National Center for Healthcare Leadership Executive Action Series:
Navigating in a Shifting Executive Compensation Environment by Timothy J. Cotter
Navigating in a Shifting Executive Compensation Environment
The external attention being focused on executive compensation programs in not‐for‐profit healthcare is at an all‐time high, and the pressure is coming from many different sources. As executive compensation levels and practices in troubled industry sectors have made headlines and drawn legislative attention, there has been a spillover effect, with questions raised about broader executive compensation practices and some critics voicing the need for greater regulatory controls. In this environment, healthcare organizations, which make up one of the largest and most visible sectors of the economy, should expect increased scrutiny of their executive compensation levels and practices (Figure 1). IN THE SPOTLIGHT’S GLARE Turbulence in the economy has heightened the level of attention paid to executive compensation. Current economic conditions have fueled public resentment about large compensation packages. The not‐for‐profit healthcare sector is not immune to such a reaction. Against this backdrop, there has been heightened media coverage as well. Stories on executive compensation levels and practices appear in the media on a regular basis, often with an unflattering tone. And, as the healthcare reform debate heats up, legislative reform proposals may include a focus on executive compen‐sation levels and practices in hospitals and health systems.
Legislators and regulators are taking an active role, increasingly questioning salaries, bonuses and per‐quisites. As an example, Representatives Henry Waxman (D‐CA) and Bart Stupak (D‐MI), in mid‐August asked 52 companies that offer health insurance plans to provide data regarding salaries, bonuses and revenue for corporate officers who made more than $500,000 annually between 2003 and 2008. A “Pay Czar” has been appointed to oversee the compensation decisions for key employees in companies that accepted federal bailout funds. In September, Senator Charles Grassley (R‐IA), the ranking Republican member of the powerful Senate Finance Committee, proposed an amendment to the “America’s Healthy Future Act” to repeal the safe harbor with respect to reasonable compensation as provided by obtaining the rebuttable presumption of reasonableness. At the state level, several legislators have introduced bills to limit the compensation paid to hospital executives, while state attorneys general are beginning to focus on high‐end compensation arrangements in not‐for‐profit healthcare organizations. Massachusetts Attorney General Martha Coakley, for example, announced on September 2, 2009, enhanced compen‐sation reporting requirements for large hospitals and health plans and a plan to carefully review their executive and director compensation practices. Of significant note, state attorneys general are not constrained by the Internal Revenue Service’s (IRS) definition of what constitutes reasonable compensation.
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Navigating in a Shifting Executive Compensation Environment
The IRS also has signaled its intent to maintain an ongoing focus on the tax‐exempt sector generally and on hospitals specifically. In February 2009, the IRS released its Hospitals Report examining the executive compensation practices at 544 hospitals, highlighting the “high” compensation provided to some not‐for‐profit hospital executives. At the urging of key congressional leaders, the IRS greatly expanded the compensation disclosure requirements in the revised Form 990, effective for calendar year 2008. WHAT TO EXPECT These forces, taken together, are likely to lead to increased scrutiny of healthcare executive compen‐sation in the near term from legislators, regulators, the media, unions, and the stakeholders within healthcare organizations. This attention is making board members increasingly concerned about executive compensation issues and will create pressure to exert greater external control over decisions regarding executive compensation. Healthcare organizations would be well advised to recognize these forces and not appear tone‐deaf to the changing tune. A failure to respond appropriately to the new environment may expose not‐for‐profit healthcare organizations to damage to their reputations, as well as decreased community and philanthropic support. It may also leave organizations vulnerable to increased regula‐tory scrutiny and adverse media coverage. SMART PLAYS This challenging environment suggests that executive compensation decisions in not‐for‐profit healthcare organizations need to be guided by a common‐sense approach and proper business judgment that reflect both the current economic circumstances and heigh‐tened legislative and taxpayer concerns. However, compensation practices also must support executive attraction and retention, which even in this economy is a major challenge because of the focus on high‐performing executives. Now is the time to ensure that your organization is making smart plays in the area of executive compen‐sation. Below are ten ways you and your compensation committee can better position your organization in light of ongoing executive compensation developments. 1. Reassess Current Approaches. Executive compen‐sation actions and approaches that were acceptable 24 months ago may now require modification. Reduced salary‐increase budgets, pay freezes, and even pay reductions are occurring in all market sectors, including healthcare. Although projections for 2010 are more
positive, it would be prudent to review upcoming compensation adjustment assumptions in light of current economic data and conditions in the communities you serve. It is also important to weigh executive salary increases and incentive awards when there are poor financial results, failures in mission or community benefit, or very modest (or no) salary increases for front‐line employees. Many previously accepted perquisites – such as the provision of country club memberships, financial counseling, loans, and spouse travel – are now being questioned. These items often play a disproportionately significant role in regulatory review, media scrutiny, and congressional focus. Review the business reasons supporting each program component and determine whether modifications are necessary to limit risk to reputation and external scrutiny. The executive compensation issues in troubled companies suggest that healthcare organizations review and evaluate severance provisions for appropriateness and affordability. The use of any type of tax‐gross‐up payments, the absence of so‐called “clawback” provisions for incentive awards related to financial misconduct, and business entertainment and meetings at high‐end locations should also be reexamined. Survey trend data indicate that in the near term, healthcare organizations can expect moderation in cash compensation increases, a reduction in perquisites, and a shift to simplified program designs. 2. Employ Governance Best Practices. Guidance issued by the IRS and governance advisory groups provides many important suggestions related to executive compensation oversight within not‐for‐profit organizations. Your organization should follow the suggestions below if it is not already doing so.
10 Ways to Better Position Healthcare Organizations in Light of Ongoing Executive
Compensation Developments
1. Reassess current approaches 2. Employ governance best practices 3. Consider an external review of the program 4. Update the public and media relations plan 5. Prepare for regulatory review 6. Enhance transparency 7. Educate the full board 8. Take steps to limit risk to reputation 9. Scrutinize the market comparability data 10. Evaluate new directions
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Navigating in a Shifting Executive Compensation Environment
Compensation for key executives should be determined by a board‐approved committee of knowledgeable and independent directors who rely on appropriate comparability data when making compensation determinations. If an outside compensation consultant is used, the consultant should be independent and engaged directly by the governing body. Furthermore, all decisions regarding executive compensation should be made only after considering all compensation provided to the individual. Executive compensation should be properly reported on the Form 990 and other required tax returns. Finally, safeguards should be established to prevent excess benefit transactions. Increasingly, critics of executive compensation are questioning the perceived disconnect between compensation packages and organizational results and community benefit. Good governance requires that executive compensation decisions reflect more than market comparability data. Critics regularly suggest that executive compensation levels are escalating rapidly because of a narrow focus on market comparability data, rather than a holistic assessment of the situation. In determining compensation adjustments and incentive awards, the process should heavily weight mission attainment and community benefit outcomes as well as financial viability. 3. Consider an External Review of the Program. Many healthcare organizations have devoted significant efforts to the design and administration of their executive compensation program. But, as in most endeavors, familiarity may limit the ability to see the forest for the trees. While this activity need not involve significant cost and effort, consider having an external lawyer or auditor not involved with your program review your process, and identify areas for improvement. Ask the following questions: Does the organization qualify for the rebuttable presumption of reasonableness? Are the market data reflective of comparable roles and organizations? Is documentation adequate and consistent? Are there issues with conflicts and independence? Such an activity need not occur frequently but will provide an additional level of comfort for management and the governing body. It may also be desirable to have the organization’s internal audit function periodically compare actual compensation practice to the policies that were approved by the governing body. Expense reimburse‐ment practices should be reviewed for adherence to organizational policy and tax regulations. 4. Update the Public and Media Relations Plan. The media are currently focused on executive compensation, and the enhanced disclosure required by the revised Form 990 will likely intensify the spotlight on healthcare practices. Ensure that your organization is
fully prepared to respond to employee, public, and media inquiries in a positive and timely manner. To this end, develop materials and talking points about the benefits of executive retention/recruitment strategies, including compensation, to the community. Identify a spokesperson and prepare that person with detailed talking points and factoids. Among the points to stress are specific examples of how the organization provides significant benefit to the community it serves, how it serves as a critical economic engine by creating jobs, spending money, and launching construction projects in the community. Also emphasize that the compensation program is designed and administered in a manner consistent with best governance practices. Board members should also be prepared with a scripted response that mentions to whom they should refer media inquiries. Such a response might include the following points: We have a best‐practices approach that is regularly reviewed with the board. Our executives are worth every penny we pay them. [Name] can provide you with more detailed information. 5. Prepare for Regulatory Review. Given the focus on executive compensation, it would be prudent to take the steps necessary to ensure your organization is positioned to successfully withstand a regulatory review. Decision‐making processes should be free of conflicts. Documentation, whether of compensation philosophy, policies, employment agreements, minutes, or reports, should be complete and thorough. The organization’s general counsel can readily assess these and related issues and help orchestrate the necessary action steps. 6. Enhance Transparency. There is now consensus that greater transparency regarding executive compensation contributes to appropriate and defensible executive compensation programs. One way to improve transparency is to use tally sheets to assist the committee and board members in understanding the total current and expected cost of all economic benefits provided to each executive. Historical and projected data may also be used to ensure an understanding of high‐cost items such as deferred compensation, supple‐mental retirement programs, and severance. Executive compensation must also be properly reported on the IRS Form 990 and should be reviewed by a board committee prior to filing. 7. Educate the Full Board. It is desirable to schedule an annual informational and educational session on the topic of executive compensation to provide board members with an opportunity to raise questions and provide input into the organization’s executive compensation philosophy. Such a session also offers an opportunity to give board members information about
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Navigating in a Shifting Executive Compensation Environment
the overall design and components of the executive compensation program and information on the amount of compensation provided to the CEO and other key executives (those whose compensation is reported on the Form 990). It will also help prepare the board for situations in which the executive compensation program might be publicly and perhaps negatively depicted, for example when the media obtains and reports on the organization’s Form 990. The full board should be provided with information about the organization’s compensation philosophy, including the markets used for comparison purposes, the components of the program, the desired positioning in the marketplace, and a summary of the process the compensation committee uses to make executive compensation decisions. Board members should also be provided with a full description of the CEO’s and other key executives’ compensation (base salary and incentive awards) and benefits program, including key employment contract provisions (severance provisions), and an explanation of how the program measures up against comparable market practices. Board members also need to know the relationship between executive compensation and organizational performance and the performance metrics considered in making compensation decisions. Overall costs and organizational impact of changes to executive compensation levels and benefits programs should also be shared with the board. This information is best given to the board around the time when executive compensation decisions are made. As part of this process, board members should be encouraged to meet privately with compensation committee representatives if they have more specific questions or concerns. 8. Take Steps to Limit Risk to Reputation. With all the focus on healthcare at this time, an organization should take steps to limit potential damage to its reputation related to its executive compensation program. Executives should be properly focused on the organization’s interest, and any outside income should be reviewed to identify potential conflicts. All significant compensation decisions, including large recruitment or severance plans and supplemental retirement programs, should be fully disclosed to the board. Items that must be specifically noted on the new Form 990 (e.g., loans, club memberships, tax gross‐ups) should be vetted to ensure they have a legitimate business purpose. 9. Scrutinize the Market Comparability Data. Regulators are increasingly expressing concern about the market data not‐for‐profit hospitals rely on when making executive compensation determinations. Ensure the data used to evaluate the relative market position of
executive compensation levels reflect comparable roles and organizations. Carefully review the use of any market data representing for‐profit companies to ensure its use is legitimate. 10. Evaluate New Directions. The “smart plays” presented above are largely defensive and intended to protect the organization from regulatory and reputational risk. But with all the concerns regarding the appropriateness and effectiveness of current programs, this may be the right time to consider new, innovative directions for your executive compensation program that create a “win‐win” situation for the organization and the executive. As the healthcare environment gets more complex, the development of leadership talent is becoming more critical. As a result, it makes sense to closely align executive salary levels with the development of leadership competencies. Instead of using perquisites where the benefits largely accrue to the executive, consider developmental activities for the leadership team that improve the organization too. Would this not be a more effective reward system for the individual, the organization, and the community? Would a health system benefit from allowing high‐performing leaders to take developmentally oriented sabbaticals (e.g., three months every five to seven years) in exchange for modest changes in the overall compensation package? Should existing supplemental benefits and perquisites be reconfigured to support community‐benefit activities by the organization’s leaders?
Incentive programs offer another area for evaluation and redesign. Today approximately 85 percent of not‐for‐profit healthcare organizations have annual incentive plans, with long‐term plans emerging. Although the recipients appreciate the payments, the key issue is whether the incentive program affects executive behaviors and decision making in your organization. Is the program encouraging the desired community benefit outcomes? Is it properly aligned with your organization’s short‐ and long‐term mission? While there are no universal answers, some incentive programs are not effective and need to be discontinued or significantly modified.
It makes sense to closely align executive salary levels with the development of leadership competencies. Instead of using perquisites where the benefits largely accrue to the executive, consider developmental activities for the leadership team that improve the organization too.
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Navigating in a Shifting Executive Compensation Environment
It should also be noted that some of the most highly regarded health systems in the U.S. compensate their executives with base salaries only. A TIME FOR ACTION Although there have been few high‐profile executive compensation scandals involving the not‐for‐profit healthcare provider sector, most such situations in other not‐for‐profit sectors (e.g., higher education, museums, foundations, public charities) were partially the result of not following one or more of the smart plays presented above. More importantly, executives from a small but increasing number of not‐for‐profit hospitals have paid Intermediate Sanctions penalties, and their organi‐zations have been subject to time‐consuming regulatory reviews. Now is the time to work with the appropriate governing body to ensure that your organization’s approach is assessed and its compensation‐related process adjusted if necessary. If these activities are completed, the organization should have an executive compensation program that supports the organization’s interests, is understood by the board, and is well positioned to withstand media, public, and regulatory scrutiny. If the not‐for‐profit healthcare industry does not make an effort to examine its own executive compensation practices from within, the scrutiny is likely to be imposed, in the form of more stringent regulatory controls. ABOUT THE AUTHOR
Timothy J. Cotter is a managing director with Sullivan, Cotter and Associates, In ., a human resources consulting firm that focuses on the not‐for‐profit healthcare sector. Mr. Cotter has provided compensation advisory services t health systems, hospitals, physician groups, and academic medical center
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