Compensation in Question

Regulatory changes and market dynamics have transformed many hospital executive benefit plans from highly flexible arrangements offering competitive benefits to annual cash bonuses.

One of the primary fiduciary responsibilities of a nonprofit board is oversight of executive compensation. Benefits are a significant component of total compensation, typically equaling 28 to 35 percent of base salary. Executive benefits commonly are delivered through a flexible format that allows executives to apply benefit dollars toward the welfare benefits they most desire, with leftover dollars flowing to tax-sheltered supplemental retirement accounts.

Changes in Internal Revenue Service regulations and economic pressures, however, have undermined this format. As a result, benefits are underutilized and dollars intended for benefits are converted into annual supplemental pay that is not tied to meeting any strategic incentive goals.

Most health care organizations want to strike a balance between cash compensation and benefits that provide protection of family income and adequate retirement benefits linked to tenure. The overall effect of the transformation of benefit dollars to cash is to raise compensation levels and destroy this balance with potentially harmful consequences.

Two Key Changes

How did this transformation occur? The executive benefit plans created in the 1990s and beyond were well-intentioned. Typical employee plans cap benefits at levels too low to protect executives. For example, a group long-term disability policy may provide a monthly benefit of 60 percent of salary to a maximum of $5,000. Any salary in excess of $100,000 will not be replaced in the event of a disability. Most executive salaries exceed that level so supplemental coverage is needed.

Additionally, legislative limits on compensation that can receive qualified retirement plan contributions render most retirement savings plans insufficient for highly paid executives. Executive benefit plans are created to provide supplemental benefits with more appropriate provisions. Most offer great flexibility so that executives can make the most efficient use of benefit dollars by purchasing coverage and services they really need. When the plans first were implemented, most executives took the long view and carefully selected benefits that would protect their families and provide a comfortable retirement.

In 2007, the IRS announced two significant changes to rules governing employee benefits. First, it published its intent to disallow noncompete agreements as a method of sheltering compensation from taxation under Internal Revenue Code Section 457(f). Without a noncompete agreement, deferred compensation in the nonprofit sector must be forfeited when a deferring executive voluntarily terminates employment. The response of virtually all executives and sponsors was to substantially shorten vesting dates for dollars that flow into supplemental retirement accounts in flexible-format benefit plans rather than risk forfeiture.

Some boards even voted their executives additional compensation to make up for the loss of the long-term deferral opportunity. It is important to note that this ruling, although announced in 2007, had not been finalized at press time. Most organizations, however, gave up waiting to find out if their executive supplemental retirement plans would continue to be viable and, instead, implemented some kind of cash or short-term deferral option. With the recession, unemployment and high college tuition costs adversely affecting family budgets, most executives now take the short view and pocket the extra cash.

The second IRS ruling disallowed the mixing of taxable and nontaxable benefits (for example, life insurance mixed with long-term care insurance) in all plans other than those qualified under IRC Section 125. Because most executive flexible benefit plans are not qualified, employers converted previously nontaxable benefits to taxable benefits to bring plans into compliance with the new rule. Executive use of these important benefits dropped dramatically after this conversion because the new tax status often makes it more cost-effective to purchase benefits outside employer plans.

Potential for Scrutiny, Litigation

A recent survey of 148 nonprofit hospital and health care association executive benefit plans reveals that of 4,100 participants with flexible benefit options, fewer than half are choosing one or more welfare benefits. Only about 2 percent are deferring compensation until retirement. On the other hand, 43 percent are electing to receive benefit dollars in cash, either immediately or within two years, and another 25 percent receive deferred compensation within five years.

This transformation has several harmful consequences. The shift of benefit dollars to cash creates an imbalance of compensation. Over time, executives tend to forget that the cash is a substitute for benefits. They inevitably view the extra cash as part of their annual compensation and adjust their family budgets accordingly. Soon they begin to lobby for better benefit packages, which results in benefit cost creep and overall total compensation inflation. Many organizations are discovering that due to this phenomenon, total compensation levels far exceed those set forth in organizational compensation philosophies. This raises red flags and invites regulatory scrutiny.

The same imbalance that results in significantly higher cash compensation levels than indicated in compensation philosophies also leads to inadequate protection of families from premature death or disability, and insufficient accumulation of retirement assets. Even though executives may choose to leave large portions of their income uninsured for death or disability, regulations governing adequate benefit communication and guidance leave open the possibility of litigation if highly paid executives find themselves and their families grossly underinsured when the unthinkable happens. Often, allegations based on organizational actions that are completely defensible still are litigated.

Health care organizations cannot afford to pay substantial compensation that is not tied to the achievement of strategic incentive goals and the measurable improvement of clinical outcomes. In an increasingly complex market, boards wrestle with how to use compensation to align executive performance with strategic goals. They must be vigilant to avoid regulatory sanctions, poor employee relations and unnecessary litigation, and proactive in preserving a positive public image, while at the same time attracting and retaining the caliber of talent needed to navigate the roiling changes in health care. Organizations that pay large amounts of cash that cannot be linked readily to improving clinical outcomes may find themselves at odds with the forces of reform.

Drew Erra (Drew.Erra@StratfordFidelity.com) is executive vice president and chief marketing officer and Kathryn Ernst (Kathy.Ernst@StratfordFidelity.com) is a senior benefits design consultant, both at Stratford Fidelity, Minneapolis.

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