Executive Compensation Issues

Executive Compensation in Six Steps
Editor's note: The following article is based on a
presentation at the CUPA-HR National Conference
& Expo held in St. Louis in October 2008.
It's no surprise that executive compensation is a
hot topic these days, with the excesses of
corporate greed highlighted nearly daily in the
media. However, the focus on executive
compensation is not limited to the firms on Wall
Street. Over the past several years there have
been documented cases of abuse throughout the
nonprofit community, including within academia.
In 2004, the Internal Revenue Service (IRS)
launched a targeted audit program of tax-exempt
organizations. The results, published in 2007,
revealed significant levels of confusion regarding
the instructions for completing Form 990 and
identified other problems associated with excessive
salary, incentive compensation, and perquisites not
reported as compensation in the nonprofit
community. In response, the IRS revised Form 990
and launched a compliance project that included a
specific focus on the higher education community.
In October 2008, the IRS issued a 37-page
compliance questionnaire to approximately 400
colleges and universities inquiring specifically about
their endowment and executive compensation
policies.
While the amounts of compensation, bonuses, and
perquisites found in higher education may pale in
comparison to those in the for-profit world, they
elicit mixed responses within the academic
community. Their mere existence can spark
controversy, especially in times of shrinking
budgets and rising tuition costs. However, the
ability to recruit, retain, and reward key
employees is as essential in higher education as in
the corporate sector, and is largely accomplished
through the use of a variety of executive
compensation arrangements. The issues surrounding
the design of these arrangements in both the
business and educational communities are similar.
Marketplace characteristics and competitive
pressures, the public's demand for accountability
and disclosure, and the changing legislative and
regulatory environment all have an impact on the
design of an effective executive compensation
program. On the legislative front, the introduction
of IRC Section 409A by the Internal Revenue
Service has had a major impact on the design of
executive compensation programs. IRC Section 409A
governs all nonqualified deferred compensation
plans, a key component of any executive
compensation program. Independent colleges and
universities also must determine executive
compensation in accordance with IRC Section 4958
intermediate sanction provisions.
A sound executive compensation program begins and
ends with good governance and a well-established
compensation philosophy, policies, and practices in
line with the institution's overall goals and
objectives. Good governance practices must include
peer-group analysis and a review of the total
compensation package (including perquisites such as
housing and car allowances along with business and
entertainment expenses) and must provide for
performance measurements that clearly define
success. Good governance practices should also be
well documented and adhere to all legislative and
regulatory requirements. Now more than ever—with
the watchful eye of Congress and the public—good
governance must include adherence to the three
C's: compliance, coordination, and communication.
The Three C's
Compliance with the legislative and regulatory
requirements surrounding executive compensation
and nonqualified deferred compensation plans is
critical in order to avoid intermediate sanctions,
fines, and potential disqualification of the plans
themselves. Coordination of all arrangements
established throughout the university—whether for
a star faculty member, university president, or
athletic coach—should be centrally managed and
maintained to ensure all arrangements are in line
with the overall executive compensation policies and
practices of the institution. And, communication
throughout the organization—faculty,
administration, board of trustees—is critical so
that no surprises or inconsistencies in policy and
practice are present.
Development of a comprehensive executive
compensation program should be looked at as a
joint venture among key stakeholders. These
include members of an institution's board of
trustees and senior administrative officials such as
the business officer, the human resources director,
and the institution's legal counsel.
Executive compensation can be divided into four
general components: base salary, standard
employee benefit plans, supplemental short- and/
or long-term incentive compensation plans, and
perquisites. Focusing on the supplemental plans,
tax-exempt and governmental institutions are
limited in comparison to their for-profit
counterparts in what can be provided key
employees. There are several types of executive
compensation arrangements commonly used in the
higher education marketplace. ( See sidebar,
"TIAA-CREF Fact Sheets on Executive
Compensation Arrangements
.") In general, public institutions tend to have more
options than private institutions because they are
exempt from certain ERISA reporting and
disclosure requirements and IRS coverage and
nondiscrimination rules.
Designing an effective executive compensation
program can generally be broken into the following
six steps.
1. Analyze existing benefit plans and executive
compensation arrangements. One of the first
things you will want to do is review the benefits
provided under the standard package of employee
benefit plans that will be offered to the key
employee. Analysis of the base retirement and tax-
deferred savings plans is necessary in order to
identify gaps in coverage and opportunities that
maximize benefits provided under the available
limits. In other words, do the math. Addressing
what is needed or desired can only be accomplished
after determining what is already being provided.
For existing executive compensation arrangements,
you will want to determine if the programs still
meet their primary objectives and remain in
compliance with current regulatory and legislative
requirements. You will also want to analyze the
administrative requirements and costs of the
benefit program to ensure that it remains
affordable and efficient. Finally, as with any
employee benefit plan, you will want to ensure that
the executive compensation package that is being
offered or considered is not only adequate, but
also understood and appreciated by the key
employee.
2. Establish primary plan objectives for executive
compensation program. This step basically asks the
question, why are we considering development of a
supplemental executive compensation package?
Is it simply to provide the key employee with
additional retirement contributions above and
beyond those provided by the standard employee
benefit plans?
Is it to restore benefits lost under these
standard plans due to the IRS limits placed on
compensation or nondiscrimination testing?
Is it to provide the key employee with additional
salary deferral opportunities?
Is it to attract or retain the services of a key
employee or to reward performance?
The answer to these questions will help identify the
most appropriate executive compensation
arrangement for the circumstance. "Yes" answers
to the first three questions can, in many cases, be
accomplished without complex plan designs and—
depending on the amounts under consideration—
within the established limits of eligible nonqualified
deferred compensation plans. Plans with an
objective of recruiting and retaining the services
of key employees generally tend to be more
complex in design and involve higher compensation
limits.
3. Identify optimal plan design features. Once you
have determined the plan's primary objective, you
will want to gauge the relative importance of
certain design features from an institutional
perspective. A common consideration is the issue of
public disclosure and/or Form 990 reporting. In the
case of a highly recruited athletic coach, these
issues generally tend to get played out in the local
media and are difficult to manage. However, the
type of plan selected will determine when or how
the compensation is disclosed. (Note: all public
institution information is subject to state open
records laws, and independent institutions must
disclose all compensation in the Form 990.)
Other considerations include determining the
importance of protecting the benefit from the
institutions' creditors, whether future service
requirements are required, and when benefits are
to be made available. (Some plans, such as 457(f)
arrangements and 457(b) plans of tax-exempt
organizations, must be "unfunded," whereby the
assets remain the property of the institution and
must be made available to creditors until they are
distributed.) Design features such as rolling risks
of forfeiture, the use of non-compete agreements,
or requirements for performance of consulting
services following separation from service are
generally no longer available.
4. Determine tax and distribution strategy. Of
great importance to both the institution and the
key employee is the tax liability and distribution
strategy associated with the executive
compensation plan selected. Although tax-exempt
and governmental employers do not have the same
tax incentives as for-profit organizations when
establishing executive compensation arrangements,
some plan designs have bookkeeping requirements
that must be considered. The institution also must
determine the importance of employer control of
the assets and benefit distributions prior to and
after vesting or before retirement. Of particular
concern to the key employee are the individual tax
consequences of the benefits during the
accumulation phase, upon vesting, prior to
distribution, and following separation from service.
Rules vary by plan type and must be analyzed
carefully.
5. Select appropriate financing methodology.
Depending on the type of executive compensation
plan under consideration, an institution will need to
base its financing strategy on projections of future
assets, benefit liabilities, and cash flows. Simply
put, how is the institution going to pay for or
account for the benefits promised? Common
financing arrangements include:
Cash/lump-sum settlement (pay as you go).
Shadow account (defined interest and earnings
assumptions).
Institutionally owned annuity/mutual fund
accounts.
Institutionally owned life insurance policy.
Use of Rabbi Trust, Employee Trust.
From the key employee's perspective, various
funding arrangements tend to involve a trade-off
between the level of security provided on the
underlying benefits and the amount of tax deferral
that can be achieved. Certain executive
compensation arrangements have maximum
contribution limits placed on them with the benefit
of spreading out the tax liability over time upon
distribution while others provide for unlimited
contribution amounts but are heavily taxed upon
vesting or distribution.
6. Establish guidelines for periodic review and
evaluation. As previously mentioned, a successful
executive compensation program begins and ends
with good governance and compliance with all
legislative and regulatory requirements. It is
critical to review these arrangements on an annual
basis to ensure they remain consistent with the
institution's overall compensation philosophy,
policies, and practices and are in compliance with
applicable laws and regulations.
While the focus of this article centered on the
types of executive compensation packages most
commonly used in higher education, the annual
review should take into consideration the total
compensation package: base salary, benefits,
short- and long-term incentive programs, and
perquisites. It is also important to ensure that all
executive compensation plans are well documented,
including the decision-making process and
procedures that went into their development. And
finally, good governance requires involving all of
the key stakeholders (human resources, finance/
business office, and legal counsel) and clear
communication between senior leadership and the
institution's governing body.
Nancy Taylor is director of executive compensation
and institutional product management for TIAA-
CREF. E-mail: ntaylor@tiaa-cref.org