatory concept. The process it describes is also a good governance practice that provides a welcome answer to concerns about intermediate sanctions. The law doesn’t require that boards follow this process, but if they do, the compensation paid is “presumed” to be “reasonable,” and it becomes difficult for regulators or litigants to pursue claims of personal liability against board members. Establish this presumption, in other words, and, as an individual and a board, you have effectively entered a legal safe harbor.

What is this prophylactic process? Let’s review the IRS regulations and then their practical application. The regulations tell us that compensation paid by a tax-exempt organization is presumed “reasonable” if three conditions have been met:

1) An authorized body (the full board or a committee) whose members have no conflict of interest approved the compensation arrangement in advance;

2) That authorized body relied upon appropriate data (for example, industry surveys or the report of a compensation consultant) as to comparability; and

3) It documented (in board or committee minutes or other records) its determination concurrently (before the next meeting of the board or committee or—if that is later—60 days after the final action is taken). Documentation should ideally include the general terms of the arrangement, relevant dates, the names of those who attended the discussions and those who voted, the data relied on, how it was obtained, and the rationale for the decision.

A Recommended Process

These laws and regulations, although not widely known to those who serve on governing boards of private institutions, should motivate board members to understand the rationale for a compensation decision, to be sure that it is appropriate, and to make their judgments (and even their dissents) on it a matter of record. Being a backbencher on compensation—not actively reviewing compensation materials and recommendations and approving or disapproving them—is a poor governance practice and a failure to satisfy a trustee’s duty of care.

Fortunately, compensation is an area in which the dictates of law and regulation are consonant with best practice in governance. Boards of independent colleges and universities can comply with the former and achieve the latter through a series of common-sense steps that those institutions’ presidents and individual board members may well want to encourage. As a governance practice, the boards of public colleges and universities will also be able to employ such steps to their advantage.

High-performing boards will:

Authorize an appropriate group to take the lead in recommending presidential compensation. The days when a president’s compensation can be handled as a private matter between the board chair and the president are long gone (and should never have arrived in the first place). Governing boards should spell out the steps they expect will be taken before a salary-and-benefits package is recommended and then, under a board resolution or bylaws provision, charge those tasks to a group that can implement them effectively.

Currently, many boards use their executive committees for this purpose, while others use their budget, audit, or governance committee. Some create an ad hoc group, then shut it down and recreate it, as necessary. The best practice— and a growing trend—is a dedicated compensation committee, consisting of properly qualified board members who focus on this critical and complex area in a continuing way, year to year.

Whichever group takes on the responsibility, its members should possess knowledge of higher education, business acumen, or experience in relevant areas of the law or in human resources. The group should have institutional memory within it and the leadership stature to carry out its responsibilities. No members of the group should do business with, or be employees of, the institution.

The group should have its own chair, appointed as provided in the bylaws or resolution. Although that may be the board chair, a better choice would be someone else who can provide a critical check and balance in reviewing compensation. In any case, the board chair should serve on the committee, perhaps ex officio, as he or she probably will have more personal experience than others in working with, and evaluating the performance of, the president.

The group should have all necessary support from, for example, the human-resources staff, the executive assistant to the president, inside or outside legal counsel, and consultants. (The committee should have authority to retain consultants without presidential approval.) The president has an important role in providing staff assistance and information regarding his or her preferences as to compensation. (He or she has a still larger role if the authorized group recommends or determines compensation for other senior administrators.) Collaboration with other committees—executive, audit, budget, governance, or any presidential search committee—is essential. The group recommending compensation should also seek out current budget parameters so its recommendations will not be dead on arrival.

Approve a compensation philosophy statement. A board-approved compensation philosophy is a vital touchstone for the authorized group’s work. It articulates the fundamental goals and objectives of the board in setting salary and benefits at the institution, often as they apply to all employees. It may indicate, for example, that the college or university will remain competitive with comparable institutions, will target the median of compensation or some multiple of it (for example, 90 percent or 110 percent), will strive for internal equity, and will ensure compliance with all nondiscrimination laws. The authorized group will then:
 

Take part in the negotiation of the initial and subsequent employment agreement(s). The board group that recommends compensation is a good choice for overseeing the negotiation with a new president or the renewal agreement for a continuing one. Its work in a search should actually begin even earlier, as it should provide the salary range that a search consultant can provide to candidates. In any case, it should be centrally involved. The tasks to be done include: 1) preparing the written employment document or having it prepared by legal counsel, 2) ensuring it is legally compliant and clear, and 3) negotiating any desired changes with the selected candidate or incumbent president. Although in-person negotiation will probably be with the board chair, those charged to recommend compensation should be involved in the deliberations so their experiences and resources can inform the process.

Too much informality regarding terms of employment puts everyone at risk. A written contract that codifies basic agreements is best practice and simple good sense. At a minimum, its elements should include: the term of the appointment, the compensation package, evaluation and review expectations, basic performance goals, and understandings with regard to termination on various grounds. The written document can be made more comprehensive in time by mutual consent.

Select an unimpeachable peer group and analyze the compensation offered by those peers. Although most colleges have identified supposed peer groups, few of those lists are highly defensible. Some colleges choose aggregations of institutions that are too large or disparate to be reliable as comparison groups. Of those colleges that use smaller groups, too many combine a few nearby institutions with which they compete in athletics or admissions with a few others that, wishfully, they hope will someday bear comparison.

For purposes of setting compensation in ways that stand up to the scrutiny of the IRS and other interested third parties, the bar should be set higher. The institution should choose a true peer group in light of a number of factors, including not only control (public or private), religious affiliation, mission, region, and programmatic structure, but also the quantifiable dimensions of the operation, such as enrollments, endowments, faculty salaries, selectivity, budget size, and the like. If institutions to which a college aspires are factored in, they should be viewed as members of a separate “aspirational” peer group—a galaxy of distant stars whose gravitational pull is felt, but whose current influence may be relatively slight.

The task for the group is then to secure information about the salaries and benefits paid to the presidents at the closely comparable colleges. Of interest with regard to salaries are the range median, mean, and percentiles. In the case of benefits, information on the categories most commonly offered—such as housing, a vehicle, club membership, deferred compensation, and performance bonus—may suffice.

But the justification of more-complex compensation packages may require additional research. Securing the needed data can be challenging. Some institutions belong to consortia that exchange compensation information, and some are well-equipped to comb through IRS 990s for data on benefits.

Institutions are usually better off, however, retaining the services of a compensation consultant. Most such professionals are expert, impartial, and able to provide advice on peergroup selection, to obtain good data, and to fit their recommendations to it. Another very important advantage: If an individual board member relies on a reasoned written opinion from an appropriate professional, the IRS will not normally consider his or her participation in an excess-benefit transaction as “knowing,” and as such he or she will not be subject to intermediate-sanctions penalties.

Help evaluate the president. An annual evaluation is an essential source of information for setting compensation. However, because it properly serves a larger set of purposes than those within a compensation committee’s charter—for example, ensuring mutual communication, anticipating emerging issues, deepening the president’s understanding of board expectations, and the like—it is best done by a group expressly created for the job. That may be a standing or ad hoc group, but it should include, among others, the chair and—to ensure coordination and an easy flow of information—a member or two of whichever committee or group recommends compensation.

A good process, one that is effective and respectful of the concerns of all parties, can take various forms. But it will always take as its touchstone the goals and expectations set out in the president’s current contract— themselves reflections of articulations like the institution’s strategic plan. Requirements of confidentiality should also be spelled out to protect the rights of the president and to help those involved feel that they can be open and candid within the process.

The annual process begins with a written self-evaluation, discussed in private with the president and reviewed by the board committee. The board chair or the assessment committee can then meet with the president to share thoughts—what’s been learned, significant aspects of the president’s strengths and achievements, and opportunities and concerns that need to be addressed. Those last become reference points for the next year’s evaluation.

The chair of the board then shares with the full board the general results of the committee’s and president’s conversations. That kind of assessment— without focusing on compensation— will nonetheless provide key quantitative and qualitative guidance relating to it.

Fit the package to the president, institution, and other local realities. The group authorized to recommend compensation best takes the lead in speaking with the president about that subject—particularly exchanging thoughts as to the types of compensation and benefits that would be of greatest value to him or her, the optimal timing of such remuneration, and the amounts to be tied to such variables as length of service or possibly performance. The package presented at the end of the process shouldn’t be a surprise or fait accompli.

The Accountability of the Full Board

Finally, the authorized group should recommend the new compensation package to the full board and secure board approval. Most boards defer and delegate too much, abdicating their collective responsibility for setting compensation to the board chair or a small group of board members. That habit has proved to be a recipe for trouble and unwelcome headlines. A chair is the first among equals, not an executive. And even a properly charged, properly constituted, and very diligent compensation committee is just that—a committee. Neither the chair nor any committee should have the authority to finally approve compensation. Only the full board should.

The authorized group should therefore offer a full written report on its analysis and recommendations to the board and seek its approval. And it is every member’s fiduciary responsibility to ensure that the process followed has been effective and compliant with the law—and has produced an end-product consistent with fair market value and common sense. While board members don’t all need to be equally involved, they will be held accountable. Thus, all should be equally attentive to the facts gathered and should exercise independent judgment. The board chair can take the lead, in executive session without the president or staff present, in guiding discussion and directing the board toward a final decision.

Different institutions will handle the full board discussions differently. All board members won’t need or want to be familiar with all details of a compensation package, and they should be expected to maintain confidentiality about what is shared. But they should be told where they can obtain further information. All have the right to see the relevant documents, to have input, and to be assured about the process and its results. The compensation amounts will be disclosed anyway in the press and/or the IRS Form 990s, which are public-record documents.

To conclude, the area of vulnerability that we’ve addressed here is real. The IRS does review executive compensation. In 2013, the agency contacted nearly 3,000 nonprofit organizations for further information, clarification, or a full audit. States’ attorneys general are taking a growing interest, as are foundations, individual donors, and, of course, the press. Each year, a number of colleges find themselves in the harsh glare of news-media scrutiny.

Virtually all scandals involving excessive compensation paid to leaders of nonprofit institutions follow a similar pattern: Compensation is set without transparency by the president and the board chair or by a small group of board members who typically do not have the proper standing or authority. The rest of the board is kept in the dark and has no involvement in discussing or approving the final package.

In this context, boards, presidents, and individual board members are wise to attend carefully to how they set presidential compensation. Establishing the rebuttable presumption of reasonableness, in particular, provides a defense for presidents, boards, and their members against challenges that they’ve received or paid excess compensation. Doing so through the kinds of good-governance practices outlined here fosters transparency, trust, and collaboration among all involved and leads to compensation solutions that are at once fair and fully competitive.

When Should You Depart from Targeted Compensation Benchmarks?

It is often important for an authorized body of the board to consider factors that might move it to set compensation and benefits for the president at some point other than the middle of a range, or some other pre-set percentile. Often—and in good faith—a board believes that there are things about a particular appointee or incumbent, position, or institution that justify a departure from such target benchmarks. Relevant questions include the following:

The Individual: Has a comprehensive performance evaluation documented an especially strong record of performance? A record of underperformance? How many years has the person served in this position at this and/or other institutions? Does compensation fairly reflect years of service? Has he or she been underpaid or overpaid in prior years? Does he or she bring unusual and highly valuable strengths to the position?

The Institution: What is the current financial state of the institution—its ability to support the expenditure that is contemplated? At what levels are faculty and staff members compensated? How would the types and levels of compensation being considered be perceived by constituencies on and off the campus? Are institutional enhancement efforts underway that are serious enough to warrant increasing the person’s compensation so as to begin closing gaps with the aspirational peer group?

The Position: Has the recruitment or retention of people for the position proved to be particularly easy or difficult? Is the job to be done more or less challenging—and does it require a more or less advanced set of skills—than is typical for the position? Does the job entail more or less professional and/ or personal risk than is typical for the position?

The Compensation Strategy: Are there components of compensation other than base salary by which the institution can more appropriately incentivize and potentially reward performance?

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ARTHUR GIRON
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