The pressure to manage the risk and return on investment in executive talent has never been greater for the boards and compensation committees of nonprofit health care organizations. These institutions must recognize that effective governance practices have evolved beyond basic oversight and should reflect the more complex dynamics of executive pay.

Indeed, nonprofits tend to focus on how well they can mitigate risks to the institution's reputation, as well as the threat that regulators may attempt to sanction the organization. There's also the risk that key constituents will have negative perceptions that could color support for the organization in other areas, a particular concern when it comes to access to public funds.

Boards and compensation committees also must confront risk related to attracting and retaining executive talent, rewarding the right performance outcomes and ensuring leadership continuity.

Responding to Scrutiny

To get a sense of how well compensation committees at nonprofit organizations are progressing in their governance of executive compensation, Mercer recently conducted a survey generating responses from 89 nonprofit health care organizations. The good news is that governance practices have evolved significantly in response to the growing scrutiny of executive compensation. To manage the reputational and regulatory risks posed by the current executive compensation environment, organizations have taken a number of steps, many of which mirror actions taken by compensation committees of publicly traded companies and those recommended by governance experts.

Several best practices are common among survey respondents, including:

  • establishing a compensation committee charter that formalizes institutional control over executive pay;
  • establishing a compensation committee agenda with multiple meetings demonstrating active governance;
  • promoting transparency of executive pay through the use of tally sheets and review of Form 990 prior to filing;
  • annually reviewing market data to determine the competitiveness and reasonableness of total remuneration;
  • being careful about including for-profits in compensation comparisons and documenting when there is evidence that they influence the talent market;
  • engaging a compensation consultant to advise the committee.

These practices tend to be more prevalent in the largest organizations ($1 billion plus in net revenues). The data suggest that compensation committees in these larger organizations have a broader scope, are more active and have more established processes.

Rigor and Risks

The survey provides a good yardstick by which organizations can evaluate their governance of executive compensation. While all compensation committees share the same goals—securing top talent and aligning performance and pay—some need to strengthen their defenses. For a number of organizations, the focus should be on instituting processes to mitigate reputational and regulatory risks. These include developing the full board's understanding of the executive compensation philosophy, emerging market trends, regulatory changes and the executive talent risk environment.

The compensation committee must employ sound governance practices that address everything from which organizations to use in comparing executive pay to taking a total compensation perspective when considering changes to any element of compensation or benefits—all the way to ensuring that clawbacks are in place to recover paid compensation in the event of a restatement of financial reports. It should examine all practices regularly with particular attention to those that are potentially problematic.

Organizations that are effectively mitigating reputational and regulatory risk have still more to do. Their focus should encompass the more strategic dimensions of executive compensation, including ensuring that the organization maintains the level of executive talent needed to deal with dramatic changes facing health care. In addressing these more complex risks, a board may find its executive talent risks and reputational or regulatory risks at odds—that is, securing necessary talent may involve assuming a greater level of risk.

Boards must manage the organization's ability to continue to attract and retain executive talent despite growing scrutiny from multiple quarters, a depressed pay market, the uncertainty of reform and its potential implications for reimbursement, and the reconfiguration of local markets. New tools may be needed to achieve this objective; that is, a one-size-fits-all compensation platform that mirrors conventional market practice may need to become more flexible and unique. This will require better communication to manage the perceptual fallout that may ensue. Also, stronger documentation of the circumstances and rationale of a new, more flexible program may be required to preserve the available safe harbor through IRC 4958, a law regarding penalties for excessive economic benefits.

Another challenge is the need to ensure a fair exchange in value between the performance delivered by the executive team and their level of compensation. Goals must reflect growth in key success areas, and this may translate into raising the bar on performance while ensuring that rewards are calibrated fairly to the difficulty of achieving the desired performance.

For example, with the anticipated federal pay-for-performance reimbursement method looming, there is the possibility that relatively good clinical outcomes will yield no greater reimbursement in the future than today, but weaker outcomes likely will yield less. As such, a meaningful link between clinical outcomes and executive pay seems likely with the value exchange being proportional and reflective of the risks to the institution's clinical reputation and, ultimately, to its financial well-being. Otherwise, compensation committees open themselves to scrutiny and criticism.

Finally, one of the greatest threats would be the inability to assure the continuity of key senior leadership. Boards must address this risk through management development and succession planning processes.

Good governance demands a view beyond reputational and regulatory risks. Preserving executive talent and aligning performance and rewards should be of equal or greater concern. Indeed, anything less than such a rigorous approach to governance will create an untenable position for the organization.

Jose Pagoaga (jose.pagoaga@mercer.com) is a partner with Mercer, Atlanta.

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