COMPEN$ATION CLASH: Complexity boosts not-for-profit pay, but should work be its own reward?

At least two large Indianapolis not-for-profits have been investigated-and cleared-as part of an Internal Revenue Service examination of compensation practices at tax-exempt organizations.

Preliminary results of the nationwide inquiry aren’t expected until fall, but the scrutiny already has increased the volume in an ongoing debate over how not-for-profit executives should be paid.

Some observers have called for setting limits on not-for-profit compensation, citing the charitable nature of the work. Others insist sixor seven-figure pay packages are not out of line given the growing complexity of the sector.

IBJ reviewed tax filings detailing pay for nearly 1,300 Indianapolis not-for-profit workers to learn more about local compensation practices. Findings ran the gamut-from $32,000 paid to the executive director of a small family foundation to $3.9 million in salary and benefits awarded to a now-retired hospital executive.

Such is the nature of a diverse not-for-profit sector, said Eugene Tempel, executive director of IU’s Center on Philanthropy.

“Many people assume folks who work for non-profits are willing to be paid less: It makes them feel good, and that should be a form of compensation,” he said. “But there’s a tension between what people expect from non-profits in terms of efficiency and effectiveness and what they are willing to pay for that.”

And the rule book that governs not-forprofit entities isn’t much help in resolving the conflict. IRS regulations warn organizations that overpaying could jeopardize their tax-exempt status-but they don’t say how much is too much.

That ambiguity may have been what brought Lumina Foundation for Education and Clarian Health Partners to IRS investigators’ attention. Both are large organizations with generous compensation packages.

Three Clarian employees earned more than $1 million in salaries and other compensation in 2004, according to the hospital network’s most recent tax return. Another eight collected over $500,000.

At Lumina, CEO Martha Lamkin earned more than $500,000, with salary and benefits totaling $671,000.

IBJ analyzed informational tax returns filed last year by 170 of the largest and most prominent not-for-profits in Indianapolis. IRS officials would not disclose the identities of the 2,000 tax-exempt organizations included in its review, but Clarian and Lumina readily admitted their involvement and shared copies of letters giving them the all-clear.

Such openness “is an important part of our stewardship,” said Lamkin, who has worked for Lumina and its predecessor for 15 years. “We are entrusted with funds to accomplish something for the public good. … We want to do whatever we can to help uphold that trust.”

“It’s an important area,” concurred Clarian board Chairman Thomas Chapman, who also works as executive director of a health-related not-for-profit in Washington, D.C. But he cautioned against trying to use such data to make apples-to-apples comparisons. “This is apples and oranges and pears all wrapped up together.”

Indeed, it’s difficult to draw conclusions using only the information included on the tax returns. Not-for-profit leaders said the stark numbers don’t reveal much about the complexity of the job, the skill of the person doing it, or whom the organization competes against for employees.

Large organizations may look to the private-sector marketplace for job candidates, something Tempel said has been driving not-for-profit compensation higher for years.

“Salaries being paid by non-profits correspond very closely to organizational size and complexity,” he said. “Some … have to operate very much like businesses.”

The public should want talented professionals running not-for-profit organizations despite the cost, said Deborah Hechinger, CEO of Washington, D.C.-based governance consultant BoardSource. Focusing only on the bottom line is “a penny-wise and pound-foolish approach,” she said.

Pablo Eisenberg doesn’t buy that argument. In fact, the senior fellow at Georgetown University’s Public Policy Institute and longtime not-for-profit executive is an outspoken critic of such reasoning.

“The whole idea that bigger budgets merit bigger salaries is extraordinary,” he said. “It’s easier to run a 300-person organization than a 25-person group, because you can delegate. That’s one of the great myths … it’s just outrageous.”

Big budgets, big bucks

It’s nevertheless a common explanation. Large not-for-profits routinely point to the size, complexity and businesslike nature of their operations to justify generous compensation.

Indeed, the IBJ analysis of tax returns filed during 2005 turned up 27 not-forprofit employees with total compensation exceeding $500,000-all of whom worked for hospitals, private foundations and massive specialty organizations like college-sports powerhouse NCAA and student-loan guarantor USA Funds.

Those kinds of not-for-profits don’t rely on financial support from the community, instead deriving their substantial annual income from sources like fees for service, investment returns, membership dues and government contracts.

Because they literally operate as businesses rather than as charities, such organizations often recruit executives from the private sector-and pay them accordingly.

Several have incentive bonus plans to augment executives’ base salary. Most pay into retirement accounts. Some offer retention bonuses. And all of that adds up.

“We are just different than a typical notfor-profit,” said Norm Lefstein, an Indiana University law professor who leads USA Funds’ compensation committee. “We are much more like a for-profit organization in terms of what we do and the amount of money we deal with. … We have $69 billion in outstanding loans and manage $300 million in foundation assets.”

Even so, congressional critics questioned pay practices at USA Funds and its then-parent USA Group in the mid-1990s, and the organization agreed not to use government money it held to pay salaries.

At the time, total compensation for USA Funds President Edward E. Pollack was $601,800. CEO Carl C. Dalstrom’s compensation totaled $668,769 on the organization’s most recent tax return.

The assets of not-for-profit USA Group were sold to student-loan giant Sallie Mae in 2000, but USA Funds kept its identity and its tax-exempt status. The $770 million sale price was used to endow the Lumina Foundation, now worth more than $1 billion.

USA Funds General Counsel David Boodt, whose annual compensation tops $291,000, said the student-loan guarantor has not been contacted as part of the current IRS inquiry.

Lumina, on the other hand, underwent an examination of its tax returns for 2001 and 2002. Officials received a letter in February closing out the review and accepting the returns as filed.

Lamkin called the process thorough and congenial. The foundation board already follows an “arm’s-length” process to set compensation, she said, benchmarking salaries against those at similar foundations.

Also, the organization is operating more like a charity than it did during the initial transition from USA Group. Early on, annual incentives were a significant part of executive compensation, for example, but Lamkin said bonuses have been “ratcheted down” to less than 10 percent of the total.

Foundation board Chairman John Mutz said the salary structure also has been scaled back. And he’s comfortable with where it has settled with the help of compensation experts who weigh in each year.

Still, he understands the scrutiny.

“It’s a healthy thing for [regulators] to periodically raise the issue, hold forums and talk about it,” Mutz said. “But what the final result will be is hard to say right now.”

Clarian’s Chapman is similarly philosophical. Even if little wrongdoing is discovered, the IRS review could serve an important purpose, he said.

“It may cause more organizations to have more discipline,” he said. “Clarian has for many years followed a very rigorous process when it comes to compensation. But I don’t know if that’s the case-it’s probably not-for smaller organizations.”

Gauging the marketplace

Indeed, sophistication levels typically rise with the organization’s budget, experts said, and there are many more not-for-profits operating on a shoestring than there are those loosening the purse strings.

Nearly half of the more than 60,000 not-for-profits in Indiana have an annual budget of less than $40,000, according to a 2004 IU study, and most of the smallest groups don’t pay staff at all.

Plenty of not-for-profits-large and small-still take a laid-back approach to setting salaries, said Marc Owens, a Washington, D.C., attorney who spent 10 years at the helm of the IRS’ Exempt Organizations Division.

“In lots of organizations, the compensation process has been fairly casual,” he said. “There has not been careful documentation. Sometimes it was done more on a handshake than a written document. That can be defended, but it makes it harder and increases the risk that someone is going to be overpaid or underpaid.”

Second Helpings Executive Director Gina Brooks knows she probably falls into the latter category. She is paid a $55,000 base salary and has the chance to earn a $5,000 bonus if she meets certain performance goals.

That’s not much, considering she also serves as the job-training and hungerrelief organization’s human resource director, operations director, finance director and building manager-oh, and she’s filling in as marketing and events manager for the next couple of months while an employee is on maternity leave.

“I know I’m underpaid for what I do, but I’m willing to accept that,” she said. “Sometimes you need to make sacrifices.”

Nevertheless, Brooks says it is important for an organization’s salaries to keep pace with the market. That’s why she will ask her board for an extra $55,000 next year to give raises to 13 of Second Helpings’ 19 employees-all of whom make less than the average minimum for their positions.

“Pay is an important way to attract and retain quality talent,” she said. “If you aren’t able to hire a good staff, you won’t get the results you want. And that’s the bottom line.”

Brooks and the Second Helpings board look at comparable agencies to determine what constitutes fair pay, even if their methodology isn’t quite as formal as larger organizations’.

Experts recommend not-for-profit boards review compensation regularly, whether or not they’re in danger of paying too much. Keeping up with the marketplace can be an important factor in retaining employees-and avoiding huge increases when turnover occurs.

“There certainly are excessive salaries, but the biggest problem is too many people who are paid too little,” said Daniel Borochoff, president of the American Institute of Philanthropy, a Chicago-based charity watchdog. “Organizations waste a lot of money recruiting and training that they could save if they paid more reasonably.”

But even when employees stay for the long haul, replacing them can be expensive. Human-services organization Noble of Indiana hired a proven not-for-profit executive when longtime CEO Erv Picha retired in 2003, for example, but it had to pay $20,000 more than the $149,500 Picha made in his last year in the job. Executive committee Chairman John Kirkwood said that’s what was necessary to attract Michael Howland from a similar post in Washington, D.C.-and he took a pay cut.

Indianapolis Museum of Art directors likewise expected to boost compensation to attract a successor to Anthony Hirschel, who made about $204,000 in his final year. Early in the search, board Chairman John Thompson told IBJ he expected to pay another $50,000 for a new director.

This month, he said even that may not be enough, “given where we see ourselves as an institution and where we’re going.”

The board wanted to hire the “optimal” person to lead the museum, he said, and “when we made that decision, we realized we’d be paying a higher level of compensation than even the $250,000” estimate.

Thompson declined to be more specific, citing ongoing negotiations with newly hired museum CEO Maxwell L. Anderson. Anderson, a 25-year industry veteran who has been a principal in a New York consulting firm, starts in mid-June.

The NCAA also had to make adjustments when it replaced former President Cedric W. Dempsey in 2003 with Myles Brand, recruited away from his job as president of Indiana University. Brand’s compensation in his first full year on the job totaled $858,722, almost $50,000 more than Dempsey’s.

That’s simply what it took to hire the right person, said executive committee Chairman Walt Harrison, who collected $346,579 during 2003-2004 as president of the University of Hartford, according to the Chronicle of Higher Education.

He cited the complex nature of the association’s work-and the pricey marketplace for employees who must understand both big-time sports and higher education.

“We need people who have expertise in a number of areas,” he told IBJ. “We don’t want to pay more than we can manage, but have to pay enough to attract good people who are devoted to the organization.”

Brand made $870,185 in the year ended Aug. 31, 2005, according to the NCAA’s most recent tax filing.

Still, not all turnover is costly. There are rare occasions when new blood saves an organization money.

Consider the Institute for Study Abroad, a low-profile not-for-profit that works to help college students arrange to spend a semester or longer studying overseas.

Its now-retired co-directors received compensation of more than $400,000 each in fiscal 2001-2002, the last year they both worked full time. New CEO Robert Gervasi, who joined the organization in June, makes $175,000.

Chairman and former co-director David Gray-who ran the organization from Philadelphia with help from Indianapolisbased partner Thomas Roberts-said the difference is that he and Roberts founded and developed the organization.

“Basically, we have shifted it over to a more traditional operating non-profit,” he said. “We looked very carefully at what other organizations are paying.”

Responding to scrutiny

The IRS doesn’t provide guidance on what constitutes appropriate compensation, but regulations do spell out a process organizations can use to arrive at a reasonable number.

It’s simple enough: Independent board members review data from similar organizations-for-profits and not-for-profits alike-before voting on compensation. Then they must document the process.

All the central Indiana organizations contacted by IBJ said they follow some variation of those steps. That means the IRS bears the burden of proving compensation is not reasonable.

Still, some compensation critics have called for shifting the burden of proof to not-for-profits.

“The thought was that if the proper procedural steps were followed, the proper result would be reached. This has not occurred,” Minnesota Attorney General Mike Hatch testified during a 2004 Senate Finance Committee hearing on the topic. “Indeed, the sanctions have had the opposite effect. … Organizations feel empowered to pay excessive salaries because they believe it will be difficult for regulators to question [them].”

And if salaries at comparable organizations are also inflated, observers said, compensation could quickly get out of hand.

Still, the scrutiny doesn’t only come from regulators. The nationally circulated Chronicle on Philanthropy called attention to pay practices at Indianapolis-based Lilly Endowment Inc. in 2003.

Chairman Thomas M. Lofton’s salary the previous year had amounted to $822,000, 83 percent more than he’d made five years earlier-despite the fact that the endowment’s assets had lost 36 percent of their value in the same period. With benefits and deferred compensation, Lofton made more than $1.2 million in 2002.

Endowment spokeswoman Gretchen Wolfram defended his salary and benefits then, telling IBJ the board believed compensation was “proportional, warranted and appropriate.”

Still, Lofton’s salary was reduced 17 percent in 2003 and was unchanged in 2004. Benefits and other compensation were cut 68 percent over the two years. Endowment President N. Clay Robbins’ pay package decreased 3 percent from 2002 to 2004.

Wolfram declined last month to answer questions about the changes, saying such matters fell into the realm of board policy, “which we routinely do not comment on.” But endowment trustee and former Gov. Otis Bowen said the reductions were a response to the recent compensation brouhaha.

“I think we realized the salaries were pretty generous,” he said. “With the signs of the times, we thought we’d better go backwards a little bit.”

Reducing their compensation does not imply that the board is unhappy with Lofton’s or Robbins’ performance, Bowen said.

And the more recent compensation packages-a total of $808,738 for Lofton and $838,781 for Robbins in 2004-are “still generous, but earned.” The board uses consultants to evaluate compensation every year, he said.

Not surprisingly, Eisenberg, the Georgetown fellow, doesn’t have much faith in compensation consultants-or private foundation boards, for that matter. The so-called experts invariably look to the corporate world to set compensation, he said, and ignore talented individuals in the not-for-profit sector.

“There is this assumption that high salaries are important, that you’ve got to compete with businesses,” he said. “There are a lot of really great people who would work for a lot less. They’d die to run the Lilly Endowment, and they’d probably take $300,000 or $350,000.”

And boards of directors are too often composed of wealthy retirees or highly paid professionals who also are biased toward higher salaries, he said.

“As long as philanthropic boards are stacked … that’s the kind of thinking you’re going to get,” he said. “Put a community representative or a teacher on the Lilly Endowment board, and they might start asking questions that lead to a lower salary. But you just don’t have those folks.”

Indeed, leaders of private foundations typically aren’t asked hard questions, said Borochoff, the charity watchdog.

“They’re like politicians that don’t have to win elections,” he said. “People want to play up to private foundations. They control the resources, so they’re able to get away with more. But they need to justify their salaries just like regular non-profits.”

Asked whether Lilly Endowment was included in the IRS inquiry, Wolfram said the organization has “complied with all requests and requirements of the government” and declined further comment.

Shedding light on process

What comes out of the IRS initiative remains to be seen. David Fish, a manager in the Exempt Organizations Division, said the agency expects to issue a report in September or October on what it has found so far.

Examiners have found some “disturbing” practices, he said, but those appear to be in the minority. The IRS already has instituted some changes to the tax return itself, seeking additional information in a number of areas, including compensation.

The stakes are high. Americans gave $248.5 billion to charity last year, and, as IRS Commissioner Mark Everson said during a public address in December: “If abuses cause us to lose faith in our charities, Americans will stop giving and those in need will suffer.”

Drawing attention to the compensationsetting process-and making it more transparent-may help keep that from happening, experts said. Indeed, that’s one reason the IRS launched its initiative in 2004.

“When people know we’re out there looking, they tend to be more compliant,” Fish said. “I think everyone knows we’re paying attention to this now.”

So what’s next?

Eisenberg threw out an often-repeated suggestion that not-for-profit compensation be capped at $400,000-the U.S. president’s salary-but Tempel and others cautioned against drawing a line in the sand, given the broad scope of the not-for-profit sector.

“A low salary is not a green light just as a high salary is not a red light,” Borochoff said. “Boards need to look at what salary needs to be paid.”

Whatever the decision, the process should be open, Tempel said.

“The more non-profits can be transparent about these things-disclose what they’re doing and why-the better off all non-profits will be,” he said.