Topic Papers and Articles

With the recent scrutiny of nonprofit practices, nonprofit boards must be aware of the public perception of executive salaries.

Compensation experts Charles Quatt and Brian Vogel answer common questions and address issues surrounding chief executive compensation. Quatt and Vogel are the authors of Dollars and Sense: The Nonprofit Board's Guide to Determining Chief Executive Compensation (BoardSource, 2005).

Q: Should the entire board be aware of and or approve the chief executive's salary and benefits each year?
A: The entire board should be aware of the chief executive's salary and benefits. A board may choose to seek advice from an outside expert when considering in detail and approving the chief executive salary and benefits. Only independent board members, however, should be involved in the final approval process.

Q: Which laws should the board be familiar with when setting the chief executive's salary?
A: Board members need to be familiar with the IRS intermediate sanctions rules and related legal doctrines, such as the private inurement doctrine. They also need to understand the state law applying to their nonprofit. If the board considers deferred compensation arrangements, it needs to understand the federal tax law governing such arrangements.

Q: Is incentive-based compensation for the chief executive of a nonprofit legal?
A: Yes, incentive-based compensation for the hief executive of a nonprofit is legal, and it is an increasingly common practice among nonprofits. Many nonprofits find incentives an effective way to link chief executive pay to organizational performance and objectives. The total amount of compensation, including the incentive, must be consistent with market practice, however, to meet the intermediate sanctions and related legal standards.

Q: We are in the process of evaluating our chief executive. How do we link this to compensation?
A: The best way to link compensation to performance is to decide before the evaluation the rewards associated with achieving your organization's objectives. Thus, you could agree with the chief executive that achieving stated objectives would mean (finances allowing) a certain percentage increase in salary, or the award of an incentive amount. Going beyond the objectives would be worth more.

In the absence of an existing link between pay and performance, the next best thing is to decide on an appropriate reward (a salary increase, an ad hoc bonus, or some combination of the two) and carefully explain to the chief executive the particular achievements that justify the boost in pay. That explanation could then serve as the basis for the following year's performance plan.

Remember that any bonus or salary increase must not increase compensation by so much that it creates intermediate sanctions concerns.

Q: What are the advantages/disadvantages of chief executive employment contracts? How common is the practice? What should be included? What should be the duration?
A: Organizations should draft a formal employment contract in all but the simplest employment relationships. A formal contract provides security to both the executive and to the board, and makes absolutely clear the details of the compensation arrangement and the mutual expectations of the two parties. As of 2002, about one-fifth of nonprofits (19.5 percent) had formal employment agreements with their chief executives. The employment contract also offers some added security to both the executive and the organization by demonstrating the organization's commitment to the executive.