FQHC Top Executive Compensation: Issues and Solutions
Monday, September 14, 2015
Edmund B. Ura, JD
President & Senior Consultant
Merces Consulting Group, Inc.
Editor’s note: This author will be presenting on this topic at our Fall Primary Care Conference on October 18, 2015.
Criticism of executive compensation has been all the rage for many years. A broad-brush picture of every CEO in the country, however inaccurate, has arisen from the actions of a few who are less than reputable. Non-profit organizations are particularly easy to attack, as their top executive compensation information is readily available to the public. As entry-level pay at many health centers is well below what is considered a “living wage,” and resources to improve this condition seem hard to come by, the argument for the need to pay more to a CEO rarely falls on sympathetic ears. Understandably, this can make boards of directors nervous and, without appropriate information and guidance, lead them to make decisions with long-term negative consequences.
The objective of this article is to examine some of the reasons for the concerns about top executive compensation, provide a better understanding of how market forces work, and help health centers develop and implement good governance programs that are fair, and competitive and support the mission of the organization.
THE NON-PROFIT EXECUTIVE COMPENSATION CONUNDRUM
Wrestling with “Right vs. Wrong”
Top executive compensation in non-profits is often attacked as an issue of morality; that is, executives should not be paid very much because money is “given to them” rather than “earned.” It is more difficult to question the morality of what private owners pay their employees, since compensation levels seem to have no victims when owners are deciding how to spend their own money. On the other hand, it seems that everyone, whether or not they have a stake in the organization, feels free to criticize non-profit executive compensation. Such criticism rarely has anything to do with good management or proper use of resources.
In 2010, Dan Pallotta wrote a blog post for the Harvard Business Review entitled “Executive Compensation, Charities, and the Curse of Proximity.” The curse of proximity he describes involves “a direct correlation between leaders’ nearness to suffering and public outrage over their compensation.” When a non-profit is a symphony, for instance, there is no question that the worth of a music conductor is what the person can bring to the organization, reflected in the market rate for such an individual. However, if your purpose is to end human suffering, the money situation is seen as a zero-sum game – every penny that goes to an executive (or any staff member) is a penny denied those who are suffering. In the social services world, the market apparently doesn’t count.
The problem, as Pallotta correctly notes, is that this type of morality play actually subverts the organization’s ability to heal the suffering. Few people are willing to make the logical leap that having a higher-skilled, more highly-paid professional in place may in fact generate more money, and deliver the organization’s services more effectively. High pay certainly does not guarantee high performance, but low pay opportunities definitely inhibit the ability to find people who can deliver high performance.
The “Non-Profit” Fallacy and How it Hinders Performance
Non-profit organizations, we are told, cannot afford to pay people correctly, as non-profits do not have the resources, and are supposed to operate as cheaply as possible. This mindset puts the organization on a path to strife rather than to success: Being cheap decreases the likelihood of finding talented staff, which reduces the ability to bring in resources, further decreasing the ability to find talented staff. As a result, the penny-wise, pound-foolish approach taken by many non-profits is self-fulfilling, and anecdotes of such experiences are used to “prove” that non-profits must operate in a miserly fashion.
Executive compensation in the non-profit sector then suffers not just the curse of proximity but the failure to understand that “non-profit” is only a tax status, not a state of mind. The ability of any organization to achieve its mission, whether that mission is winning the Super Bowl or providing health care to the underserved, is directly linked to the strength of the organization. Having an important purpose is not enough; the organization must acquire and deploy the strongest possible team. In a health center, where two-thirds to three-quarters of the budget is devoted to the members of that team, using those funds wisely is essential, and skimping on the people who are responsible for management seems counter-intuitive at best.
UNDERSTANDING THE MARKET
The labor market is the place where organizations’ needs collide with the supply of individuals qualified to meet those needs. Understanding the market is key to using it wisely. The best starting point for understanding the executive market is to understand that it is not a single market. For some job roles, all employers compete for qualified candidates. The executive compensation market, though, tends to be linked directly to specific industries. Because employers demand expertise in their area of focus from the people who are to manage them, there are subsets of the executive market. Rather than looking at the entire market for individuals with executive skill, employers look to the market for individuals with executive skill in their industry.
The division of the executive market into industry segments explains how executive pay works differently in different industries. In industries where talent is in shorter supply or is more specialized, pay tends to be higher. This is another place where the use of the term “non-profit” can cause problems. Simply put, there is no industry called “non-profit.” In some industries non-profits predominate, but all non-profits cannot be lumped together. In considering health centers, for example, it makes much more sense to hire executive talent with healthcare experience than with non-profit experience. Even more specifically, it would make more sense to hire someone with ambulatory healthcare experience than someone with hospital expertise. Of course the optimal solution is someone with expertise in non-profit community health center (preferably FQHC) experience, but this only serves to illustrate how far the FQHC industry is from non-profits in general.
Once focus is placed on the right industry, it is time to determine what variables influence pay within the industry. Generally speaking, the size of the organization is a very good predictor of executive compensation – but this works only within an industry. Trying to compare across industries will result only in confusion. It is also true that other factors contribute to market rates at the executive level, but understanding these differences - and having the appropriate data to actually use the differences - can be difficult. Some factors that impact CEO compensation in the FQHC world might include:
· Practice Setting – While compensation for providers is higher in rural settings, compensation for management staff, including the CEO, tends to be lower. This is partially the result of perceived and real pressure from the community, as well as the fact that there will likely be local or internal candidates eager to take the jobs.
· Geographic Region – While the market for senior managers, particularly the CEO, tends to be national, local factors cannot be ignored. Significant compensation differences do not appear in broad geographical regions, but certain metropolitan areas definitely call for higher pay rates. In short, the real “market” when recruiting and retaining nationally is going to be the greater of the national rate or the local rate.
· Complexity of Operations – Much harder to measure, but a variable that makes sense to consider is the complexity of the organization. Multiple sites vs. single sites, special situations such as residency programs, particularly difficult to reach target populations and many other factors can be considered. The problem is finding enough data on truly comparable organizations to consider these variables.
· Organizational Performance – This is a tricky variable in collecting data for a compensation program because it will be difficult to determine whether the performance is a factor of the CEO or other variables that make it easier, or more difficult, to succeed. Merces’ studies show only a weak link, if any, between financial performance measures such as net income and compensation.
Surveys with information on CEO compensation in FQHCs, including those produced by NACHC, State and Regional Primary Care Associations and private organizations such as Merces, Consulting (which conducts two separate studies of senior management compensation) are readily available. How this data will be used is our next area of focus.
CONQUERING THE CONUNDRUM
The need to deploy a high quality team requires high levels of skill throughout the organization. This is just as important at the entry level, where we always claim we have our “most important employees,” to the CEO, who will, fairly or not, receive credit for the organization’s success and take the blame for any failings. While it is certainly not always the case, more often than not higher levels of skills come at a higher cost. For such a highly visible role, it is incumbent on governing boards to ensure that they attract, retain and motivate the best possible top executive to increase the odds that the health center will achieve its mission.
First the organization and its board must recognize the need to establish a CEO compensation program for the FQHC, not simply figure out a way to pay its current CEO. This is much more than a semantic exercise; developing a program based first and foremost on the organization’s needs will help ensure fairness. The application of the program to any CEO will help the board understand whether the terms it is considering are in the best interest of the health center.
The Problem Usually isn’t the Number but the Logic Behind it
When it comes to CEO compensation in FQHCs, few compensation packages would be considered “outrageous,” and those are usually pretty easy to find. When one of our analysts spots a number that looks far from what is expected, it takes only a moment or two to find that person on the Internet – usually under indictment, unemployed or struggling under media attack. Yet many FQHC CEOs have found themselves in the local newspaper under a headline suggesting that any amount of pay that reaches six figures for a “non-profit” that “serves the poor” is inappropriate. Responses to media inquiries tend to bring “no comments” or, even worse, reveal confusion on the part of board members and senior staff as to exactly why the executive received the compensation in question.
To solve this problem and ensure that you are not only competitive but also free from ill intent, simply follow this procedure:
Step 1: Establish a Board-approved compensation philosophy.
This is a statement by the board clearly setting forth its approach to people and pay. Anyone who reads the philosophy should understand the logic behind the board’s decisions, and actual compensation should follow from the philosophy. A philosophy should include, at a minimum:
· What the board wants to achieve - for example: “to attract and retain exemplary staff capable of providing cutting-edge services to our patients…”
· Where the board will target compensation - for example: “…compensation opportunities will be targeted at the seventy-fifth percentile of the market…”
· What the market will be - for example “… defined as not for profit health care organizations nationwide of comparable size and complexity.”
Step 2: Create a performance-based compensation program.
The board should establish a base pay range with a range “target” at the competitive rate defined in the compensation philosophy. This starts by ensuring that there is a job description in place that fully and accurately describes the job; that will help in determining how close the job is to that of other top executives. While it is generally safe to assume that “a CEO is a CEO” for the purpose of gathering market data, it is especially important that a job description support any departure from targeting other than the median of the market.
Data should be collected from as many reputable sources as available. Competitive information should be collected by a board member or by an independent compensation consultant. Staff should never be asked to collect and analyze data (except to the extent that a staff member is ordering a survey on behalf of the board). Requiring that the CEO collect data (or having the CEO forced to do it because the board will not) is unfair to the CEO and poor governance practice. Having other staff collect and analyze data is a clear conflict of interest, and is similarly unfair to the staff member, putting the employee in a position to potentially impact the pay of the manager.
The base pay program and salary range should clearly identify where an individual with various levels of performance will be paid. This provides firm guidelines to the board and fair expectations for the CEO, and is key to transparency. Any incentives or bonuses should be governed by a formal, board-adopted incentive plan. Objectives should be set in advance, and the subjective influence in determining the award should be minimal, applicable only in the case where objectivity would result in unfairness to the CEO or the organization.
The compensation program and all its elements establish the “price tag” for the services of a CEO at various levels of performance. As a matter of good governance, this is the point for determining whether a given cost is appropriate, because this discussion is about the program, not the person. The board should be developing a program it can easily execute on an annual basis without yearly discussion about how to pay the current executive.
Step 3: Measure the CEO’s performance.
Most performance appraisal forms used by boards are inadequate for either measuring performance or tying performance to compensation, and most provide only minimal real feedback to the CEO. As a general rule, boards either love their CEOs or don’t like them at all. It should be no surprise then that the vast majority of CEOs are rated “outstanding” or “exceeds expectations” on a regular basis. (Consider for a moment that if all of the CEOs are “outstanding,” then “average” is “fantastic.”) All joking aside, the translation of this type of performance review to compensation is problematic at best. If we target the median of the market, presumably performance exceeding expectations should result in pay above that target. However, if everyone feels their CEO is “outstanding,” then “outstanding” is the new “average” and outstanding performance should result only in pay at the target. These sentences, while awkward and confusing, accurately depict the situation when “meeting expectations” is not well defined.
A better approach to performance management is to reduce personal bias by measuring against the expectations of the job, perhaps by using the board-approved job description. If the board has set forth its expectations in the job description, than managing and reviewing performance is a straightforward task: Simply assess performance on each element of the job description. This will tend to move performance ratings back to what they should be. If someone is performing the job the way it should be performed, that person’s pay should be near the target. Inflating ratings with terminology like “outstanding” is harder to do, because we need simply ask something like “isn’t providing monthly reports to the board doing the job the way it is supposed to be done?” How would one be “outstanding” at providing monthly reports to the board?
Step 4 – Establish an Appropriate Salary
The conclusion of a CEO performance appraisal should be the determination of an appropriate position in the pay range. If the program has been set up correctly, the “price tag” for a CEO at varying levels of performance is put forth in the salary range. If the performance appraisal is conducted correctly, it will identify where pay should be within the range. It should not equate to a percentage increase, nor should it matter what the prior pay was. The program establishes the individual’s value to the health center, and the only question should be “is there anything truly unfair about the result?”
While there may be provisions for minimum increases in a CEO employment agreement, specifics should be avoided. The amounts set forth in the contract may be too much or too little, particularly when contracts project several years into the future. Contractual language can simply refer to the salary adjustment process, which is likely to result in a much more accurate assessment of appropriate pay.
GOVERNANCE MADE EASY
Once a program is in place, governance becomes a process of execution. Done correctly, this will be routine, simple, have no surprises and be rather dull. The CEO and board should know what to expect and results should be generally predictable. In CEO compensation, dull is good. Dull does not attract the IRS, local politicians or the media. Dull is CEO compensation done right.
All matters related to CEO compensation should be approved by the full board. While most of the work may be done at a committee level, the full board should approve all related resolutions – and establishing an annual salary should have a resolution.
Responsibilities and Timing
Boards should have a human resources committee charged with, among other things, determining the compensation of the CEO. Other key functions would be reviewing pay structures for board approval as well as reviewing and passing judgment on human resources-related policies requiring board approval. The committee should have a chairperson, who should also be responsible for identifying any board actions that could potentially change the expectations the board has of the CEO (or incentive objectives, or anything else that could result in discord between the board and CEO).
In many health centers, these issues are dealt with by the Executive Committee. While this might be the most expeditious route, it is probably not optimal. Having a separate human resources committee encourages participation from other members of the board and also reduces any impression that the Executive Committee is too close to the CEO. Board members are frequently suspicious of executive compensation decisions, and many board members are being asked to approve salaries far in excess of amounts they have ever earned – it would be wise to ensure that they know exactly what they are being asked to approve and how it came about.
Compliance and Transparency
For every compensation-related decision, the board will want to take the steps necessary to establish the “rebuttable presumption of reasonableness.” To make a long story short, the rebuttable presumption is a technical term used to describe the process by which the IRS will consider a financial transaction to be per se reasonable. If the process is followed, the IRS will have the burden of proof to show that compensation is unreasonable. As any attorney will attest, having the burden of proof on someone else makes life much easier.
Establishing the rebuttable presumption of reasonableness requires that:
· The decisions were made by “disinterested” directors
· Relevant competitive data was considered in making the decisions
· The decisions, including the logic and rationale, were documented contemporaneously
A remarkable number of health centers say that they follow the rebuttable presumption but typically fail not on whether it was done right, but on whether it was documented. To find out what your health center claims it does, go to your most recent IRS Form 990, turn to page 6, Section VI, Section B, Items 15(a) and (b), which reads as follows:
“Does the process for determining compensation of the [CEO and other officers or key employees] include a review and approval by independent persons, comparability data, and contemporaneous substantiation of the deliberation and decision?”
Those who answer “yes” are required to explain the process used in the notes section (Schedule O). Assuming your health center said “yes,” look in the Schedule O notes and see if you recognize the process that it says you used. Put on your skeptical hat and ask yourself: “if I were a reporter, could I read that note and determine how compensation was established, and thus be so bored that I would conclude there is no story here?” If you can’t do that, you need to work on your Form 990. It is highly likely, however, that you will not even recognize the process described in the Schedule O note. That is because most Form 990s are filled out by auditors or accountants who have no first-hand knowledge of your governance processes, and the text that appears is frequently just stock language that they expect will be reviewed by the board and corrected as necessary. In a recent study, we found the exact same text in the Schedule O notes of three health centers in the same basic geographic area. As one was a client, we observed that the described process was not the one that was actually followed. On a hunch, we looked at the person who had completed the Form 990s in question. No surprise: the same auditor, at the same firm.
Getting… and Staying… on the Same Page
All members of the board, the CEO, and any staff members who might need to know, should understand completely the process by which CEO compensation is addressed, particularly when it comes to non-salary items such as bonuses and retirement contributions. They should also understand how things will look. In a particularly embarrassing series of articles concerning a health center, published several years ago, a columnist took offense at a particular item reported in an FQHCs Form 990 – a payment of about a quarter of a million dollars. The amount concerned him, but in his dogged research into the amount, he found a source that reported the bonus was to make up for the lack of retirement contributions in the past. However, the minutes of the meeting said that the bonus was the result of excellent results achieved by the organization. It probably didn’t help that the consultant who wrote the report was subsequently hired three months later by the health center in an executive role.
That this could happen should really come as no surprise, although it does look like a “perfect storm” for that particular organization. Sadly, however, upon honest reflection, it is more than likely that at most health centers, if board members were individually polled concerning how CEO compensation was set, the responses would not be in agreement.
Establishing a cohesive executive compensation program requires more than reading an article online, no matter how comprehensive it might be. It is a process requiring the board to determine what the organization needs and what it can afford. To be done right, the process must be completed without reference to the current CEO. A well thought out and implemented approach will, on the other hand, make life much easier when trying to address the performance and compensation of the current CEO.
NWRPCA welcomes and regularly publishes white papers and articles submitted by members, partners and associates with subject matter expertise. The appearance of any guest publication in our Health Center News database represents the views of the author and does not constitute endorsement by NWRPCA of the stated opinions or perspectives, nor does it suggest endorsement of the contributor's products or services.