Tax-Exempt Healthcare and the Executive Pay Gap: How Boards Can Compete

Jake: We're turning our focus to tax-exempt organizations, beginning with the healthcare sector, and the challenge of competing for executive talent when the available compensation tools can look very different from those used by for-profit organizations.

Mark and Aalap are joined by managing director Alexander Yaffe, who leads Pearl Meyer's work with tax-exempt organizations and advises boards and senior executives on executive compensation, incentive design, retirement and retention programs, and related governance and tax considerations. They discuss why boards should start with the talent market rather than tax status, how to think about total remuneration when equity is not available, and how tax-exempt health systems can build competitive, performance-oriented compensation programs without simply trying to replicate a for-profit model. Let's listen in.

Mark: Alexander, excited to have you here today on our podcast.

Alexander: Thank you so much. I'm excited to be with you guys. I've enjoyed listening to these over the last period of time we've been doing them and happy to participate today. Looking forward to the conversation.

Aalap: Alexander, you're too kind and really appreciate you listening. I'd love to jump in with a question that I've been wrestling with. Tax-exempt health systems and for-profit health systems can compete for many of the same executives. Where should a board start when the compensation models are fundamentally different?

Alexander: It's a question that we get a lot and what I tell my clients is to start with the talent market. Tax status is important for lots of reasons, but when we talk about recruiting and retaining talent, it's important to understand, from where are we recruiting those individuals? Where might we be losing individuals to?

I think it's important to understand the roles that you're looking at, where those roles are coming from and going to, and ultimately what the compensation looks like for that role in those different environments before you start to design the program or even concern yourselves with some of the unique aspects of being a tax-exempt organization.

Aalap: And when you think about that, is there a question of whether you're supposed to separate what the compensation is versus the pay design?

Alexander: I think separating those two things is important because for a tax-exempt organization when looking at a particular individual, you want to understand what organizations like you are paying. That's important for the organization to know relative to where the individual is today, and certainly to satisfy the requirements under Code Section 4958 that you look at organizations of a similar size and type. Functionally comparable positions for similarly situated organizations. Understanding it under the tax-exempt umbrella is very important just in terms of quantum, how much are we paying these people?

If you look at that same position on the for-profit side, again, I would want to understand if we can look at for-profit systems of a similar size and the individuals doing similar work, how does that pay structure look similar or different? Understanding the pay value first is critical before you get to the design.

Aalap: So, where the rubber meets the road is, are you focusing for the tax-exempt ones really on tax compensation? Or how do you think about long-term incentives and looking at that total compensation picture?

Alexander: Total remuneration is critical, again, not only for an IRS point of view, but for a board and management to understand all of the components of the package. I encourage clients to look at the entirety, cash and benefits, total value. And a client needs to be able to understand where does this all sit relative to where we are today? If that package looks markedly different than a similarly situated for-profit competitor, the question then becomes, how comfortable are we moving towards a higher value? And what does that look like for our tax-exempt comparisons, even though we're competing with for-profit health systems? That's where I think the design of the program, in addition to the overall amount that you may be paying, becomes important.

Aalap: Right, Alexander, let's pause there for a second because this is a question that comes up often is really the role of long-term incentives. From my understanding, the data still indicates there is not a hundred percent adoption rate for long-term incentives in tax-exempt organization. Based on what you're saying, is this something that you would advocate for?

Alexander: I think that organizations continue to look for ways to tie higher compensation to long-term performance outcomes. And there are a variety of ways to peel that onion. I encourage clients to consider long-term incentive opportunities in some way, shape, or form. Sometimes it may be more performance-based. Sometimes it may be more of a focus on retention. But when we talk about the difference in quantum between what can be provided to a tax-exempt organization versus what might be provided in a for-profit. A tax-exempt organization may be more comfortable being more aggressive relative to market if they feel compelled to do so because for-profit comparisons are higher. And they may be more comfortable with that number if those dollars are only delivered through true performance outcomes. So, they're in a stronger position to say, “yes, we paid at a higher percentile, but we did so to retain top talent and only after they delivered meaningful and demonstrable performance outcomes.” Otherwise, they may not feel as comfortable being at a higher value.

Mark: And Alexander, please correct me if I'm wrong here, but we often see more retirement and other very long-term retention tools being used in the tax-exempt, which are paid in cash. How do we think about that comparison and the risk of actually earning it in the public? I mean, they're not really apples and apples. So how do you benchmark?

Alexander: Well, that's exactly right. They're not apples to apples, and that's why I think it's important to try to differentiate between how much is being paid and how it's being paid. There is obviously a role for cash compensation through annual incentives. I think there's even a role for cash compensation in long-term incentives. With respect to retirement in the tax-exempt world, it does end up looking like more of a quilted, woven pattern of components, where there is an element of cash, there may be an element of long-term cash, but there also may be an element of performance compensation that is deferred into the future.

You can't exactly mirror what's happening through equity, but you can get closer to it through a patchwork quilt of cash, deferred compensation, and other elements that may track more closely with enterprise value than simply whether a goal was achieved or not achieved. But you do need to be more creative in the design and the tools utilized to get there. So, you get closer, but it's not a mirror image.

Mark: Alexander, as we think about these various different tools that we have, I'm also a former tax nerd, or maybe I still am a tax nerd, the concept of reasonable compensation versus how much we should be paying. So, “it's sometimes reasonable” is different than how much you should be paying because you're trying to accomplish something and the value might be a little higher because you have a certain incentive, and so that benchmarks to a higher level that's reasonable, but might be above the median. So how do you think about this concept of reasonable versus here's our recommendation?

Alexander: I think that at the end of the day, it's important for organizations to be thoughtful about where they are, where they're going, and the talent that they need to help them get there. The market is not static and there is nothing that says that above the 50th percentile is problematic and below the 50th percentile, you are free and clear. Circumstances matter.

And so, in the same way that paying a more competitive compensation package for someone who has never been in a role before may be as risky as paying at a much higher percentile for someone that has a proven track record but is now taking something on that may be existential to the future of the organization. So, it really has to do with understanding the dynamics and laying out the story for why the organization is doing what it's doing and why in these particular cases something may be reasonable. 

There's a big difference between guaranteeing compensation and keeping your fingers crossed that the person's going to deliver, versus putting it into a performance component that pays out over a number of years, versus deferring it and tying the achievement to whether or not the outcomes actually deliver what was expected. And that's a much longer-term horizon than simply, did you get the blocking and tackling done? I really think that the circumstances within which the organization finds itself is as important to answering reasonableness as the numbers themselves.

Aalap: What I seem to be hearing from you, Alexander, and please correct me if I'm wrong, but in your conversations focused on performance, it seems that your expectation is that regardless of tax status, so focusing on specifically tax-exempt organizations, the way to structure compensation, the way to determine if the quantum is appropriate, is really using a for-profit public company, standard in a way, which is pay-for-performance.

Alexander: Absolutely. I see no reason why a tax-exempt health system shouldn't look at the world in a similar fashion. What are we paying for? How much are we paying for it? The reasonableness question becomes one where you are looking at specific data sets or dealing with circumstances, and you cross that bridge when you get there. But I would see no reason why a tax-exempt health system shouldn't consider all the same things that a for-profit would. It's just a matter of how it's structured and how it's delivered, and whether at the end of the day, we can say that we feel as though it is both reasonable and competitive. Because at some point those comparisons would diverge.

Aalap: And to that end, when you think about the comparative group of companies that you're using or comparative survey data, is there a particular third rail here in terms of, can tax-exempt organizations be compared to for-profit organizations? Or should they only be tax-exempt organizations? It sounds like if you have a pay-for-performance philosophy, and you focus on that, then you can have a wider comparison peer set.

Alexander: There is nothing that prohibits a tax-exempt organization from comparing itself to for-profit organizations that are similar, we know that. The question is, when does it become appropriate and why would you need to do it? And the more you compete with for-profit organizations, the more that may be a reality that you need to contend with.

But I think that at the end of the day, it does become a question of, who's in our peer group? What data sources are we looking at? And what organizations may we want to know about or understand without necessarily saying they're going to be a peer or we're going to use them as a direct comparison? It may be influential in positioning, but that doesn't mean that they're going to be a peer organization. I would add that wrinkle to the analysis.

Aalap: Great, and let me ask you a personal question here, because this is something I've experienced in the boardroom consulting to organizations. This is a little bit of a “behind the closed doors,” if you will. The question of mission and how it plays into calibration of compensation. What I mean by that is, I've definitely heard conversation coming from the board or even the CEO that individuals in the organization are devoted to the mission and so therefore we may not calibrate compensation to the fiftieth percentile or something higher because of that mission focus. What’s your view on that?

Alexander: I think that mission is important and I think that when you find executives that buy into the mission of a tax-exempt organization and are supportive, that's a wonderful thing. But I don't think that should be used as a way to pay less competitively. The reality is that if an executive is delivering for the organization, and there is a value in the market for that executive and their skills, the for-profit comparators need to be thoughtfully considered in the question. Because while there is an extent to which you may feel as though someone should buy into the mission, the question then becomes, well, what is that worth?

And if you look at two organizations and one is paying X and the other is paying X plus fifty percent, is the haircut really fifty percent, because it's a nonprofit organization? Here again, I think the board needs to think about the talent and the market first and then determine the question of mission and any haircut that a tax-exempt organization may expect in creating a differential between a for-profit entity and a tax-exempt entity.

Organizations that lean too heavily on someone buying into the mission may find it challenging to retain talent because at some point an executive for their own welfare and that of their families may not be able to just write off significant economic opportunities outside of the tax-exempt organization they work for and tax-exempt organizations would be thoughtful to keep that in mind.

Mark: Alexander, when you're advising your clients now, what's the one thing you want them to get right regarding the competition from for-profits, before they would change the incentive program in some way. What do you want to try and make sure they're doing well?

Alexander: I would say that there are three things they should be doing well. One is thoughtfully defining the market so they understand what compensation actually looks like for tax-exempts and then tax-exempts plus other relevant organizations. Understand those differences.

Second important thing is, once you understand those differences, are we trying to deliver a similar amount of compensation or are we trying to get close? So, what are we trying to do and why are we doing it? Because then that's going to lead to the third thing that they need to get right, which is the design and the tools that they're utilizing to deliver that benefit, whether it's a one-to-one match with what they see in the market or something different. They need to understand the market, they need to understand how they want to try to reach that market, and then they want to figure out the right tools to do that, that are going to be best for the organization and the impact on the executive because not all tools were created equally.

Aalap: I only dabble in this market, so I envy the ability for you to handle this complexity. I really appreciate the time that you've taken with us today. I think this is really eye opening.

Alexander: This has been great. I appreciate the invitation. I look forward to another topic and we do it again.

Mark: Yeah, thanks a lot, Alexander. I really wanted to slip in something around what are the performance metrics you're seeing, but I wasn't able to get to it, so we may need to have you back.

Alexander: I would love that.

Mark: Thank you.

Jake: Our thanks to Alexander for helping us to understand why tax-exempt status does not define the talent market, and why compensation strategy should reflect where an organization actually competes for leaders while still fitting its mission, governance, and economic model.

In our next episode, we'll be examining long-term incentives in the tax-exempt space. Outside of public companies, long-term incentives are less standardized and are not automatically appropriate. Pearl Meyer principal Tim Dupuis will join the pod to discuss how HR and compensation leaders can determine when a long-term incentive is appropriate, how to build a defensible, competitive reference point with imperfect data, and how to design a program that fits the organization rather than simply copying the public company model.

As always, 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.