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CEO Compensation Practices in Nonprofit Hospitals:
A Matter for Pubic Concern and Action?
Hardly a week goes by when there isn't a national, state or local news story raising concerns about
compensation for chief executive officers (CEOs) or other executives of nonprofit hospitals or
health systems.
This special Alliance report summarizes the views of two nationally recognized experts on this
important issue.
The two experts--Ken Ackerman, Chairman of INTEGRATED Healthcare Strategies
(INTEGRATED), based in Minneapolis, MN and David Bjork, Senior Vice President and Senior
Advisor of INTEGRATED's executive compensation practice--shared their perspectives with the
Alliance's President, Bruce McPherson, in June 2013.
Basic Objectives in CEO Pay Practices
The board’s fundamental goal in setting CEO pay is to pay what’s necessary to find and retain the
best CEO to lead the organization.
With that basic goal in mind, the board's practical objectives are to pay enough to maintain the
CEO's morale, minimize controversies within the board over the CEO's pay, and make sure that
decisions are defensible to regulators and others—such as the media, the general public, the
medical staff, and the hospital's employees.
Board Dynamics and the Competitive Labor Market
Virtually all nonprofit hospitals and health systems are facing major challenges such as labor
shortages, intense competition, and increasing financial risk for various dimensions of
performance—quality, patient safety, patient satisfaction and efficiency. Such challenges have
intensified the competition for talent—for CEOs and other executives—between independent
hospitals and between regional and national hospital systems.
Even with sector consolidation through mergers and acquisitions, the nonprofit hospital sector is
still very much a cottage industry. For instance, with nearly 5,000 hospitals in the country,
hospital CEOs typically progress in their careers by moving from smaller institutions to larger
ones, from smaller systems to larger systems. CEOs often move three to five times in their careers.
This leads to lots of turnover, crates lots of opportunities for CEOs to enhance their compensation,
and forces boards to compete for talent.
Boards have two strategic options for CEO recruitment. The first is to develop CEO talent
internally; but independent hospitals and smaller systems tend not to do so, because they are
organized in professional silos that don't develop general managers and because they can't afford
to keep extra talent around in jobs designed as pathways to the CEO position. The organizations
that are really good at developing CEO talent internally tend to be big, decentralized systems with
six or more operating units.
The second option is the path that most boards take: recruiting from the outside someone who
has already been successful at doing the same job in a comparable organization. To do this they
are willing to pay top dollar, which is often more than what the last CEO made. When it’s time to
recruit a new CEO, boards want to minimize risk by choosing someone who has already proven
capable of handling the job. It's hard to find a board or a search committee that would set as a
criterion finding the best inexpensive CEO or the best young CEO--even though there may be
many good ones who would be glad to take the position at lower pay than would a seasoned CEO
from a comparable organization.
Likewise, boards have only two strategic options for retaining their CEOs. The first is to let them
move on whey they are ready to go—to recognize that, no matter how well they are paid, CEOs will
move on if and when they want to move to enhance their careers or to live where they want to live.
This can mean living with frequent turnover, as many small hospitals do. It can mean choosing or
settling for a CEO who is likely to stay put for one reason or another. But it also means that
boards are less likely to pay a lot just to retain the CEO, since it’s almost impossible to pay enough
to hold onto a successful CEO who wants to move on or who is willing to move on to make more
money.
The second option is to try to pay enough to retain the CEO. The only way this works is to pay as
much as bigger organizations are willing to pay to attract the CEO and to structure the pay
package so the CEO would forfeit a lot by leaving. Even then, another organization is likely to be
willing to cover the forfeiture with a hiring bonus. Unfortunately, many boards fall into the trap
of paying a lot to retain the CEO (and other executives as well), hoping that the CEO will stay as
long as the board is generous. Just as boards want to minimize risk in recruiting, they want to
minimize the turmoil and stress caused by CEO turnover, and that often leads them to pay more
than what the organization’s compensation philosophy calls for—paying as much as they dare, as
much as they believe is reasonable, in order to retain an executive who is performing well,
Public Concerns: Warranted or Not?
Boards pay what they have to pay, or what they believe they need to pay, to recruit and retain
good CEOs. They no doubt believe that they are paying no more than they need to, and that what
they are paying is entirely reasonable. They generally obtain reasonably good information and
advice about pay levels in the industry. Sophisticated boards generally exercise considerable
discipline in following best practices in governing executive pay and in meeting the requirements
for the presumption of reasonableness.
Nonetheless, a few federal and state government officials, most notably Senator Chuck Grassley
(R-IA) and Massachusetts Attorney General Martha Coakley, have recently questioned the value
of the "rebuttable presumption of reasonableness" established by Congress and the Internal
Revenue Service (IRS) to strengthen governance of executive compensation by boards of
organizations exempt from taxation under section 501 (c) (3) of the Internal Revenue Code.
Organizations meeting the requirements for the presumption are in effect provided a "safe
harbor" from IRS sanctions on excess compensation. The requirements include (1) approval in
advance by an authorized body (i.e. compensation committee), the members of which have no
conflict of interest with regard to executive compensation; (2) reliance on appropriate
comparability data on total compensation paid by comparable organizations for comparable
positions in comparable situations; and (3) adequately documenting in timely minutes the terms
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approved, the process followed, and the basis for determining that the compensation approved is
reasonable.
The critics argue that the presumption provides an easy pass for boards that pay executives too
much—an easy way to justify excessive pay, a lot of busy work to paper over the problem. They
point out that boards and their consultants can rig a peer group to provide whatever data is
needed to demonstrate that compensation is reasonable, and that any board or compensation
committee can go through the motions and document its decisions in timely minutes.
Much of the criticism of executive pay in not-for-profit healthcare organizations is based on
figures reported in IRS Form 990, which requires reporting compensation in ways that
misrepresent actual compensation. The instructions require double-reporting of deferred
compensation, and the biggest figures reported virtually always represent vesting of retirement
benefits earned over many years. What gets reported in the press is often badly misconstrued—
total compensation being reported as “salary,” for example.
What the critics miss is that boards have been entrusted by law with governing those tax-exempt
organizations, entrusted to make all kinds of decisions, many of them more important than
decisions about executive compensation. What they misunderstand is that most boards are well
intentioned, and that it is those good intentions that lead to generous pay. All the boards are
trying to do is pay as much as other organizations do, so they can attract and hold onto leadership
talent. There is nothing wrong, after all, with paying competitively, or with paying enough to
recruit the leaders you need to be successful, or paying enough to keep them from going
somewhere else for more pay.
The criticism of use of peer group data in setting compensation doesn’t make much sense in
healthcare, with all the turnover and movement from one organization to another. The labor
market for healthcare executives is pretty clearly defined: it is a broad market—either a broad
regional market or a national market—of other organizations about the same size, with
comparable services and comparable challenges. It is only small rural hospitals that look only or
primarily at in-state data in setting executive pay. Other hospitals and health systems almost all
look at national data, because that best represents the labor market in which they compete for
talent.
We should point out something often overlooked by the media, that the overall rate of increase in
CEO pay in the nonprofit health sector is averaging only about 3%--no higher and perhaps lower
than salary increases for other employees, such as nurses and pharmacists.
Possible Actions
Boards are increasingly sensitive to public scrutiny--from regulators, the media, unions,
employees and others. Better board education, more transparency, and perhaps some regulatory
"tweaking" could help strengthen governance of executive pay in nonprofit health care
organizations.
One of our suggestions is that there be even more disclosure of compensation practices,
especially regarding the organization's compensation philosophy, the peer group it uses in
determining pay, and the nature and extent of incentive and retirement programs. This is already
required in the for-profit sector. The Securities and Exchange Commission now requires publiclytraded firms to describe their approach to selecting comparability data and disclosing whether, as
part of their executive compensation philosophy, they set pay at the median, the 75th percentile
or some other percentile. Requiring disclosure of this sort of information could be very helpful in
deterring overly generous compensation philosophies.
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Another suggestion is that nonprofit health care boards should seriously consider the elimination
of defined-benefit supplemental executive retirement plans (SERPs) for CEOs and other
executives, as most employers have eliminated final-average-pay pension plans for other
employees. Pensions for other employees used to require 30 years of service to get maximum
credit, but SERPs for executives typically deliver maximum value after only 20 or 25 years of
service. Retirement benefits based on final-average pay make even less sense for highly-paid
executives than for other employees, since executive pay at the end of a career is generally much
higher than it was 15 or 20 years earlier, and since few CEOs serve much more than five or 10
years before retiring from their final CEO position. Providing a lifetime retirement benefit of 50%
of final average pay after 25 or 30 years of service might make sense for a nurse or a housekeeper,
and it might make sense for someone who has been CEO for 25 years, but it makes no sense for
someone who was CEO for only 3 years, after 25 years in lower-paid positions.
Other suggestions we have for nonprofit health care boards to consider:
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Limit severance pay to 12 or 18 months, to avoid having to pay fired CEOs full salary or
full pay for 2 or 3 years;
Avoid bizarre benefit designs intended only to reduce a well-paid executive's tax
obligations; and
Forget about "keeping up with the Jones's." Stop worrying about what everyone else does
and do what’s right for your own organization.
Don’t get trapped in thinking that you always have to pay more than you did last year—
another salary increase, maybe a bigger one than last year, and just as big a bonus or even
more than last year.
There are no magic bullets, however, to make the issue go away. Executive compensation is
always going to look high to most people, since most people are paid a lot less than executives.
The fundamental public policy question comes down to whom would you rather trust to make
these decisions--some government official or agency or the independent board members of these
nonprofit health care organizations? We opt for the latter without hesitation. They bring
community values and perspectives to bear on decisions; they have to defend their decisions to
their local communities; and they know what it takes to recruit and retain executives in a highly
competitive labor market.
Nonprofit health care boards include some of the most prominent leaders in their communities,
often CEOs or other executives of local businesses. If we entrust them with making good decisions
about the best ways to meet the health care needs of their communities, why shouldn’t we trust
them with making good decisions about executive pay?
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