Editors’ note: This article is adapted from “The Price of Doing Good: Executive Compensation in Nonprofit Organizations,” an article by the authors published in the August 2010 issue (volume 29, issue 3) of Policy and Society, an Elsevier/ ScienceDirect publication. (The original report can be accessed here.) We published it in the Summer 2011 edition of the Nonprofit Quarterly, “Working Concerns: About Nonprofit Talent.”
When it comes to attracting and retaining talented leaders, the setting of executive compensation packages has posed continuing challenges to nonprofits since the 1980s. These challenges relate to the professionalization of the sector, the increasing desire to measure and reward success, and the need to retain and promote the most talented managers.
Due to commercialization and increased competition from for-profit and other nonprofit providers, the thinking around executive compensation practices has changed significantly over this period. Some nonprofits have shifted from fixed salaries to ones containing a variable cash-compensation component based on fundraising, cost reductions, or specific programmatic outcomes.1 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—namely, mission fulfillment. Nonprofit managers have also sought “comparable pay” with business managers.2
Also influential is the fact that the benchmarking of salaries of nonprofit and business executives has become more prevalent—encouraged in the United States by a new set of IRS regulations allowing sanctions and fines to be levied on nonprofit organizations that pay their executives excessive compensation relative to similar nonprofit and for-profit firms.3 Fully implemented in 2002, these new regulations allowed for cross-sector comparisons, and set standards and procedures for justifying compensation levels in nonprofit organizations. For many nonprofits, however, increasing executive compensation remains prohibitive due to budgetary and moral constraints.
So what really affects salary levels for nonprofit executives?
The short answer seems to be organizational size. According to our research findings, in most parts of the nonprofit world you will find a base rate of pay that increases in direct proportion (in most cases) to every $1000 of operating expenses. To better understand nonprofit compensation practices, we tested three main competing explanations. First, we considered whether executive compensation in nonprofits is a function of the size of the organization. Second, we examined the prevalence of pay-for-financial-performance in this sector. Third, we looked at the role of liquidity, or “free cash flow,” and examined its effect on compensation. The second and third tests are particularly important in the nonprofit context: if a strong association exists between compensation and financial performance or liquidity, it would challenge the effectiveness of the nondistribution constraint, a standard that prohibits the paying out of excess earnings and requires instead their application to advancing the mission of the organization.
For-Profit CEO Compensation
Since one of our assumptions was that nonprofit executive pay concepts are being influenced by the concepts underlying business pay, we first looked at the factors that determine CEO pay in business.
The extensive body of research in this area reveals three general themes. First, compensation studies consistently find a link between the size of the company and executive compensation.4 Faced with considerable uncertainty, companies pay CEOs based on the scope of their responsibilities and the amount of resources they are charged with managing. Herbert A. Simon’s early explanation of this phenomenon was that firms use compensation to distinguish between different managerial levels, and since large firms have more levels, they tend to pay their leaders more than smaller and less hierarchical companies.5 Subsequently, extensive empirical work has demonstrated that managers earn more when they have been entrusted with leading large companies.6
Second, many studies have examined the link between a company’s financial performance and executive pay. Some have found a connection to profitability, although many other studies have concluded that firm performance is not a key driver of CEO compensation.7 Researchers also focused on relative performance evaluation, and tested whether CEO pay decisions were driven by the performance of a manager compared to his or her peers in a given field.8 One reason why boards might take into consideration the compensation decisions of other companies stems from the possible increased efficiency that such information might make possible.9
The third theme relates to the independence and relative power of the board.10 In situations where the board is not independent or is weak, CEOs may be highly compensated due to poor oversight or collusion. In either case, the control systems designed to protect the interests of shareholders fail. Some research has also considered the relative power and influence of shareholders in an attempt to understand board decision making.11 Recent compensation studies have been primarily practitioner focused, with salary ranges and averages reported, making it difficult to attribute reasons for differences.12
The conceptual framework for business remuneration, however, cannot be directly applied to nonprofits, since they must, by law, observe a nondistribution constraint. And, if they adhere to this constraint, neither liquidity nor financial performance should—in principle at least—result in higher pay.
We did not examine the question of board oversight in our study, focusing instead on size, performance, and liquidity. We went into the project with some conjectures, namely that (1) CEOs managing large nonprofits will earn more than CEOs at smaller organizations, (2) nonprofit CEO pay will not be based on the financial performance of the organization, and (3) nonprofit CEO compensation will not be determined by liquidity or free cash flows.
The sample data used in our analysis originate from the annual IRS Form 990 nonprofit tax filings for the period of 1998 through 2000. At the outset of our analysis, we ran pooled sector-wide regressions to understand the overall relation between compensation and the explanatory variables. The sector-wide regressions were then compared to determine if one hypothesis accounted for significantly more of the variance in compensation. To control for firm dependence, we assessed the statistical significance of individual variables using a t-test, which assesses whether the means of two groups are statistically different from each other. To assess the relative explanatory power of groups of variables, we used the Vuong test, which evaluates whether the difference in the explanatory power of two regression models is statistically significant.13 For our dependent variables, we used three different measures of compensation: CEO salary, CEO benefits, and total CEO compensation (which simply combines executive salary and benefits).14
To test our first hypothesis, we relied on two variables: lagged total fixed assets and lagged total program expenses. We chose total fixed assets as a proxy for scale of operations and total program expenses as a measure of the annual budget.15 To test our second hypothesis, we developed two variables associated with pay-for-performance compensation: administrative efficiency and dollar growth in contributed revenue.16 To test our third hypothesis, we selected three variables that determine whether