Hot Topic: The Benefits of Incentive Compensation In Challenging Times

Sandra Pace is Managing Director and founding member of Steven Hall & Partners, an executive compensation consulting firm.  Previously, Sandra served as Vice President and Consultant at Pearl Meyer & Partners for 13 years.  She is interviewed regularly in the area of non-profit compensation and is author of related articles and studies. 
Christina Young joined SH&P as a Managing Director in 2011, before which she was an associate at Sullivan & Cromwell from 2006 to 2011.
Sandra and Christina advise clients on all aspects of executive compensation and board remuneration matters and co-lead the firm’s non-profit practice.

 Non-profit boards are making executive compensation decisions in an increasingly difficult environment.  More and more funding sources are uncertain given the state of the economy, reduced government budgets and potential limitations on itemized deductions for higher- income earners.  As a consequence, many organizations must do more with less.  Particularly at non-profits, shrinking budgets can impact compensation levels for senior executives whose talents are needed to steer the organization through challenging times.  But do they have to? 

Incentive compensation is used by many for-profit companies and some non-profit organizations to focus executives on organizational goals and provide compensation upon achieving such goals.  Incentive pay is often considered synonymous with rewarding employees for making the organization more money, a concept that does not typically translate in the non-profit mission-based context.  However, evidence suggests that incentive pay usage may be increasing among non-profits.  A study of 208 New York-based non-profit organizations showed only 19% paid an annual bonus to their top executive in 2010/11, but this actually reflected an increase of 33% over 2009/10.  
As non-profits continue to struggle with how best to use resources, “pay-for-performance” is becoming an appealing mantra.  If structured appropriately, incentive pay can be a powerful tool providing executives with a razor-sharp focus on achieving organizational goals and objectives.  If the organization is successful, executives are rewarded and incentivized to continue performing; if performance is sub-par, compensation costs for the organization will go down.
Picking the “Right” Metrics
As with all compensation programs, design considerations are critical when establishing a successful incentive plan.  Among the most important and problematic tasks is determining appropriate performance metrics.  The right metrics can provide focus, help strengthen the organization financially, and encourage desirable behaviors and outcomes.  The wrong metrics can devastate and undermine the mission and create conflicts of interest, real or perceived, between organizational interests and those of executives. 
Fortunately, the “right” quantifiable metrics should already be embedded in the organization’s mission.  For example, an animal shelter may focus on reducing time animals spend in the shelter, increasing the number of rescues and raising community awareness.  Other potential metrics include expanding services, reaching new constituencies, providing higher quality services, and improving efficiency and effectiveness.  Selected metrics must be quantifiable and ones that executives can reasonably influence.
Non-profits are particularly vulnerable to negative publicity related to executive pay, which can lead to decreased funding.  When selecting performance metrics, boards should consider potential unintended consequences and how disclosure of a particular metric might be perceived by stakeholders, including clients, donors, regulatory agencies, and the IRS.  
How Many Metrics?
While the number of performance metrics varies based on the facts and circumstances of the organization, in our experience selecting more than three metrics results in a diluted focus by executives and can minimize the impact of incentive awards.  If possible, achievement of selected metrics should result in achievement of other, unspecified metrics.  For example, metrics measuring the number of clients successfully served might also imply enhanced efficiency.
Target Levels of Achievement
Performance targets are usually determined when performance metrics are selected.  These targets serve as the benchmark against which performance will be assessed.  To be successful, performance metrics and targets should be meaningful, measurable and achievable. 
It is often helpful to establish a range of performance levels of achievement, typically defined as threshold/minimum, target and maximum.  For performance below threshold, no incentive compensation is earned; however, as performance surpasses threshold levels, greater awards are earned, until the maximum performance level is achieved.  Performance above maximum often does not warrant additional payout.  Capping the upside of incentive compensation and restricting pay for performance below threshold will both help reduce financial risk (particularly with respect to maximum payouts), send a strong message regarding linkage between pay and performance  and ensure a clear understanding of the goals within and outside of the organization.
In general, incentive compensation participation should be limited to executives deemed most critical to achievement of the non-profit’s mission.  This typically includes the Executive Director/CEO and key direct reports.  In some organizations, it may be appropriate to cascade the program down to others within the organization.  However, prior to expanding the participant-group, consider whether all participants really have the ability to impact the achievement of the applicable performance metrics.
Additional Considerations
Incentive award opportunities are typically defined as a percentage of base salary and vary depending on industry, participant’s tenure, and organizational size.  The Board and participants should be clear about whether incentive compensation is intended to motivate and reward behavior to accomplish ordinary course tasks or extraordinary organizational goals. 
When considering a new incentive plan, examine the overall structure of the compensation program.  Organizations should review the competitive market to ensure compensation levels are competitive and reasonable according to IRS standards.  This review may highlight areas of concern such as excessive or deficient pay levels.  Where compensation lags the market, incentive opportunities can help bring overall pay up to appropriate market levels.  Conversely, if compensation levels unreasonably exceed the market, total compensation can be restructured through shifting some of the salary to incentive pay.  Such a move aligns compensation with market standards and signals to all stakeholders the importance of superior executive performance.
While there is no one-size-fits-all solution, a well-designed incentive program helps focus executives on accomplishments critical to the successful fulfillment of the organization’s mission and aligns compensation with organizational achievements.  A commitment to paying for performance also helps demonstrate to all stakeholders that the organization is committed to the most efficient and meaningful use of the capital entrusted to it.  Non-profits would be well-served to borrow from their for-profit brethren and take advantage of incentive compensation as a way to inspire behavior necessary to achieve organizational success.

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