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In 2009, health care boards and compensation committees confronted a complex problem: how to reward executives in a recession. As their surrounding communities struggled with unemployment and foreclosures, some health care organizations flourished, due in large part to visionary management. Tough questions arose even in struggling institutions, where attracting or retaining seasoned leaders remained a priority, regardless of external economic factors.

Despite these challenges, boards and compensation committees have not only done their jobs and met their regulatory responsibilities, but they have also exercised good governance and made the difficult decisions necessary to avoid disaster.

Health care organizations must recognize that we have likely entered a period of turbulence that extends to the horizon. A number of factors, including reform legislation, changes in payment systems and the continuation of a slow macroeconomic recovery will make navigation difficult. At the same time, the health care industry will need to meet the demands of caring for an aging population while deriving maximum benefit from the impressive developments in medical technology.

The decisions that boards made with management input often strengthened the board-management relationship in ways that will make it easier for both parties to navigate the future.

Thriving Amid Disaster

While the media has concentrated on the acrimonious dialogue around health reform, health care boards and management teams have been much more focused on the operational impact of the ongoing recession. Many health systems have had to cope with volatile patient volumes, a worsening payer mix and rising borrowing costs. Even where operational performance has been good, total income and days-in-cash have still fallen as investment portfolios have suffered.

In the first half of 2009, many health systems managed to regain their solid financial footing, but only by strategically curtailing capital spending plans or taking other painful cost-reduction steps including staff reductions and benefit cuts.

Paradoxically, some health systems have thrived even while the broader economy has foundered. Using good management and good timing, many organizations have done very well in this economy.

Consider the example of one respected billion-dollar health system serving a community where the recession's impact was serious, although not catastrophic. Even as the community suffered, the health system experienced its best year on record as measured by patient satisfaction, quality of care and operating performance. After much deliberation, the board decided to reward its management team with base pay increases and to distribute bonuses as stipulated by the design of the incentive program.

From a compensation point of view, health care organizations seeking to reward their executives for outstanding performance (whether measured by financial or other broad-spectrum criteria) may face a tough community relations challenge. They need to figure out how to properly compensate their management teams without offending the sensibilities of community board members or other influential citizens of communities who have been hurt by the recession.

In the example cited above, the board felt that pay increases and incentive payments were justified despite the recession because in addition to the organization's exemplary performance, the management team achieved it without major staff reductions or other painful cost-reduction initiatives.

Health care systems associated with major universities, particularly private institutions, have also faced a delicate balancing act. Endowments at many schools have plummeted 30 to 40 percent, reducing expansion plans, curtailing operations and sometimes even leading to salary freezes, benefit cutbacks and staff reductions. Despite the bad news on endowments, university-based health systems often continued to perform quite well. This can create a tense situation when health care executive members of the university "family" receive greater compensation than the academic members.

Trustees of several academic health systems have tried to defuse the tension by withholding base salary increases and reducing incentive payments despite superb management performance. While such decisions have led to some challenging boardroom conversations, in the end all parties recognized that they needed to make some short-term sacrifices to preserve a sense of harmony and good will within a broader university community hurt by the recession.

Faith-based health care organizations face a related challenge at a time when those at the lowest levels of the economy have experienced the greatest hardships. The boards of those institutions must balance the pressure to appropriately reward executives with the organization's culture of social justice and responsibility. This year, many faith-based health care organizations have frozen base salaries and reduced earned-incentive payouts, unable to justify rewarding top executives while their employees and communities suffer the effects of the recession.

There may also be regional disparities in the fortunes of health care organizations. In the Northeast, where the impact of Wall Street's misfortunes has been particularly severe, even high-performing health care organizations have had to cope with key board members and colleagues' diminished ability to provide advice, influence or contributions. In some cases, high-performing management teams have taken the initiative and suggested that the boards adjust incentive payments downward. Typically, the boards concur with such suggestions.

Let Performance Guide Decisions

Most high-performing health systems have detailed capital allocation plans and growth strategies built on assumptions of a much lower cost of money. In the past year, of course, access to capital has fallen sharply. Should executives be held responsible for overly optimistic predictions even if the changes in the cost of money were completely out of their control?

We believe that health care companies should continue to base annual financial rewards on operating performance. By following this practice over the past several years, board members have been able to focus management attention on key decisions and accountabilities.

Health care organizations that decide to reward managers for excellent operational performance may face challenges in justifying such compensation at a time when required public reports will show significant drops in total income. The board can defend its decision, provided that operating performance has been sound, by suggesting that management should not be held responsible for the extraordinary stock market decline in 2008 and early 2009 that wreaked havoc on corporate investment portfolios and thus had a negative impact on total reported net income.

In times of relative stability, market data also has been useful in helping compensation consultants and boards to determine appropriate executive rewards. Even the Internal Revenue Service sees the merits of this approach. But market data cannot always provide insights into the unique circumstances in which some health care organizations now find themselves.

Now more than ever, the challenge for organizations is to balance this sort of comparative compensation information with their own particular needs and circumstances. This balancing act requires intensive scrutiny of annual compensation decisions. Fortunately, in almost every instance, independent board members have made sensible and appropriate compensation decisions based on both quantitative (that is, market data) and qualitative (or organization-specific) factors. While health care organizations are naturally curious about the base salary and incentive practices of their peers, the best approach this year is for each organization to develop compensation packages based on the totality of its own circumstances.

Board members may not enjoy defending compensation increases during a recession, but it is critical for organizations to remember the value of having the right leadership team at the helm. Particularly in times of turmoil, respected leaders are highly prized. Many high-performing executives routinely receive recruiting offers. Despite public consternation, such retention concerns will continue to put upward pressure on executive compensation.

Safe Strategies

The pace of economic recovery will be slow, and reform legislation promises new challenges. Meanwhile, health care organizations must maintain their ability to attract and retain top management talent. They should also strive to achieve good relations between management and board members. At the same time, organizations cannot ignore conditions in the broader community or circumstances within their own ranks. Here are five strategies for charting a safe path:

Ensure the organization has robust and well-founded core governance processes. Now more than ever, members of the compensation committee and even the full board must be able to measure the scale, complexity and performance of their own organization against its peers. Such an assessment requires deep understanding of the health care organization's performance and processes to make sound compensation decisions. With this understanding the board can determine, for example, whether an organization's performance, scale and circumstances justify staking out a premium compensation position in the talent marketplace.

Clarify roles and processes now to prepare for difficult circumstances later. Board members should strive for immediate clarity on the roles, responsibilities and decision-making processes of all players in the compensation process. Such clarity will help the board act with confidence, speed and decisiveness when it faces tough decisions.

Consider the organization's total circumstances. Over the past several years, market data has taken on an outsized role in the overall decision-making process. Now is the time for the compensation committee and members of the management team to take a careful look at the organization's unique circumstances and characteristics. Decisions that appear unbalanced or inappropriate within the context of the organization are the ones that cause trouble. Paying incentives to managers at a time when the organization has made significant staffing reductions can lead to problems. At the same time, neglecting to offer fair compensation in the absence of compelling organization-specific reasons can also cause recruitment and retention headaches. Looking beyond such extreme examples, it is worth noting that many committees have been talking about the need to broaden the list of variables used in calculating compensation packages. These discussions that have taken place over the past several years should prove useful in helping committees frame their compensation decisions this year and beyond.

Prepare for ongoing, intense public scrutiny. Even though executive compensation has not been a part of the health care reform debate, we believe that it is likely to become a big part of the post-reform dialogue. Discussions of executive compensation in other industries have now entered the public consciousness and have become part of the accepted lexicon in political circles. The newly redesigned Form 990s will only fuel this fire as public access to executive compensation packages, including supplemental executive retirement plans, total cash compensation, base and variable pay, and perks—and the philosophies behind them—are made public through tax filings. While the average citizen is not likely to examine these documents, the media certainly will. On an annual basis—and more frequently if circumstances warrant—the compensation committee should review its planned response to any potential outside inquiries on its compensation packages and prepare the full board for such a possibility.

Recognize that the days of easy executive compensation discussions are over, at least for now. In all likelihood, executive compensation discussions will continue to be complex and even a little messy for the foreseeable future. These conversations will often include variables such as values, social justice, community circumstances and fairness balanced against executive team flight risk. The new parameters of discussion will take some getting used to, but the richness and depth of the discussions will ultimately help both managers and board members develop ideal compensation solutions.

More Variables, Better Decisions

The prevailing economic climate has unleashed major challenges with which boards and compensation committees have grappled over the past year. In the health care sector, such challenges are very likely to continue.

In 2009, community boards and compensation committees have taken their task very seriously, generally making good decisions based on a broadening list of variables including performance and market data, but also internal circumstances and sensitivity toward the community.

This perspective will shape future discussions on executive compensation. By using strong core governance processes coupled with clear decision-making, boards should be able to have a vigorous and constructive dialogue with management to reach mutually agreeable compensation solutions.

By C.J. Bolster (CJ.Bolster@haygroup.com) is national director, Healthcare Practice for Hay Group, Atlanta, and Ron Seifert (Ron.Seifert@haygroup.com) is senior consultant, Healthcare Practice for Hay Group, Philadelphia.

Sidebar - A Sensible Approach to Salary, Incentives