Incentive Metrics That Matter: Balancing Mission, Financial Sustainability, and Performance

Jake: We're wrapping up our series on tax-exempt organizations with a closer look at how boards choose and calibrate the performance measures that drive incentive compensation. Mark and Aalap are joined again by managing director Alexander Yaffe and principal Tim Dupuis, who each return to the podcast after our recent discussions on competing for executive talent and long-term incentive design.

Together, they explore how tax-exempt organizations can balance financial sustainability with mission and operational priorities, how many goals belong in an effective incentive scorecard, and how boards should approach goal difficulty, payout leverage, and discretion. They also discuss why there is no universal formula and why the right metrics ultimately need to reflect the organization's strategy, circumstances, and the behaviors it wants to encourage. Let's listen in.

Aalap: Alexander and Tim, we really enjoyed the past two conversations that we had with you individually and would love to really go through in a little bit more detail how incentive programs, specifically annual incentive programs and metric calibration and setting work within the tax-exempt environment.

Alexander: Sounds great. Happy to be back, and Tim, happy to have this conversation with you.

Tim: Yes, happy to be back and look forward to this discussion.

Mark: Yeah, thanks a lot, guys. Why don't we just jump right in? One of the things we touched on in the individual discussions was this balance of financial, operational, and mission-related priorities. And I know I always get a lot of questions on that linkage to the mission, but maybe you guys could talk a little bit about how you think about that.

Alexander: I advise my clients to begin with the mission and the strategy, and that's going to encapsulate a whole variety of topics and categories like finance, operations, programs, etc. But ultimately, they should begin with their mission and their strategy and strive for a balanced scorecard, at least in the not-for-profit sector, because they want to maintain a focus on their charitable purpose. And so that's where I think most of these conversations often begin.

Tim: Yeah, I completely agree with Alexander, especially with the tax-exempt organizations that I work with. They do tend to have more metrics within their incentive plans than I would say a large for-profit or publicly traded company because they are trying to incentivize and reward behavior for a variety of things outside of just financials. Their plans do tend to be a little bit more complex at times, but I think it's certainly warranted.

Aalap: Tim, when you say more metrics, how many are we talking about? What tends to be the average or the median number?

Tim: Yeah, if I think about some of my larger tax-exempt organizations, they can have six to ten metrics within their incentive plan. Maybe a couple of those are financial or sustainability-type metrics, but generally, the rest are more mission-focused or operationally focused.

Alexander: Yeah, I think that's the real tension for tax-exempt organizations, is there obviously needs to be a focus on financial outcomes. The old adage, "No margin, no mission," is real. But they want to be sensitive to their tax-exempt status, even though, if they had a financial goal, that's all working for their tax-exempt status. They want to be broader than that. But the tension is you can't have too many goals because then you're not really focused on the key drivers of success.

And that's where I think tax-exempt organizations sometimes struggle, is in that balance. But my experience is similar to Tim's. I advise clients to try not to have more than ten because if you have too many, then the weight becomes diffuse for any individual goal. I would agree with that sweet spot, six to eight is probably what they're striving for.

Mark: Do you think about any of these as having some judgment, or I hate to use the word discretion, but board members are going to take into account the fact that you can't predict what's going to happen during the year, and the way that the management teams are able to deal with those situations is often extremely important. How do you think about, we're going to play it where it lies, whatever targets we set at the beginning of the year, versus the ability to adjust midstream or take into account things that happen that were not anticipated?

Alexander: From my point of view, I think that those conversations should happen at the outset. Establishing appropriate performance expectations, how the program is going to work, what discretion exists, if any, are the metrics going to be revisited during the year for whatever reason? I have a number of clients that will, at least once during the year, if not quarterly, review the goals and the progress and ask the question: Is there a reason why any of these metrics would have to change? Not to shift the goalposts, but if something dramatically or materially changes, you don't want to wait until the end of the year to figure out how you want to deal with that.

I see that with a lot of my clients, it's really an ongoing conversation. But to your question around discretion, none of my clients really want to feel like they're in a box. They want to be able to utilize flexibility where it makes sense. The question is where it makes sense. And so, are you using discretion to modify a goal that was missed by a hair? Or are you using discretion in some other fashion? Tim, what do you see in all of this?

Tim: Yeah, I think it really depends on the organization I'm working with and their overall complexity. For example, I work with many nonprofits or tax-exempts who have maybe just introduced incentive compensation for the first time. And in their programs, most of their goals are more discretion-based than you might see in a more mature, larger tax-exempt organization. The goals are softer and more qualitative than quantitative, and so discretion plays a big part there. The board plays a major part in determining, okay, to what level was our mission achieved, etc.

For my large organizations that I work with, discretion works a lot like you would see in most organizations. Try not to use it very often, let's stick with our formulaic approach. If there are extraordinary circumstances that our executive team maybe didn't have oversight over or were outside of their span of control, then let's talk about discretion and, hey, do we need to bump a threshold payment up a little bit closer to target or things like that? There's really a span of approaches that I've seen.

Aalap: Yeah, and I think what you're saying around whether discretion itself is a weighted metric is a good contrast to when we think about it for other sectors, applying discretion is usually an after-the-fact adjustment to the formulaic outcomes. For tax-exempt organizations, what is a good governance strategy when you're talking about those after-the-fact discretionary adjustments to a formulaic payout? Any counsel there that you would provide?

Alexander: I think that it's important to try to understand how you might operationalize the incentive program at the beginning of the year. How might we apply discretion? Under what circumstances might we apply discretion? And then let's evaluate circumstances at the end of the year and adjust accordingly if it's warranted.

I think that's important from a recordkeeping perspective, so it doesn't look like you're changing the goalposts to fit a circumstance, as opposed to, we recognize that our environment needs discretion in order to appropriately acknowledge performance.

I have a number of clients that will maintain a portion of their incentive opportunity to account for things during the year that may be outside the goal framework, but for which they want to acknowledge either exceptional performance or lower incentives because something during the year was not handled the way they would have expected it. There is discretion to adjust the goals, and then there is discretion to acknowledge things that were off the grid entirely.

Aalap: Continuing on this strain of accountability and when you apply discretion and when sometimes you may not want to, how should boards set performance expectations and structure payouts, including financial gates and upside leverage?

Tim: It's a really good question, and I think once again, it depends on the type of organization that I'm working with. But I would say that most of the tax-exempt organizations I work with do have a more conservative leverage model or payout model. Whereas in a large for-profit public company, you might see two times payout for maximum performance, I work with a lot of organizations that have 125% or 150% upside, just to mitigate excessive risk-taking, but also from an affordability standpoint.

They want to be mindful of what their incentive payouts are sending to the population and the broader market. But I think wherever you're setting your payout leverage, that comes with mindful goal setting as well. If we're going to pay out 150% of someone's bonus for maximum performance, where are we comfortable making sure that performance achievement is met? And so there's kind of a back and forth there.

Alexander: Yeah, and I think that with tax-exempt organizations, given the sensitivity around reasonableness and ensuring there are no excess benefits, a lot of the incentive plan design also focuses on the behaviors and the psychology of leverage.

It's one thing to say to an executive, you're going to be able to earn up to 100% of a 20% opportunity. It's something else to be able to say you can earn up to 200% of a 10% opportunity, and then you calibrate your goals accordingly based on cultural expectations around how you set your budget or what other factors there may be.

When dealing with a lot of Type A people, if you don't use leverage and getting to 100% is, in fact, a stretch, that may be a less attractive design than allowing target to be 100%, but having upside leverage if you outperform. I think that from a tax-exempt perspective, there's managing the reasonableness, and then there's also understanding the team that you're trying to motivate and the best way to do that. And upside leverage can be an important tool as a part of that design.

Mark: How deep in the organization do you go, and do you see differentiation between different units within the organization that may have slightly different or sometimes significantly different objectives?

Tim: I think from an annual incentive plan design, a lot of the organizations I work with, the participation is fairly broad to almost all of the participants or full-time employees within the organization. And I think it's more of a cultural aspect where they're trying to drive a culture where we're all in this together.

For the most part, in those types of organizations, the metrics are similar across all employee groups. However, the weighting would be different. So, for example, the executives of an organization would have a higher weighting on some of the financial aspects of the business, whereas at the lower level in the organization, they're trying to create more line of sight. And so you'll see a larger weighting toward some more of those operational or mission-based objectives where those people have more control over the outcomes.

Alexander: Yeah, that's been my experience. If you're starting from zero, I see a lot of organizations wanting to get comfortable with an incentive plan for the chief executive. That then quickly goes to the next level of senior leadership, and it raises the question of, are we all rising and falling together, or what degree of differentiation is there based on individual responsibilities?

In an ideal world, even those individual goals are going to roll up to support the corporate or organizational objectives writ large. But you can have circumstances where the payouts as a percentage look different, and some organizations get comfortable with that over time or see it as all for one and one for all with one set of goals, which can be easier to administer but isn't as sensitive to individual circumstances. So that's another tension in the design work.

Aalap: Alexander, that was very helpful in talking about how these programs would also look deeper in the organization. I think the other thing that brings up is the role of long-term incentives alongside annual incentives. I'd love to hear your thoughts on that.

Alexander: The only thing that I think is worth adding on long-term incentives is that they are worth considering because they can play a different function, and they can play multiple functions. Retention being one that annual incentives don't have as much teeth into.

But long-term incentive plans can play a role, whether on an ongoing basis or for a specific need. While many organizations don't have them today, I would encourage nonprofits to think about how they might be utilized and how they are distinct from or complement the annual plan.

Mark: Gentlemen, I think this was a great conversation. We could probably talk for another 30 minutes on exactly how you would think about these for each individual industry within the tax-exempt world. This has been a good teaser on how to think about incentives. I'll certainly give you a shout next time I have a client question. Really appreciate you being here. Thanks a lot.

Alexander: Great to be with all of you today. Thanks for the invitation.

Tim: Thanks Mark, thanks Aalap.

Aalap: Really appreciate it. Take care. Bye.

Jake: Our thanks to Alexander and Tim for helping us to understand how tax-exempt organizations choose and calibrate the performance measures that drive incentive compensation. Next week, we will be moving to our final industry area of the season, banking.

David Seitz will join the pod to give an overview of incentive compensation in the banking industry and explain some of the unique aspects of banking incentives, I hope you'll join us.

In the meantime, you can find all of our Unscripted episodes on Spotify, Apple Podcasts, pearlmeyer.com, or wherever you get your podcasts. Thanks for listening, and we'll meet you back here next week.