What’s the Right Incentive Compensation Plan?
By Thomas Flannery and David Hofrichter
A properly designed and implemented incentive compensation program is a powerful tool that links an organization’s strategic and operational plans to the rewards it provides to executives. Health care organizations have been adopting incentive compensation as part of their executive pay package since the mid-1980s, and it is a rare health care organization today that does not have one. Despite this, trustees and executives continue to struggle with incentive compensation. Why are incentive compensation programs so problematic for health care organizations? Discussing the following six key questions can provide insight and guidance for trustees and executives as they adopt or update an executive incentive plan.
All Compensation Must be Reasonable
Q: How can we determine whether an executive compensation package is “reasonable,” when we do not know how much executives will earn in the first place?
A: “Reasonable” means that any amount paid to an executive must be for “like services by like enterprises under like circumstances,” according to the Internal Revenue Service code. In making this determination, both taxable and nontaxable entities can be considered in defining “like,” and the maximum compensation that could be earned is what has to be established as “reasonable.” So if the compensation committee approves a package that includes a maximum incentive opportunity of, for instance, 50 percent of base salary, the compensation committee assumes the executive could earn his or her base salary plus 50 percent. It also assumes that this total amount is “reasonable.”
Committee Action Guidance: First, we advise compensation committees to use a “tally sheet” approach when approving executive compensation. The tally sheet sets forth all elements of compensation, including the maximum earnings under an incentive program, base salary and deferred compensation.
Second, when approving the executive compensation package, compensation committees should look at the compensation twice. The first time is at the inception of the entire program, when the board first approves total remuneration up to the maximum potential earnings under the incentive compensation program. The second examination comes when the board approves the actual incentive payment, which it does after determining an executive’s actual performance level achieved under the plan and his or her corresponding incentive awards.
Not-For-Profit Versus For-Profit Incentive Compensation
Q: Why do we need to put a cap on what executives can earn through the incentive program?
A: One of the major differences between incentive compensation in not-for-profit and for-profit organizations is simply that total maximum compensation is capped in not-for-profits. In the for-profit sector, cash compensation may also be capped, but, generally, most for-profits impose no determinable maximum for equity-based compensation. Although a for-profit organization may target a value or number of equity units to be delivered, the amount actually realized by the executive may be substantially different because of the change in stock price over time. We also find that some for-profit companies do not set maximum bonus payouts, as they believe that puts limits on rewarding performance that are not in the best interests of the shareholders.
The stakeholder issue is the other major difference between not-for-profit and for-profit organizations. The not-for-profit organization’s “shareholders” are the public it serves. Since the organization exists to provide a service to its community, the proceeds from that service provided cannot inure to the benefit of an individual executive. In a for-profit entity, however, all proceeds inure to the shareholders and all other stakeholders.
The implication of this difference is fairly straightforward in terms of setting incentive program goals in health care organizations—a hospital’s incentive compensation program cannot be designed to simply reward financial results, whereas executive rewards for financial results are commonplace in for-profit companies. In a health care organization, incentive program goals must reflect the reasons why the organization is exempt from taxation.
Committee Action Guidance: First, a not-for-profit organization’s incentive goals should reflect the organization’s mission as defined by such performance objectives as: providing quality health care services to the community; improving community wellness; providing safe care; ensuring patient satisfaction; providing integrated care; and operational and related goals that support the tax-exempt status of the organization.
Second, financial goals can be used in health care organizations, but they should not be structured in a manner that suggests the organization’s primary purpose is either to make money or to pay the executives a portion of the profits. Although financial performance is critical to a health care organization’s on-going success, it should be no more than half of the incentive performance plan.
Try to Remember
Q: When we compare the plan’s goals at year-end with actual results, why is there often confusion and debate about what we meant when we first adopted the goals?
A: A typical problem many trustees and executives face at year-end is remembering what yardsticks they intended to use to measure goals when the incentive compensation plan was first adopted. You would think this would be an easy problem to solve, but it has proven to be a major stumbling block. Incentive plans are reviewed by compensation committees before the plan’s performance period begins. Plans are discussed, adopted and put into effect, and many committees don’t think about the plan again until after the year has ended. At that time, the committee often struggles to remember why it adopted the provisions it did. Since most compensation committees meet only once or twice each year, the “institutional memory” about what they intended fades. The struggle to reconcile the past and present is compounded by the fact that compensation committees often change members during the year, leaving new members without any idea of what they are being asked to approve.
Committee Action Guidance: This problem’s solution is complex because it requires a fundamental rethinking of the incentive compensation program and committee roles. First, the committee should be accountable for monitoring the CEO’s performance under the executive compensation program, including performance under any incentive plan. While executives provide performance reports to the entire board, they should also prepare reports that show performance of each plan participant relative to incentive plan performance. Second, the compensation committee should review and discuss these reports each quarter to ensure that there is no disconnect between what is being reported to the entire board and the reward that may be paid to each incentive plan participant. Third, the committee should recognize its responsibility for advising the chief executive about performance issues.
The implication here is that there should be a single committee—either executive or compensation, including the board chair and the chair of the finance or audit committee—accountable for setting compensation, monitoring executives’ performance and advising the chief executive on overall executive team performance issues. This committee is expected to report back to the entire board on executive compensation and performance issues.
What’s the Goal?
Q: What should we use as goals?
A: Goal setting is a thorny issue in any industry, but especially so in health care, which has to reconcile margin and mission and has numerous “stakeholders” to satisfy. However, there are common objectives that most stakeholders can agree on that reflect basic health care performance issues. These include:
- Safe care
- Satisfied patients
- Reasonable costs
- Appropriate financial margins
- Community benefit.
There is no agreement, however, about how to define or measure any of these performance indicators, some of which may actually conflict with one another. For example, some would argue that achieving an appropriate financial margin might be at the expense of providing a benefit to the community.
Yet, if there is to be a performance-based compensation program, boards will need to make some decisions and select optimum, rather than absolute, goals.
Committee Action Guidance: At a minimum, there are five standard criteria that we feel must be clearly defined in the incentive program plan:
1. Be clear about the purpose of the incentive package. Some boards consider the incentive payment as remuneration for expected, rather than superior, performance. If this is the case, spell out in the plan document that some or all of the incentive payment is actually subject to specific performance criteria.
2. Define measures that you understand and that reflect the organization’s strategic objectives. Accept that there are no perfect measures and select those with which you are comfortable and can measure and verify.
3. Document what you are doing and why. Documentation should include the plan document, as well as documenting in the minutes of the committee meeting, periodic discussions of participants’ performance.
4. Whenever possible, use externally developed benchmarks. This will help ensure that the board and executives, at a minimum, maintain objectivity. Also, match definitions with your chosen benchmarks. Having clear definitions will prevent debates in the future about what was meant when the plan was approved.
5. Avoid or minimize potential conflicts in the goals. For example, do not set your operating margins so that they can only be achieved by sacrificing charitable care.
Remember, Your First Job Is …
Q: How should we set incentive levels?
A: The job of the governing board is to govern. The role of an incentive compensation program is to support the board’s efforts to achieve higher levels of performance by providing a financial reward to executives who stretch to get these results. What does this mean? Typically, an executive earns his or her base salary for meeting expected goals and incentive compensation is reserved for those whose performance rises above those expectations—in other words, a “stretch.”
There is significant confusion about the difference between expectations and a stretch. For example, we have seen plans that include goals such as: “Complete the new facility on time and on budget.” Should the plan participant be paid for reaching a goal that the board assumed would be met? This is a question that requires the compensation committee to think carefully about the relationship between base salary and incentive compensation.
If the compensation committee sets base salary artificially low, an argument can be made that meeting the goal to complete the new facility on time and on budget is worthy of an incentive payout. In this regard, the incentive payment is a way for the committee to signal that, if the executive meets the goal, he or she will be paid more competitively relative to the market. In addition, executives could earn even higher incentive pay for beating the completion date and/or for coming in under budget.
At any rate, the committee should be explicit about how it is setting compensation so that there is no confusion. If pay is set low and incentive opportunities are high, the rationale should be spelled out along with the compensation committee’s sense of the probability of achieving any particular level of performance and compensation.
Financials are Easy to Measure
Q: Why can’t we just use financials to measure our performance?
A: “No margin, no mission” is a mantra of sorts in the health care field. And there is no question that without a sound financial base, even the most socially conscious organization will eventually lose money. But making a margin is not the reason a not-for-profit exists—it is there to provide some benefit to the community it serves. To meet this goal and preserve its tax advantage, a health care organization must do more than make a profit. It should do good. At the same time, the organization needs to build enough of a financial surplus to help sustain it during the economy’s ebbs and flows so that it can continue to invest in its mission.
Committee Action Guidance: Incentive goals should address the following criteria to ensure that the board compensates executives appropriately:
1. Faster—Is there a value to the organization to beat some deadline, such as recruiting key talent, opening a new program, or decreasing the time goods and products are in inventory?
2. Improvement—Better quality of care is a desirable outcome. Encouraging executives to stretch to achieve this goal can have a significant effect on the reputation of the organization.
3. Safer—The use of bar coding, radio-frequency identification (RFID) controls, technological improvements and structured protocols, including improved handwriting, can have a significant effect on reducing errors.
4. Rethinking core capabilities—Many organizations do not always have the resources to maintain the full range of skills required to operate many administrative functions. But if the board must choose between hiring more clerks or more nurses, adding more nurses should win. When it comes to delivering noncore services, organizations should consider alternatives, such as outsourcing.
5. Less cost—How could the organization save money by improving the supply chain, decreasing revenue cycle time, opening clinics to divert ambulatory patients away from the emergency room, or reducing the need for contract nurses?
In Summary
There are many issues for health care organizations to consider as they begin to implement or update executive incentive plans. (See “Making a List, Checking It Twice”.) Remember that incentive plans do exactly what the name suggests: they motivate participants to achieve results. In this era of increased scrutiny of executive compensation, thoughtful implementation of your incentive compensation plan is imperative to ensure you are motivating your executive staff to achieve desired results.
Thomas Flannery, Ph.D., is a principal with Buck Consultants in its Boston office. He can be reached at thomas.flannery@buckconsultants.com or by calling (781) 883-4249. David Hofrichter, Ph.D., is managing director of Buck Consultants’ compensation consulting practice in its Chicago office. He can be reached by e-mail at david.hofrichter@buckconsultants.com or by calling (312) 846-3400.
This article 1st appeared in the July 2007 issue of Trustee Magazine.
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