The Price of Doing Good:
Executive Compensation in Nonprofit Organizations
Peter Frumkin
Professor of Public Affairs
LyndonB.JohnsonSchool of Public Affairs
Box Y
University of Texas at Austin
Austin, Texas 78713
Elizabeth K. Keating
Assistant Professor of Public Policy
KennedySchool of Government
HarvardUniversity
79 JFK Street
Cambridge, MA02138
Tel: (617) 495-9856
E-Mail:
We thank the Aspen Institute's Nonprofit Research Fund for their financial support of this project and the NationalCenter for Charitable Statistics at the Urban Institute for providing us with Form 990 data. We appreciate the helpful advice of Burton Weisbrod, Rachel Hayes and members of the HauserCenter faculty research seminar.
The Price of Doing Good:
Executive Compensation in Nonprofit Organizations
Abstract
This article examines the foundational assumption that nonprofit organizations operate under a non-distribution constraint, which prohibits paying out excess earnings and requires their application to the organization’s mission. Examining determinants of nonprofit executive compensation, we find that nonprofit CEO pay is strongly predicated on that in similar-sized organizations. Nonprofit executive compensation is modestly affected by CEO performance, measured by fund-raising results or administrative efficiency. We find evidence, inconsistent with the principle of not distributing profits, that CEO compensation is significantly higher in organizations with “free cash flows”. We discuss implications of this finding on distinctive organizational identity of nonprofit organizations.
Keywords: executive compensation, nonprofit organization, efficiency, accountability.
The Price of Doing Good:
Executive Compensation in Nonprofit Organizations
I.Introduction
Nonprofit organizations depend on good will, generosity, and commitment. Existing studies of nonprofit compensation indicate that the pay of nonprofit workers and executives is lower than their employees in comparable positions in for-profit firms (Preston, 1989; Steinberg, 1990; Handy and Katz, 1998; and Ruhm and Borkoski, 2000).However, appropriate compensation for the leaders of these organizations is central to the long-term viability and success of the entire nonprofit sector. Quality leadership for nonprofit organizations must be recruited, motivated and retained. Thus, it is not unexpected that nonprofit organizations frequently find themselves under competitive pressure to find ways to offer compensation packages that are comparable to similar nonprofit, or even for-profit, organizations.
To protect their charitable status, nonprofit organizations are legally prohibited from distributing earnings that “inure to the private benefit of any private shareholder or individual.”[1] This prohibition, called the “non-distribution constraint,” limits a nonprofit’s ability to reward nonprofit executives directly for many forms of financial performance. Historically, nonprofit compensation decisions have not been incentive-based but rather determined by revenues or earnings or loosely connected to social or programmatic goals. (Kertz, 1997; Frumkin and Andre-Clark, 1999).
Modest executive compensation packages and limited use of incentives have posed challenges to nonprofits during the 1980s and 1990s. Due to the commercialization and increased competition from for-profit and nonprofit providers, nonprofit executive compensation practices have changed. Some nonprofit organizations have shifted from fixed salaries to ones containing a variable cash compensation component based on fundraising, cost reductions or specific programmatic outcomes (Barbeito and Bowman, 1998). However, these plans have met with resistance because they tend to focus heavily on financial measures of nonprofit performance rather than on the social dimensions of performance, namely mission fulfillment.
Nonprofit managers have also sought “comparable pay” (Pappas, 1995; Drucker, 1992) with business managers. Benchmarking of salaries of nonprofit executives has become more prevalent, encouraged by a new set of IRS regulations that allows sanctions and fines to be levied on nonprofit organizations that pay their executives excessive compensation relative to similar nonprofit and for-profit firms. However, for many nonprofit organizations, increasing executive compensation remains prohibitive because of budgetary and moral constraints.
To better understand nonprofit compensation practices, we test three main competing hypotheses. First, we consider whether executive compensation in nonprofit organizations is a function of the size of the organization. We expect to find that nonprofit managers are more highly compensated in larger organizations, consistent with pay levels reflecting managerial responsibility. Second, we examine the prevalence of pay-for-financial performance in the nonprofit sector. We expect to find little or no connection, given the weak relation between financial performance and mission fulfillment and the existence of the non-distribution constraint. Third, we look at the role of liquidity or “free cash flow” and examine its effect on nonprofit compensation. We expect, if the non-distribution constraint is indeed operative, that liquidity will not affect CEO compensation decisions. The second and third tests are particularly significant in the nonprofit context. If a strong association exists between compensation and liquidity or financial performance, it would challenge the effectiveness of the non-distribution constraint.
The paper proceeds in five steps. First, we present a review of corporate compensation literature and discuss its applicability to the nonprofit sector. Second, we develop our research hypotheses. Third, we describe the panel data, the variables, and our research design. We then present the results of the analysis and interpret their meaning. Finally, we offer some concluding remarks about the challenges of explaining executive compensation in nonprofit organizations.
II. Literature Review
A. For-Profit CEO Compensation
To understand the nature of nonprofit compensation, we start by examining the management literature on the determinants of CEO pay in business firms. Much of this extensive body of research relates to three general themes. First, compensation studies have consistently found a link between the size of the company and executive compensation levels (Gomez-Mejia, Tosi and Hinkin, 1987). Faced with considerable uncertainty, companies pay their CEO based on the scope of their responsibility and the amount of resources they are charged with managing. Simon’s early explanation (1957) of this phenomenon was that firms used compensation to distinguish between different managerial levels, and because large firms have more levels, they tend to pay their leaders more than smaller and less hierarchical companies. Subsequently, extensive empirical work has demonstrated that managers earn more when they have been entrusted with leading large companies.
Second, drawing on agency theory, many studies have examined the linkage between company financial performance and the executive compensation levels. Some have found a connection to profitability (Agarwal, 1981; Lewellen and Huntsman, 1970), though many other studies have concluded that firm performance is not a key driver of CEO compensation (Benston, 1985; Deckop, 1987; Jensen and Murphy, 1990; Kerr and Bettis, 1987; Murphy, 1985; Redling, 1981; Rich and Larson, 1984). Researchers then have focused on relative performance evaluation and tested whether CEO pay decisions were driven by the performance of a manager compared to his peers in a given field (Holmstrom, 1982). One reason why boards might take into consideration the compensation decision of other companies stems from the possible increased efficiency that such information might make possible (Antle and Smith, 1986; Kerr and Kren, 1992; Morck, Schleifer and Vishny, 1989). Interestingly, institutional theory has not been actively used to examine compensation decisions. Outward-oriented decision making has been understood and rational comparative evaluation of performance, rather than as a mimetic process, an organizational ritual, or a symbolic legitimizing behavior (Meyer and Rowan, 1977; Tolbert and Zucker, 1983; DiMaggio and Powell, 1991).
Because of the weak link that has been established between pay and performance, alternative explanations of compensation patterns have been advanced. A third interesting explanation of CEO compensation has focused on the independence and relative power of the board. In situations when the board is non-independent or weak, CEOs may be highly compensated due to poor oversight by board or by collusion. In either case, the control systems designed to protect the interests of shareholders fail. In analyzing CEO compensation levels, board-CEO relations thus becomes a critical factor to consider (Westfall and Zajac, 1994). Some research has also considered the relative power and influence of shareholders in explaining CEO pay patterns (Gomez-Mejia, Tosi and Hinkin, 1987) in an attempt to understand board decision making.
B. Nonprofit Compensation and the Non-Distribution Constraint
As a whole, nonprofit organizations tend to pay their workers at lower salaries than their business firm counterparts. Several theories could explain this finding: Many who choose to work in the nonprofit sector engage in “labor donations,” preferring altruistic and other non-pecuniary benefits to monetary rewards (Rose-Ackerman, 1986, Preston, 1989). Wages may be lower in nonprofit jobs as a screening device, attracting only those managers willing to restrain their desire for profit (Young, 1977; Hansmann, 1980). Other theories suggest that paying nonprofit executive salaries that rival those in the business would be highly problematic given expressive character and social orientation of these organizations (Mason, 1996). However, if the compensation differences between the sectors grows too large, then nonprofits will be unable to attract personnel with strong management and leadership skills needed to ensure organizational growth and capacity building (Letts, Ryan and Grossman, 1999).
Due to these competitive pressures, research has explored the compensation differences across nonprofit and for-profit sectors (Borjas, Frech III and Ginsburg, 1983; Frank, 1996; Goddeeris, 1988; Johnson and Rudney, 1987; Mocan and Viola, 1997; Preston, 1989). These cross-sector studies generally apply tests from one or two of the three strands of for-profit literature. Roomkin and Weisbrod (1999) and Brickley and Van Horn (2000) focus on profit and nonprofit hospitals, while others concentrated on variations in executive pay (Oster, 1998; Baber, Daniel and Robert, 1999; Hallock, 2000). These papers often explain differences between the nonprofit and for-profit sectors using the labor donations, screening or social orientation theories. In contrast, our study focuses on one of thedistinguishing legal features of the nonprofit sector: the non-distribution constraint.
In principle, the nonprofit organizational form allows society to overcome certain market or "contract failures" (Hansmann, 1980). In exchange for the provision of services to the needy, nonprofits are provided tax-exemptions and the ability to offer contributors tax-deductions for their charitable gifts. Hence, nonprofits can enable society to increase the output of certain goods and services, without moving to direct government provision or the provision of subsidies to for-profit firms. To ensure that nonprofits do not abuse their privileged tax position, nonprofits are legally subject to the “non-distribution constraint.” Hansmann (1980, 840) describes this requirement as:
A nonprofit organization is, in essence, an organization that is barred from distributing its net earnings, if any, to individuals who exercise control over it, such as members, officers, directors, or trustees…. Net earnings, if any, must be retained and devoted in their entirety to financing further production of services that the organization was formed to provide.
By consenting to the non-distribution constraint, nonprofits agree not to distribute profits to employees or third parties but, instead, to use any excess resources to fulfill the organizational mission.
The theory of non-distribution creates a line demarcating nonprofits and business organizations. While for-profit entities can and do freely divide up profits between shareholders and management, nonprofits are thought to operate differently. For some nonprofit constituents, the presence of an operating surplus is a sign that nonprofits are charging too much for their services, either to clients paying a fee or to donors making contributions. Instead of accumulating surpluses and applying it to future mission-related work, nonprofits face some pressure to reduce the costs of their services to the break-even point or expand the volume of services. At the same time, they must be prudent and accumulate enough surplus to sustain a reasonable level of net assets in the event that their financial position changes unexpectedly.
III. Research Hypotheses
A. Organizational Size and Managerial Responsibility
Extensive for-profit research indicates that corporate executive compensation is a function of organizational size.[2] Murphy (1998) argues that size is a proxy for managerial skill requirements, job complexity, and span of control. Nonprofit compensation research also suggests that size may be an important determinant of CEO compensation (Hallock, 2000). Size or organizational scale may actually be a more significant determinant of compensation in nonprofit than for-profit organization since inputs such as program expenses and tangible assets are the most visible and measurable element of the organization’s production process.
Organizational size may also be an important factor in nonprofit pay because governing boards often determine compensation by benchmarking against senior executives in nonprofits that are comparable in size and industry focus (Barbeito and Bowman, 1998). A growing number of professional associations across fields of nonprofit activity now actively collect and disseminate compensation studies, which report average salaries and benefits for executives at organizations across different budget categories. Boards are able to rely on this data to guide their compensation decisions.
Finally, organizational size provides legitimacy (Scott, 1995; Zucker, 1988). Large institutions typically garner more publicity, have higher prestige, and are viewed as more effective by virtue of the scope of their activities. Moreover, boards of large institutions are typically made up of leaders from the community, whose judgment is less likely to be subject to questioning and critical scrutiny. Managers can and do receive larger compensation packages at these larger institutions because they are simply perceived as deserving and entitled to earn more. Organizational size can also help overcome norms of frugality and self-denial that those who work for financially struggling nonprofit organizations often experience. In a sector where resources are generally scarce, size thus brings with it financial flexibility and allows for personal rewards. We posit as a first hypothesis:
H1: CEOs managing large nonprofits will earn more than CEOs at smaller-sized organizations.
B. Incentive Compensation
As nonprofit boards deliberate over the question of CEO compensation, a compelling criterion is managerial performance. Nonprofit management has become increasingly understood as a legitimate profession, with its own body of expert knowledge and a set of best practices (Light, 2000). Leaders of major nonprofit organizations have come to adopt a more business-like approach to their work, adopting concepts such as quality management, process reengineering, and benchmarking from the world of corporate strategy. Pay-for-performance in the nonprofit sector is especially problematic due to the difficulties in measuring performance and the risk of violating the non-distribution constraint. Still, two forms of performance have been the focus of most incentive plans: fund-raising and cost efficiencies.
While many large organizations have development staffs that manage the fund raising process, the CEO is ultimately responsible for the financial position of their organization. The ability to raise money is frequently taken as a sign that the organization is performing well. The logic is that donors reward organizations that are doing good work and punish those that are not by withholding contributions. Hence, fundraising provides an easily measured metric that proxies for mission fulfillment.
Another way that managerial performance can be judged is by how resources are used. Frugality is viewed a virtue in nonprofits. Administrative cost-cutting in nonprofits is often an organizational necessity, particularly when revenues wane or when the community needs addressed by the nonprofit is extremely pressing. Many funders and watchdog organizations interpret low ratios of administrative to total expenses as a sign that a nonprofit is well run and mission-focused.
Traditional agency theory recommends pay-for-performance compensation as way of aligning agents’ actions with principals’ goals, thereby encouraging effort and reducing perquisite behavior (Jensen and Meckling, 1979, Fama, 1980). However, paying incentives based on excess earnings directly conflicts with the non-distribution requirement, since revenues or cost savings are converted into in higher salaries and benefits for staff rather than services for clients.[3] For this reason, nonprofits have traditionally sought to avoid paying employees compensation based on financial measures of performance. With all these factors weighing against pay-for-performance in the nonprofit sector, we hypothesize:
H2: Nonprofit CEOs pay will not be based on the financial performance of the organization.
C. Free Cash Flows and Liquidity
The diversion of “free cash flows” to increase executive pay is another pressing concern in the nonprofit sector. Most nonprofits seek to achieve stability and sustainability as a means of improving their capacity to pursue their missions effectively. Given the multiple funding streams that support nonprofit organizations, including individual contributions, foundation grants, fees for service, and government contracts, this task can be complex and demanding. One tempting response to uncertain funding flows is to build financial reserves to protect organizations from precipitous changes in one or more revenue streams. Organizations that are able to increase their liquidity are able, in principle, to cope more easily with changes in the funding environment. However, this financial slack creates the temptation to use these resources for personal inurement.
Nonprofits have developed several mechanisms to limit the use of the financial slack. Donors place restrictions on the use of their funding. Both donors and boards can set aside funds in permanent or quasi-permanent endowments. Since these funding sources generally do not fully cover the cost of services, many nonprofits pursue one or more strategies for developing financial slack. First, nonprofits may actively solicit individuals for unrestricted funds through special events, direct mail marketing or telemarketing campaigns. Unlike restricted grants, these funds, which come from many small and/or loyal donors, do not trigger significant monitoring and oversight.