Understanding Executive Compensation in the Unique World of Nonprofits

by Lindsay Hill on November 25, 2019

in Compensation,Nonprofit

Woman pushing a puzzle piece into place

Nonprofits face many unique challenges when establishing executive compensation which oftentimes deals with issues like regulatory compliance, board governance, limited budgets and equitable pay across the organization. Nonprofits typically have a Board of Directors who have a financial responsibility when setting executive pay to ensure that it is fair and reasonable. This poses an ongoing challenge for many boards who are trying to be reasonable while either recruiting for top/key talent or retaining qualified and knowledgeable Executive Directors in nonprofits where the area of expertise is oftentimes very specialized.

It used to be that Executive Directors in a nonprofit were typically paid much less than their counterparts (CEO/President) in for-profits, but over time that gap has gotten much smaller. While there is an obvious difference in what drives a for-profit vs. nonprofit, nonprofits are recognizing that in order to be successful, they have to employ talented individuals and that comes at a much higher price tag. Nonprofits on average still pay less than for-profit organizations, due to the many factors that go into this such as scope of work, size of the organization and cash flow.

A good way to overcome some of the challenges when establishing executive compensation is to have a formal philosophy and strategy created and implemented. This philosophy/strategy is oftentimes developed by the board and will include how pay decisions are made (the process and who will be involved), when adjustments will be made, and the basis of salary vs. total compensation (healthcare, deferred compensation, performance, etc.). A market-based salary structure can also be very beneficial in setting base pay and staying within a defined pay range based on market data.

Performance of Executive Directors is oftentimes tied to incentive compensation and can be a grey area. It isn’t uncommon for a nonprofit to be scrutinized for rewarding executives with additional compensation for a job well-done. As the mission of most nonprofits is purpose driven, many feel that any additional cash flow should go to the purpose and mission itself rather than in the pocket of the executive. With that being said, more and more nonprofits are providing incentive compensation to executives and the incentives as a percentage of base pay has been increasing. If a company determines to set incentive pay based on a percentage of base pay, it is imperative that base pay rates are set market competitive to ensure total cash will be reasonable.

If the success of the nonprofit has surpassed far and above the budgets of earlier years, it is likely due to the efforts of the executive providing exemplary leadership to the organization. So why shouldn’t they be rewarded (as long as it is reasonable and not excessive)?

As mentioned earlier, many Executive Directors have a specialized set of credentials, and if they are successfully leading the organization, it is best to retain this key talent to solidify more successful years to come.

When looking at nonprofit executive compensation, it is very important to keep in mind the Federal Private Inurement Prohibition that strictly forbids a tax-exempt organization’s decision-makers from receiving unreasonable benefits from the Nonprofit’s income or assets. A nonprofit is guilty of offering excessive compensation when it pays employees amounts over a market equivalent wage for those positions.

Key factors to take into account ahead of time when setting executive pay to ensure that it is fair and reasonable include:

  • The current market rate paid at similar organizations for equivalent positions in similar locations
  • Whether the compensation was approved by an independent Board of Directors
  • Being able to explain the details of how and why the compensation plan was created with documentation and the process involved

Some additional factors that should be taken into consideration as well:

  • The uniqueness of the employee’s skills, education, training, experience, responsibilities, etc.
  • Job performance
  • Internal value of the position and how crucial it is to the organization
  • Any comparable roles within the organization and what they are paid

It is prudent to tie any sort of incentive pay to overall performance of the organization whether it be based on things like revenue/budget growth, net income/operating surplus, customer service/quality, etc. However, the overall make-up of the organization should never be overlooked when setting incentive pay.

There is a broader range for executive pay and compensation mix than with other positions so it is important to look at multiple survey sources when researching market data. Total budget, total number of employees/personnel costs, overhead costs, etc. should always be taken into consideration when establishing total compensation and the percentage of incentive pay. Different scenarios should be run and evaluated regularly to establish a plan that will benefit all parties involved.

Ultimately, to best protect the organization as well as those serving the organization, compensation plans should be a thoughtful decision that addresses both the strategic and best practices elements of the organization.

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