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Disclosure rules to build an effective executive compensation strategy.

The evolution of disclosing the total value of executive compensation packages and the methodology organizations use to compensate senior management has occurred at a rapid pace in the past few years. Since the first major changes in the public sector with the Securities and Exchange Commission modifying the disclosure requirements for publicly traded companies, investors have demanded further transparency in executive compensation and the methodology behind how compensation levels are set. Now the Internal Revenue Service (IRS) is requiring nonprofits, charities and other tax-exempt organizations to provide more clarity regarding the way competitive executive compensation is defined and delivered, due to revisions to the Form 990 tax return.

The two critical components that have the broadest impact on key executive compensation and how that information is disclosed are tabular disclosures and the Governance, Management and Disclosure section of Form 990.

The first component-tabular disclosures--presents all of the key components of compensation including base salary, annual incentives and longterm incentives, such as stock options and stock awards. The clarity such disclosures provide in how key employees and executives are paid will prove invaluable for companies that rely on Form 990 for competitive peer-group pay data.

The second component--the Governance, Management and Disclosure section of Form 990 may be particularly challenging for many organizations as the entire section will be new to fliers and may lead to more complex disclosures involving the organization's process for determining compensation.

Fundamentally, it is important for compensation professionals and members of the board of directors or governing body to recognize that, while the time commitment for new compensation governance disclosure rules may be substantial, there is a tremendous opportunity. The process of completing the disclosures will enable an organization to design and deploy an effective compensation strategy and ensure that competitive compensation levels are achieved through a rigorous methodology.

While the tabular data is an important component of the Form 990 filing, this article will focus mostly on how organizations can embrace the new governance disclosures as a catalyst for modifying or creating a complete and effective executive compensation strategy.

Who is Affected

For those organizations that believe the new disclosure and reporting rules are an opportunity to modify or create an effective compensation strategy, the first step is to determine when your organization will be required to file the complete Form 990 and use the new disclosure format. This step will help set the timeline for implementing any compensation strategy that is ultimately chosen. Figure 1 presents the gross receipt and total asset thresholds at which point organizations will be required to file the modified Form 990. Organizations that fall below these thresholds may choose to file the Form 990-EZ, which does not require many of the disclosures of the full Form 990. For example, an organization with $780,000 in gross receipts and total assets of $1.67 million would not be required to file the Form 990 for the 2008 tax year.

The following table presents the gross receipt and total asset thresholds at which organizations will no longer be able to choose between the new Form 990 and the Form 990-EZ.

During the determination process, organizations may find that more individuals than expected meet the thresholds for inclusion in the tabular disclosures and compensation governance disclosure. Figure 2 summarizes which individuals are intended to be covered in the tabular disclosures.

Once an organization determines when it will be required to file and who the compensation governance and tabular data disclosures will cover, it can begin the process of defining a compensation methodology that will fulfill the requirements outlined by the IRS.
Figure 2: Individuals Covered In Tabular Disclosures

* the organization's current
officers, directors and
trustees, regardless of pay
level

* all current key employees
who earn more than $150,000
in reportable compensation
from the organization
or related organizations
(e.g., a parent company
or subsidiary), who are
one of the top 20 highest-compensated
employees
in the given tax year and
who have control of or are
responsible for 10 percent
or more of an organization's
assets, activities, income or
expenses

* the current five highest-compensated
employees--other
than officers or key
employees--who earn more
than $100,000 in reportable
compensation from the
organization or related
organization.


Governance, Management and Disclosure

Did the process for determining compensation of the following persons include a review and approval by independent persons, comparability data, and contemporaneous substantiation of the deliberation and decision:

a) The organization's CEO, executive director or top management official?

b) Other officers or key employees of the organization?

--Form 990, Part VI, Section B, Question 15 (a) and (b), IRS

Question 15 is a rather robust question and is the heart of policy disclosures. While a yes or no response is all that is required, there is a tremendous amount of implicit information that will be communicated by filers in this answer. Ultimately, organizations are indicating if they have a comprehensive methodology for defining competitive market compensation, setting the organization's internal pay levels and structure, and using an independent review, discussion, approval and documentation process.

First consider an organization that responds no to this question. Organizations that respond no are indicating that they do not have a formal methodology for defining competitive levels of pay for their executive and key employee talent. What is more, they are indicating that they do not have an independent oversight and review process.

While this does not mean that the organization is paying its executives outside of competitive levels, it does suggest that the organization lacks the appropriate oversight and review process that would normally ensure competitive pay. Furthermore, this may indicate to key stakeholders, donors and, more importantly, the IRS that insufficient controls and poor governance may be systemic to the organization. It certainly doesn't inspire confidence. Therefore, organizations that answer no should use this opportunity to design a formal compensation strategy and address any inadequacies in their methodology and approval process for defining an effective executive and key employee compensation strategy.

For organizations that must file for the tax year starting on Jan. 1, 2008, there is not an opportunity to incorporate a process for compensation already paid or to modify an inadequate or incomplete methodology. These organizations should prepare for a greater level of scrutiny of their current governance practices, or lack thereof, as well as begin to ratify a formal, independent design and implementation process.

Those organizations that aren't required to file a full Form 990 for the 2008 tax year can take advantage of the transition rules and implement a formal compensation strategy and review structure for the start of 2009.

Now consider an organization that responds yes. This means that the organization has conducted "a review and approval by independent persons, comparability data, and contemporaneous substantiation of the deliberation and decision," per the IRS. While the IRS doesn't explicitly define this process, the following four key components to an effective compensation design process should fulfill the IRS requirements: compensation philosophy, competitive data, pay mix and independence.

Compensation Philosophy

Because an organization's compensation philosophy covers executives and the broader employee population, it is always recommended that the board of directors and the organization's human resources team work together to define the philosophy. The philosophy, formally stated and communicated to employees, is the perfect place to start when building a comprehensive compensation strategy.

An effective compensation strategy should be grounded by a compensation philosophy that complements the organization's goals and is reinforced by the way in which compensation is paid to all employees. At the core, a meaningful compensation philosophy should provide the board of directors and compensation professionals with a guide on how to define the competitive market for attracting and retaining human capital, the key components the organization believes will best motivate and retain that human capital, the relative value between those components, and the value of an employee's total compensation relative to competitive market values. Note that some organizations choose to identify specific methodology including where pay is targeted (median, 45th percentile, average), while others take a broader approach and outline how the organization believes compensation should be set. Again, the compensation philosophy should reinforce the organization's culture and current or anticipated pay practices.

Competitive Data

While gathering and understanding competitive market data is always a critical component of attracting and retaining talent, nonprofit organizations find themselves in the unique position of competing against not only other nonprofits but also publicly traded organizations that have stock options and other equity incentives at their disposal. Therefore, most nonprofits should become comfortable incorporating competitive data into the annual review process. This process includes identifying a peer group of companies that the organization directly competes with for executive talent and being mindful of the competitive organization metrics that will drive pay, including operating budget, organizational headcount or assets.

Having a clear understanding of the competitive market provides the board of directors with crucial information on the value that is being delivered. However, the total compensation package as a dollar amount is only part of the picture. An organization should also consider perquisites, benefits and any deferred compensation arrangements that are being provided. This leads to the next component of defining and delivering a comprehensive compensation strategy and pay package to key talent: pay mix.

Pay Mix

Once a compensation philosophy has been defined and the organization has identified appropriate comparable data, the next step is to determine an appropriate mix of pay that is consistent with the organization's compensation philosophy and complements the organization's mission. The total cash compensation offered to executives and the relationship between each component of pay are important considerations when assessing pay competitiveness.

In order to structure an optimal pay package, organizations must determine how much total pay should be derived from base salaries, incentives and other forms of recognition and rewards. Evaluating pay mix relative to competitive market practices from an accurate peer group is a good start. In addition, organizations must be cognizant of the industries or sectors from which they recruit key talent. Boards and compensation professionals must also be mindful of the degree of control or influence the executive position can reasonably exert over any performance criteria associated with each pay component.

Note that executive officers of publicly traded companies can significantly impact strategic results and tend to have a greater proportion of their compensation tied to short- and long-term company performance paid in cash and/or equity. However, this may not be the case in many nonprofit organizations. For these organizations, the design process for developing a more detailed Form 990 disclosure should ultimately align with the organization's goals and the underlying compensation philosophy.

For example, the trend for performance--based pay is not completely pervasive in the nonprofit environment, but more organizations are headed in that direction. However, members of the board of directors and compensation professionals must recognize that an attempt to align more closely with their for-profit counterparts may not be in the best interest of the organization. Hasty decisions made in an attempt to give the appearance of an evolved compensation strategy will have unintended consequences, with the most problematic and often most common unintended consequence being rewarding employees for meeting objectives that, without careful and diligent analysis, may not align with the organization's strategic goals.

Independence

The final piece to designing a compensation strategy relates to who is involved in the process. Independent review of the compensation practices is critical for assuring key stakeholders and the IRS that the review is free of any conflicts of interest. Organizations should ensure that those involved in defining the compensation strategy, reviewing the competitive data and assessing the organization's pay levels are independent from the organization. Final approval of these practices then rests with the independent members of the governing body, identified as those individuals who are not compensated as an employee of the organization, are not paid as independent contractors of the organization, are not related to an individual at the organization, and don't receive material financial benefits from the organization.

Putting It All Together

It is clear that there will be continued pressure to disclose the methods and practices organizations use to set and deliver compensation to executive officers and key employees. Using a compensation philosophy as a starting point, incorporating competitive data and, finally, ensuring that there is appropriate alignment across the components of cash compensation, equity compensation, perquisites and benefits will put most organizations in a position of strength in their Form 990 disclosures.

Furthermore, it is always recommended that all independent members of the board of directors or governing body engage in a full discussion of the methodology, competitive data and ultimate recommendations for executive compensation.

Finally, organizations should not be fearful of providing more information than less. While some may argue that this puts organizations at a competitive disadvantage, it is rarely the case that these disclosures will significantly impact an organization's ability to attract and retain its human capital. In addition, more complete disclosures provide key stakeholders and the IRS with a clear and precise understanding of how the organization sets and delivers competitive compensation.

Quick Look

* The disclosures will enable an organization to design and deploy an effective compensation strategy.

* Compensation philosophy, competitive data, pay mix and independence are key to an effective compensation design process.

* An effective compensation strategy should be grounded by a compensation philosophy that complements the organization's goals.

Brandon Cherry is a principal of Presidio Pay Advisors in San Francisco.

This article was first printed in The Magazine of WorldatWork and is reprinted with permission.
Figure 1: Form 990 Filing Requirements

Form 990 filing         Gross receipts          Total assets
required for tax        (U.S. dollars)         (U.S. dollars)
year starting

Jan. 1, 2008       if    > $1,000,000    and      $2,500,000
Jan. 1, 2009       if      > $500,000    and      $1,250,000
Jan. 1, 2010,
  and beyond       if      > $200,000    and        $500,000
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Author:Cherry, Brandon
Publication:Management Quarterly
Article Type:Report
Geographic Code:1USA
Date:Sep 22, 2009
Words:2308
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