Does it pay to do good?

An analysis of CEO Compensation at Large American Charities

Jessica Reif, B.S. ILR Honors Candidate

April 2014

Cornell University School of Industrial and Labor Relations

Adviser: Professor Kevin Hallock

Second Reader: Professor Robert Smith

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Introduction

Many donors are appalled to learn that the executives managing their favorite charities

earn six-figure salaries. The national media and watchdog organizations frequently draw public

attention to the arena of nonprofit compensation (Wallock 2013, Charity Navigator 2013).

Though only a small fraction of the public is educated in compensation, articles such as the “Ten

Insanely Overpaid Nonprofit Execs” published in the Huffington Post draw millions of readers

and hundreds of commenters (Strachan 2013). Recent financial scandals involving CEOs at large

charities including United Way, the Smithsonian Institution, and Covenant House have shaken

the public’s faith in nonprofits (Frumkin 2011).

Charity Navigator, a nonprofit institution that seeks to aggregate publicly available

financial information from charitable organizations to assist donors and would-be donors, also

stresses the importance of executive compensation in evaluating charities. Annually, its research

division publishes a study of CEO compensation at charitable organizations, highlighting

differences based on organization size, mission, and location. The 2013 study notes, “Many

donors assume that charity leaders work for free or minimal pay” (2013 CEO Compensation

Study). While reassuring donors that the median salary for nonprofit CEOs increased only 2.5%

from the previous year, Charity Navigator encourages donors to be vigilant about excessive

nonprofit compensation – particularly at organizations where the CEO is paid $1 million or

higher (2013 CEO Compensation Study).

Six- and seven-figure compensation packages at large charities have led to action by

some state governments. A December 2013 report from the Massachusetts Attorney General’s

office called for reform of compensation disclosure at nonprofits, after a study of 25 large

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Massachusetts-based charities showed CEOs earning over half-million dollar compensation

packages in addition to lavish perks (Wallock 2013). In May 2013, New York Governor Andrew

Cuomo issued an executive order prohibiting charities who receive state funding from paying

more than $199,000 to any employee. Similar measures were enacted by Florida and New Jersey

(Wallock 2013).

While very few consumers review the executive compensation practices of the for-profit

companies to whom they bring their business, executive pay carries particular importance to

citizens interested in charitable giving and the governments that provide tax-exemptions to these

organizations. To build trust from the public, nonprofit organizations must prove to their donors

that they are worthy of the contributions they receive. Without this trust, nonprofits will be

unable to garner enough public support to fundraise enough to accomplish their goals. For

donors, appropriate compensation indicates that their contributions move forward the espoused

social mission of the organization, not boost the pay of executives. Likewise, governments offer

nonprofits special tax benefits not available to for-profit companies. These financial benefits are

intended to permit the nonprofit to achieve greater social welfare, not raise executive pay. The

government legally prohibits nonprofits from paying executives beyond what is ‘reasonable’

under the totality of circumstances and from distributing excess earnings to managers, thus

executive pay is subject to special oversight and government scrutiny (Hansman 1980).

Many management scholars and nonprofit leaders challenge the assumption that the

compensation the public deems to be inflated is in fact too high. The consensus in management

literature is that compensation is an important tool for attracting and retaining top talent (Drucker

1990, Conyon et al. 2009). Nonprofit organizations are highly complex like their for-profit

counterparts, and therefore require educated leaders with high levels of managerial skill.

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Individuals of this quality come with a price. In order to compete for top talent nonprofits need to

offer competitive wages to those in charge.

Without question, a lot is riding on managerial pay. Appropriate compensation of

nonprofit managers is necessary to establish the public trust needed for consistent donations, to

maintain the nonprofit’s tax-exempt status, and to reward the leaders who drive the success of

the organization. In the face of six- and seven- figure salaries at many of America’s largest

nonprofit institutions, what constitutes appropriate compensation is not an easy question to

answer. With watchdog groups criticizing organizations whose CEOs make over $1 million, the

State of New York punishing nonprofits who pay any employee over $199,000, and the

Massachusetts Attorney General concerned about nonprofit CEOs earning over half a million,

calls for oversight tend to be accompanied by an arbitrary numerical figure for what level of

compensation is appropriate.

Conversely, the compensation packages awarded to executives at the largest charities are

anything but arbitrary. They are the output of highly complex processes, often involving a

variety of input variables, a team of outside consultants, benchmarking exercises, compensation

committees, and a thorough evaluation of the executive’s performance in key areas. Nonprofit

organizations are required to disclose the resources they use to determine executive

compensation in their tax returns, and often go above-and-beyond this call by further detailing

their compensation policies on their websites.

Yet, cries for lower compensation attack the total compensation figure rather than the

well-documented process used to arrive at that number. Furthermore, the debate ignores the mix

of components that comprise an executive pay. Existing literature discusses how executive pay is

associated with other financial measures, most notably organizational size as measured by assets

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or annual program expenses. Additionally, many studies attempt to explain the gap between

executive compensation at for-profit and nonprofit organizations (Drucker 1990, Oster 1998).

Though certainly useful insight, neither body of research gives credence to the arguments of

those individuals and governments calling for lower executive compensation or to the charities

that award their CEOs with compensation others deem to be unreasonable. This paper will begin

to reconcile the gap between the cries for lower pay in charitable organizations and the variables

the previous literature has found to be associated with higher compensation by examining how

specific pay determination practices used by charitable organizations are associated with total

compensation.

The national debate over nonprofit compensation must expand beyond a narrow focus on

total CEO pay to a conversation about the practices nonprofit organizations employ to determine

how their leaders are rewarded for their work. The aim of this research is to provide insight into

how executive compensation is determined, and what influence compensation consultants and

contracts may have on top executive pay. This paper will proceed in six steps. First, it will

provide a brief summary of the American nonprofit context, including the requirements

governing CEO pay. Next, it will provide a literature review of the current body of research on

nonprofit executive compensation. Third, it will provide the hypotheses of this study. Fourth, it

will explain the methodology I employed to test the hypotheses. The fifth section will describe

the results, and the sixth section will conclude with a summary of findings and suggestions for

further research.

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Section I - The American Nonprofit Context

Nonprofits are a fundamental part of the American tradition and emerge from the free

market to meet societal needs that go unaddressed by the state. Frumkin and Keating write, “the

nonprofit organizational form allows society to overcome market failures and to increase the

output of certain goods and services, without moving to direct government provision or the

provision of subsidies to for-profit firms” (Frumkin 2011, 3). By reducing the need for state

subsidies and in-kind transfers in a variety of areas, nonprofits lift a great burden from the

government.

The nonprofit sector is growing at a rapid pace, with a 25% increase in the number of

organizations from 2001 to 2011. In 2010, nonprofits accounted for 5.4% of Gross Domestic

Product and 10% of total employment. The rate of growth in this $779 billion industry has

surpassed that of the private sector (Roeger, Blackwood, Pettijohn 2012). In exchange for

taking on this burden of creating greater societal welfare, nonprofits are granted two key tax

benefits. First, nonprofits are provided with exemptions from income, sales, and property taxes.

This indirectly subsidizes the activity of the nonprofits, thus allowing them to achieve greater

output at a lower cost. Second, nonprofits can offer their donors tax deductions for their

charitable gifts. This encourages the public to donate to charitable organizations by allowing

them to deduct the dollars they donate from their taxable income. Both of these tax benefits are

help nonprofits achieve their mission.

Because tax exemption enables nonprofits to undercut for-profit firms’ prices for the

same activity, one might ask why all firms don’t operate as nonprofits. To quality for tax exempt

status, organizations must meet the eligibility requirements set out in Section 501(c) of the tax

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code and consent to certain governance requirements. While some industries, such as religious

organizations, are almost entirely comprised of nonprofit organizations, in other industries, such

as healthcare, nonprofit organizations and for-profit companies exist side-by-side. The IRS

governance requirements allow nonprofits to increase social welfare by increasing the production

of certain goods and services without encroaching on the free-market by subsidizing for-profit

firms, while regulating them enough to ensure that they are not abusing the tax advantages they

receive.

Eligibility Requirements

Section 501(c) broadly defines nonprofits as organized for “charitable, religious,

educational, scientific, or other purposes.” Nonprofit organizations exceeding $25,000 in annual

revenue are required to file a Form 990 with the IRS. This publicly available document discloses

information from the nonprofit’s financial statements and includes additional schedule filings for

certain designations of nonprofits. The IRS has 29 classifications for nonprofits, with the far

most popular classification being 501c(3).

A 501c(3) nonprofit is one whose purpose is “Religious, Educational, Charitable,

Scientific, Literary, Testing for Public Safety, to Foster National or International Amateur Sports

Competition, or Prevention of Cruelty to Children or Animals Organizations” (Internal Revenue

Service 501c3 guidelines). These organizations tend to align with the classical interpretation of

the word “charity,” in a way other tax-exempt designations, such as labor unions and sports

clubs, do not. 501c(3) organizations are public-serving rather than member-serving, and typically

rely on grants from the government and donations from the public to succeed.

While the IRS code gives broad definitions of nonprofits, Salamon’s research described

six characteristics that define America nonprofits (1996). First, these organizations are formally

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constituted to fulfill an established mission. Nonprofits typically have a public mission

statement, outlining the organization’s broad objectives and purpose. Second, nonprofits are

private institutions not operated by the government. While some nonprofits rely heavily on

government grants for support, managers of the organization are unaffiliated with the state.

Third, nonprofits are not created to generate wealth for their owners. The non-distribution

constraint designed for maintaining this principle will be described in the “governance

requirements” section. Fourth, nonprofits are self-governing and maintain full control over their

activities, so long as they meet the standards set forth by the IRS code. Fifth, nonprofits are

voluntary in nature. Their activity is not compelled by the government or any other entity.

Finally, nonprofits are designed to serve the public interest. They are organized to, in some way,

“do good” (Salamon 1996).

Governance Requirements

With managerial performance difficult to measure and a noncompetitive operating

environment, nonprofit executives have potential for corruption. Several legal mechanisms exist

to regulate pay and discourage poor managerial behavior, including the non-distribution

constraint and the “reasonable but not excessive” compensation requirement. A failure to meet

these governance standards can result in sanctions, the most extreme being revocation of the

organization’s tax-exempt status.

The Non-Distribution Constraint. Executive compensation in for-profit companies

typically reflects the financial performance of the firm. The promise of increased bonuses

incentivizes executives to cut costs wherever possible and run the business with a clear focus on

the bottom line. In turn, higher profits create higher earnings for shareholders and higher

compensation for executives – a “win-win” situation for investors and managers (Frumkin 2011).

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There is a fundamental problem with this approach applied to nonprofit executives. A

narrow focus on financial metrics is inappropriate to reward nonprofit management, because the

mission of a nonprofit is to fulfill a societal need rather than generate profit. Hansmann notes

that nonprofits are not barred from earning profits, so long as those profits are invested in the

social mission of the organization rather than distributed executives. He calls this restriction the

“non-distribution constraint” (Hansmann 1980, 835). The non-distribution constraint does not

prevent nonprofit employees from receiving pay or receiving incentive compensation, it simply

prohibits the distribution of net earnings to those in charge (Hansmann 1980).

The non-distribution constraint ensures that nonprofits’ excess earnings will be retained

and used to provide future services, rather than distributed to managers. This measure

discourages leaders from cutting program costs for the sake of higher compensation, as Boards

avoid tying executive rewards to the financial performance of the organization. The constraint

also underscores the importance of appropriating funds to the social mission of the organization,

rather than diverting them for personal gain. This is important for two groups: the government,

who as previously discussed essentially subsidizes the operations of the organizations in the form

of tax-exemptions, and the public. Donors and others who pay for the services that the

organizations provide expect their contributions to be used for the services, not the leaders’

paychecks.

Reasonable but not excessive compensation. While nonprofits are prohibited from

distributing excess revenue to executives, managers are not expected to work without pay. The

IRS recognizes the importance of competitive compensation in attracting and retaining talent to

lead nonprofits, and thus actively encourages compensation committees to reward executives

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with “reasonable” compensation, without paying excessively. The IRS defines excessive

compensation as compensation that “exceeds what is reasonable under all of the circumstances.”

While this vague yardstick of what constitutes reasonable provides little guidance for

determining executive pay, the IRS lists several mechanisms for determining executive pay on

Form 990. As of 2008, filing organizations must disclose which of the following six mechanisms

it employed to establish the compensation of its CEO or Executive Director: compensation

committees, independent compensation consultants, Form 990s of other organizations, written

employment contracts, compensation surveys or studies, and approval by the board or

compensation committee. Though organizations are not legally required to use any of these

methods of determining CEO compensation, a clearly defined process for how pay is determined

may reduce the possibility of an IRS investigation of the organization’s pay practices.

Management scholars debate the question of what compensation is reasonable for

nonprofit executives. Compensation studies consistently show nonprofit employees earn less

than their counterparts in similar positions in for-profit firms (Ruhm and Barokski 2000).

Some scholars suggest that paying nonprofit managers levels of pay similar to those at for-profit

firms would create a conflict of interest. They theorize that nonprofit executives engage in “labor

donations,” forgoing the higher pay in the for-profit sector for the sake of doing good through

nonprofit employment (Rose-Ackerman 1986, Preston 1989). Other scholars contend that lower

pay is necessary in the nonprofit sector to deter managers whose biggest concerns are monetary

Rewards from seeking employment there (Hansmann 1980). In both cases, researchers advocate

for the continuation of lower pay for nonprofit managers on the premise that executives who run

organizations seeking non-monetary outcomes knowingly consent to lower pay than those who

do not.

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On the contrary, other scholars contend that it is imperative for nonprofit executives to

earn similar pay to individuals in similar roles in for-profit firms (Drucker 1990). They argue that

the success of a nonprofit hinges on its ability to attract and retain top quality managers who are

willing to bear the uncertainties of working at a nonprofit, such as inconsistent funding and often

difficult to measure outcomes. The social orientation of nonprofit organizations does not

eliminate the demanding nature of managing a complex organization, and thus it shouldn’t solely

govern how much nonprofit mangers earn (Letts, Ryan, and Grossman 1999).

Determining a level of executive compensation that is reasonable but not excessive

proves to be yet another challenge facing nonprofit organizations. With limited guidance on how

reasonable is defined, there is an extra burden on boards to provide a thorough, transparent, and

honorable process for determining managerial pay.

Sanctions. In addition to losing public trust, nonprofits that violate the non-distribution

constraint or offer excessive executive compensation packages face legal sanctions. Until 2002,

the only punitive measure for inappropriate compensation available to the IRS was a complete

revocation of the organization’s tax-exempt status. The IRS seldom employed this drastic

measure, as proving a violation was extremely difficult given the vague nature of the rules. More

recently, the IRS adopted a less threatening punitive measure: an excise tax. Rather than

revoking a nonprofit’s tax-exempt status, the tax serves as an intermediate sanction for

nonprofits found to violate the legal restrictions governing executive compensation. Executives

of organizations found to pay excessive compensation must forfeit the portion of their pay ruled

excessive in addition to a 25% excise tax on the amount. Oversight boards who approved the

executive compensation must also pay a penalty (Internal Revenue Service 501c policies).

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Though enforcement action is still rare, several nonprofits are sanctioned each year with this

relatively moderate penalty.

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Section II – Literature Review

Carroll, Hughes, and Luksetich note, “literature concerned with the determinants of

executive compensation in the nonprofit sector pales in comparison to the quantity and depth of

the theoretical and empirical research in the for-profit sector of the economy” (2005, 19). While

much remains unknown about executive compensation at nonprofits, previous research has made

significant headway in answering many of the common questions about nonprofit pay practices.

This review will outline the existing research in the arena of nonprofit compensation and will

contain five parts. First, it will discuss some of the variables correlated with executive pay,

specifically focusing on organizational size and IRS classification. Second, it will summarize the

possible explanations for year-to-year changes in CEO pay presented by prior management

research. Next, it will elaborate on the difficulties of implementing pay-for-performance systems

in the nonprofit setting and the metrics of performance used by nonprofits that do offer

performance pay. Fourth, it will touch upon the wage gap between nonprofits and for-profit

companies. Finally, it will discuss the limitations that a lack of quality nonprofit data has

imposed upon prior research. This body of literature informs the research hypotheses in the

following section.

Predictors of Nonprofit CEO Pay

Previous research has identified associations between organizational size, IRS

classification, and executive pay. A more recent study has identified a link between free cash

flows and CEO pay as well.

1. Organizational Size

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The most tried-and-true predictor of CEO pay in nonprofits is organizational size.

Murphy (1998) notes that larger organizations require leaders capable of more complex tasks and

exercising control over more operations, thus organizational size is a proxy for managerial skill.

The most commonly used measures of organizational size in previous nonprofit compensation

studies are total fixed assets and total program expenses. Hallock used total assets and log of

total assets as a proxy for size, noting that an organization’s assets are typically linked to its

operations (2000). Frumkin and Keating (2011) argue that it is necessary to use both total assets

and total program expenses as proxies for organizational size. Total program expenses exclude

fundraising and administrative costs, measuring only the expenses related to the specific

mission-related activity of the nonprofit. They note that boards of directors at nonprofits

generally set CEO compensation based on annual budgets and scale of operations compared to

industry peers, and total program expenses are an appropriate representation of annual budget

(Frumkin and Keating 2011).

Regardless of the measure of size, the results have consistently demonstrated that CEOs

of larger organizations receive larger paychecks. Nonprofit compensation studies consistently

show a link between organization size and executive compensation (Oster 1998, Hallock 2000).

In a study of CEO compensation at 6,590 nonprofits, Frumkin and Keating found increases in

CEO pay by $0.25 and $0.07 for each additional thousand dollars in fixed assets and program

expenses, respectively (2011). Similarly, Hallock found increases of $0.10 in pay for every

thousand dollars of fixed assets (2000).

While these studies were not limited to 501(c)(3) organizations, a 2013 Charity Navigator

CEO Compensation Study confirmed that the trend of larger organizations offering higher CEO

pay is evident within the context of charities as well. This study examined CEO pay at 3,929

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mid- to large-sized charities, and found that the median compensation earned was $125,942 in

2011. The median compensation varied substantially with organization size, however; large

charities with more than $13.5 million in expenses paid median CEO compensation of $244,209,

medium-sized organizations with between $3.5 million and $13.5 million in expenses paid

median CEO compensation of $145,230, and smaller organizations paid median compensation of

$95,661. There were also clear distinctions in pay among the charities based on size, with the

largest charities of over $500 million in annual expenses paying their CEOs a median salary of

$422,578 (Frumkin and Keating, 2011).

While program expenses, total expenses, and fixed assets may serve as proxies for

organizational size, the measures can be misleading when used to represent the impact of the

organization. For example, consider a nonprofit that provides free malaria vaccinations to

children. Changes such as increased volunteer labor or lower costs of vaccination and travel can

allow the nonprofit to increase its impact without increasing its program spending or assets. The

relationship between expenses or assets and the scope of the organization’s activities is not

always clear, and thus one must be careful when using these measures to evaluate the efficacy of

a nonprofit or its executives.

2. IRS Classifications

As previously mentioned, nonprofits are classified by the IRS based on the nature of their

activities. Several studies explore the differences in executive compensation practices based on

their IRS classifications. Frumkin and Keating note that industry-specific regressions have much

greater explanatory power than those that seek to explain executive compensation in all

nonprofits (2001); certain variables carry more weight in particular subsectors. In all sub-sectors

except religious nonprofits, Frumkin and Keating found nonprofit CEOs typically are paid a

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substantial fixed component independent of variables such as programs or assets. This amount

varied across the subsectors, with the lowest found in arts organizations at $81,139.98 and

highest in healthcare organizations at $151,477.30. The arts and human services sub-sectors are

unique in that CEO compensation is more closely linked to an organization’s fixed assets. Their

study found increases in pay of $1.29 and $0.50 for each additional thousand dollars of fixed

assets in arts and human services nonprofits, respectively. Significant relationships between

fixed assets and CEO pay were not found in the education, health, religious, or “other” sub-

sectors (Frumkin and Keating 2011).

The arts, education, health, religious, and “other” classifications of nonprofits exhibited

no statistically significant association between changes in CEO pay and changes in dollar growth

in contributions (Frumkin and Keating 2011). As changes in contributions are typically a

considered to be a performance measure for nonprofits, this suggests a weak performance-pay

relationship.

Similarly, the 2013 Charity Navigator study showed median salaries to be drastically

different across IRS classifications. Education had the highest median total compensation at

$170,178, followed by Arts at $159,650, and Health at 137,919 (2013 CEO Compensation

Study). As indicated by Frumkin and Keating’s research, religious charities compensate

significantly less than other nonprofits, with a median CEO package of $82,746 (2011).

3. Free Cash Flows

Keating and Frumkin introduced the free cash flow hypothesis, which speculates that

CEO compensation will be higher in nonprofits that have relatively more free cash flows

available. They note, “unrestricted funds within organizations give nonprofit boards the ability to

use “free cash” for non-essential and non-budget items, including increased salaries and benefits

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for senior staff’ (2001, 14). There are several reasons why a nonprofit might have unrestricted

funds available, including commercial revenue not subject to donor oversight, income from an

endowment, or undesignated donations. Two of these variables were found to have a significant

relationship to CEO pay (2001, 21). For organizations that receive unrestricted funds through

commercial revenues, a 1% increase in commercial revenue share was associated with a $600

increase in CEO pay. Similarly, organizations with higher endowment-related income had higher

CEO pay.

Changes in Pay from Year to Year

Baber, Daniel, and Roberts studied the way changes in various accounting measures

frequently reported publicly by charity oversight agencies are related to the compensation of

CEOs at charitable organizations. They note that such agencies are typically concerned with

changes in program spending, revenue, and relative costs of administering the charity. They

hypothesized that changes in each of these three performance measures would be positively

related to changes in executive compensation, and tested their hypothesis using a sample of 331

Maryland-based charities (1999).

Their study showed significant relationship CEO Compensation and these performance

metrics. For instance, a 10% increase in annual revenues was associated with a 0.9% increase in

total compensation for the CEO. Additionally, increasing program spending by 10% was

associated with a 0.76% additional compensation for the CEO (Baber 688). The increase in CEO

compensation that was not associated with either changes in revenues or changes in program

spending was 5.8%. These data suggest that changes in performance measures from year to year

may have some bearing on CEO pay (Baber, Daniel, Roberts 1999).

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The Baber, Daniel, and Roberts’ study also notes that charities are inclined to report a

breakeven condition whenever possible, as charities with excess revenue may appear overfunded

and charities operating on a deficit may appear irresponsible; salaries are a discretionary expense

item that can be raised if a charity is not already at or below its breakeven point (1999, 691).

These adjustments may account for some year-to-year changes in CEO compensation.

Pay-for-Performance

Pay-for-performance systems dominate executive compensation structures in for-profit

companies, yet are still rare in the nonprofit setting. Steinberg notes that while incentive

contracts are not entirely prohibited by the non-distribution constraint, some pay-for-

performance metrics may compromise donor trust by creating a perception that their

contributions are diverted away from the organization’s purpose in favor of higher executive

compensation (Steinberg 1990). For instance, consider a CEO who receives a percentage of

funds raised at a fundraiser. Even if that percentage is small, it has the effect of increasing the

amount that donors need to give to have the same effect on output of the organizations services

(Carroll 20). This may make it more difficult for nonprofits to attract donations.

Despite this difficulty, many nonprofit organizations use incentive pay systems to reward

managers. Pynes notes that there are innovative approaches to nonprofit pay-for-performance

that run less risk of compromising donor trust. She suggests broad banding pay structures to

allow for more lateral growth within one’s pay grade, in addition to skill-based pay, merit pay,

and gainsharing (Pynes 1997). Other researchers have noted the importance of performance-

based pay systems to create risk-sharing among executives and the firms they manage (Rose-

Ackerman 1986).

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Nonprofit For-Profit Wage Gap

Though the wage gap between for-profit and nonprofit organizations is not a primary

concern of this paper, the theoretical explanations for the difference inform our understanding of

nonprofit executive compensation and thus deserve brief attention here. As Hallock outlines,

there are four dominant theoretical reasons for the gap (2000). First, nonprofit employees engage

in labor donations. This means they knowingly accept a wage lower than what their skill,

education, and experience would command in the for-profit sector and essentially donate the

difference to the organization (Preston 1989). The second explanation is that nonprofit workers

accept lower pay in exchange for more favorable working conditions, such as more flexible

hours or job stability. This concept is known as compensating wage differentials. The third

explanation deals with the efficiency-wage hypothesis, and holds that workers whose outcomes

are difficult to measure are paid more than their market value and work must work hard to

maintain their position to avoid losing their jobs and having to accept a lower paying position.

The final explanation is that those who accept nonprofit positions may have skills that would be

more useful in another sector (Hallock 2000).

Limitations of Existing Research

While previous research has made substantial headway in uncovering the determinants of

nonprofit CEO pay, researchers encounter common roadblocks when attempting to study this

phenomenon. First, a lack of accurate data plagues the nonproft research community. Though

recent changes to the Form 990 have required nonprofits to disclose the compensation of their

top five most highly-paid officers more clearly, prior to 2007 the data were reported without a

corresponding name. This made it difficult to determine whether or not the CEO changed from

year to year. Similarly, the breadth of objectives of nonprofits makes it extremely difficult to

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compare one nonprofit’s goals to another’s goals. Because a variety of non-accounting metrics

may be employed to determine executive compensation, comparisons from organization to

organization are difficult.

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Section III - Research Hypotheses

With the unique context constraints and requirements in mind, I examine the processes

used to determine executive compensation at the largest American charities. I take a different

approach than the recent literature, focusing less on the outcome of pay itself and more on the

methods employed to reach that outcome. I evaluate the role of organizational size, as well as

the influence of compensation consultants and employment contracts in determining executive

pay.

A. Organizational Size

As previously discussed, a great deal of prior research shows an association between a

nonprofit organization’s assets and the pay of its CEO (Oster 1980, Hallock 2000, Frumkin and

Keating 2011). The prevalence of this finding is consistent with the notion that CEOs managing

larger, more complex organizations earn more than those who manage smaller ones. Because the

scope of operations of nonprofit organizations are difficult to compare and other proxies for

organizational size used in the for-profit setting such as market share and gross revenue are less

relevant to nonprofits, assets is the most reliable proxy for organizational size.

I expect that this finding will hold true even among our sample of the largest organizations, and

as such:

H1: Larger organizations will offer higher total pay to their CEOs.

B. Compensation Consultants

Given the dearth of research on the use of compensation consultants in the nonprofit

sector, my hypothesis is informed largely by associations confirmed in studies of for-profit firms.

Employing outside consultants to determine executive pay has been repeatedly associated with

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higher compensation in the for-profit sector. Executive compensation expert Graef Crystal said

in 1991:

Executive compensation in the United States did not go out of control simply

through some random process; it went out of control because of the actions – or

inactions – of a number of parties. The first cultprits in what will be a litany of

culprits are compensation consultants (Conyon 401).

A number of studies have confirmed his assertion, showing CEO compensation is higher in firms

utilizing compensation consultants to set executive pay (Conyon 2011; Armstrong, Ittner,

Larcker 2012). A study of 755 large U.S. corporations found significant increases in CEO total

pay in organizations where consultants designed the compensation packages (Cadman, Carter,

Hillegeist 263). Given the similarity of the roles of consultants in the for-profit and nonprofit

setting, I expect these findings will hold true with charities, and therefore propose:

H2: Nonprofit organizations who use compensation consultants will have higher

paid CEOs.

C. Employment Contracts

The use of employment contracts for CEOs of both nonprofit and for-profit firms is

somewhat controversial. Zhao elaborates on the ways in which a CEO is protected by a contract.

Her job is secure until his contract expires, enabling her to pursue higher risk opportunities. She

is also guaranteed certain compensation, has quantifiable measures of performance, and is

granted generous change-in-control provisions. Yet, these contracts can also be very

entrenching, making it difficult to make large annual adjustments when necessary (Zhao 2005).

Lund and Polsky argue that CEO employment contracts laced with incentive pay actually have

diminishing returns and that firms should reconsider the extent to which their compensation

packages emphasize specific performance measures (2011). Specifically, they note that

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incentives tied to particular accounting measures are ineffective when outcomes are difficult to

measure. Despite these limitations, contracts typically provide some level of guaranteed reward

compensation (2011, 683-4).

Because contracts usually ensure CEOs some automatic reward compensation in addition

to performance-based incentives, I posit:

H3: Charity CEOs with employment contracts receive higher total pay.

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Section IV – Method

A. Sample Population

The organizations chosen for the sample are those which appeared in Forbes Magazine’s

annual list of the largest 200 American charities as measured by total assets for the years 2008,

2009, 2010, and 2011. The data Forbes uses to compile the annual list come from the National

Center for Charitable Statistics. Though Forbes always employs the same methodology for

determining its annual list, the organizations that make the cut vary substantially each year. A

one-time grant or campaign can lead assets to spike in one fiscal year, securing an organization a

spot on the list for that year but not the next. Only the 115 organizations that appeared on the list

for each of the four consecutive years were included in the sample, because the focus of this

study is charitable organizations who were consistently among the largest throughout the period

of interest.

I chose to use the organizations listed by Forbes because these are the nonprofits that

have the closest ties to the general public. Compensation practices at the organizations the public

subsidizes, through both taxpayer-funded government grants and private donations, carry the

most weight on how the public thinks about charity compensation. There are two notable

exclusions that Forbes makes when compiling the list, which make it an optimal group for this

study. First, large charitable organizations that do not solicit donations from the public or grants

from the government are not included in the group. Consider for example the Bill and Melinda

Gates Foundation, which is funded primarily through the assets of a single family. Second,

organizations that primarily solicit donations and grants from individuals who have received

their services in some capacity are excluded from the group. This exclusion is important because

24

it eliminates institutions whose primary donor base is not the general public, such as colleges and

universities who primarily solicit donations from alumni. A complete list of the organizations

used in the sample and the number of observations from each organization can be found in the

Appendix.

B. Data Collection

Each organization is required to file a Form 990 tax return each year, and the returns are

subsequently made publicly available. Returns were retrieved from each organization for the

years 2008, 2009, 2010, and 2011. Most of the returns were available on the organizations’

websites or nonprofit charity rating agencies such as GuideStar and Charity Navigator. In a few

rare cases, the organization’s controller provided the returns electronically directly from the

charity.

I obtained data from the Form 990 for the organization’s total revenue, total expenses,

total salaries & benefits expenses, total fundraising expenses, assets and liabilities for each year.

I also recorded the Schedule J disclosure of which of the following resources the organization

used to set CEO pay: compensation committee, independent consultants, other organizations’

Form 990s, an employment contract, a study or survey, and/or approval by the board of directors.

I also recorded the name, base compensation, bonus and incentive pay, other reportable

compensation, retirement and deferred compensation, nontaxable benefits, and total

compensation of each CEO. In a few cases, I was unable to obtain copies of the organizations’

tax returns, leaving 441 usable observations.

C. Testing the Hypotheses

To test the first hypothesis, I used log of total assets as a proxy for organizational size,

consistent with previous research (Hallock 2000). I also considered the log of the number of

25

employees as a second proxy for organizational size. I regress log of total pay accounting on logs

of assets and employees. To test the second hypothesis, I add the independent variable for

whether or not the organization used a consultant. This shows whether the addition of a

consultant has any association with executive pay. Similarly, I test the third hypothesis using the

independent variable of whether or not the CEO was under contract. This shows whether

association exists between employment contracts and CEO pay. All calculations were performed

using STATA 13.0.

26

Section V – Results and Discussion

Table 1

Summary Statistics on Charity CEO Compensation (in thousand USD)

Component Observations Mean

Std.

Dev. Min

25th

Percentile Median

75th

Percentile Max

Base 441 384 298 19 224 337 451 3208

Bonus 441 62 197 0 0 0 50 1950

Other Pay 441 93 419 0 0 10 45 7087

Retirement 441 64 188 0 5 80 42 2076

Nontaxable

Benefits 0 27 22 1 8 22 39 74

Total Pay 441 629 758 80 282 427 635 9185

Organizational Size

I found no significant association between the log of assets and the log of CEO total pay

in this population, contrary to the findings of several other nonprofit compensation studies

(Hallock 2000, Oster 1980). One reason why this might be the case is that the sample in this

study consists exclusively of the largest organizations by asset volume. It is possible that asset

levels are associated with CEO pay when assets range from the levels of mid-sized organizations

to the levels of large organizations, but that this affect disappears after a certain threshold has

been reached.

27

Figure 1.

Pay and Assets

Another proxy for organizational size, the log of the number of employees, did show a

significant association with increased executive compensation. This measure has not traditionally

appeared in compensation literature, but may be particularly important in the non-profit setting

where financial metrics take a backseat to the social orientation of the organization. At charitable

organizations, the complexity of a CEO’s position may be more closely associated with the

number of people he manages rather than the organization’s assets, thus organizational size as

measured by number of employees is a more reliable predictor of CEO pay.

Figure 2.

Pay and Employees

28

Consultants

I found that total CEO pay was significantly higher in organizations that used

compensation consultants to set pay for their top executive. Organizations who hired consultants

offered mean total pay of $773,207 compared to $363,481 in organizations that did not use

consultants (p <0.001). Interestingly, there was a statistically significant difference in each of the

individual compensation components that make-up total pay, with the exception of nontaxable

compensation. Though base compensation is still the largest component of total pay for

organizations that use consultants and organizations that do not, bonus pay, other reportable

compensation, and retirement compensation was significantly higher in the organizations that

used consultants. CEO pay packages offered by organizations that employed consultants tend to

more closely mirror those offered by for-profit firms, with bonus compensation and other

reportable compensation comprising a very significant portion of total pay.

Table 2.

Mean Compensation in Thousands by whether a Consultant is used

Mean Consultant No Consultant p-value

Base 384 446 272 0.000

Bonus 62.4 84.4 22.2 0.001

Other Comp 92.8 132 20.3 0.007

Retirement Comp 63.8 84.6 25.7 0.002

Nontaxable Benefits 25.6 27.4 26.0 0.528

Total Pay 629 774 363 0.001

N 441 285 156

Given the significant gap in pay in organizations that use consultants relative to those that

do not, it is necessary to investigate possible differences between the two groups of

organizations. There was no significant difference in the assets of organizations that used

consultants and the assets of those who did not. However, the mean number of employees at an

29

organization that used a consultant was 2,378 compared to only 947 at organizations that did not

(p < 0.005). Because we already know a positive correlation exists between total compensation

and number of employees, we regress the log of total pay on the log of assets and the log of

employees as an indication of whether using a consultant would still be associated with higher

pay all else held constant. In Table 3, we see that using a consultant is still associated with higher

total pay controlling for organizational size as measured by assets or employees. This is

consistent with H2.

Table 3

Log of Total Pay Regression accounting for use of a consultant,

assets, and employees.

(1) (2) (3) (4)

Consultant 0.69*** 0.55*** 0.55*** 0.11

(0.07) (0.06) (0.06) (0.09)

Log of Assets -0.10*** -0.10*** 0.02

(0.02) (0.03) (0.03)

Log of Employees 0.18*** 0.18*** 0.08*

(0.02) (0.02) (0.03)

Constant 5.67*** 5.13*** 5.12*** 5.41***

(0.05) (0.19) (0.20) (0.26)

R2 0.1946 0.3988 0.4 0.86

Time Indicators NO NO YES YES

Organization Indicators NO NO NO YES

N 441 441 441 441

Note: *** significant at 0.01, ** significant at 0.05, * significant at 0.10.

Standard errors in italics.

I also investigated the year-to-year pay differences in the organizations that reported

using a compensation consultant in some years but not in others. At the individual organization

level, there was no significant difference in pay from year-to-year associated with using a

30

compensation consultant in some years but not others. It is important to note, however, that the

Form 990 does not make it clear whether or not an organization must indicate that it has used a

compensation consultant if the consultant designed the compensation package currently used in

another tax year. Using a compensation consultant to design a plan in one year can have an

impact on other years as well, and thus the stability of pay in years in which an organization did

not use a consultant is unsurprising.

The coefficient on the indicator variable for whether the organization used a consultant is

0.55, indicating that controlling for other characteristics, organizations using a consultant pay top

managers 55% more than those that don’t. This seems large and is worthy of additional

consideration. Note, however, that if we control for the organizational indicator variable, there is

no significant difference in pay for CEOs in years that their pay is determined by compensation

consultants relative to years where it is not. This may be misleading, however, because IRS

instructions do not indicate whether or not using a multiple year compensation plan designed by

a consultant in a prior year requires the organization to disclose that it used a consultant on the

Schedule J. It is possible that the effects of using a consultant in one year spill over into

following years.

Contracts

Though not as large as the effect of consultants, employment contracts were also

associated with higher CEO pay. The mean CEO total pay in organizations using employment

contracts was $790,289 versus $517,645 in those who did not (p < 0.001). As Table 3 shows,

there were significant differences in base compensation, bonus compensation, and other

reportable compensation associated with the use of employment contracts.

31

Table 4

Mean Compensation in Thousands on whether a Contract was used

Mean Contract No Contract p-value

Base 384.4 470 326 0.000

Bonus 62.4 90.0 43.4 0.014

Other Comp 92.8 147 55.1 0.023

Retirement Comp 63.8 53.4 71.0 0.334

Nontaxable Benefits 25.6 26.0 27.5 0.472

Total Pay 629 790 518 0.010

N 441 180 261

Once again, it is important to distinguish what other characteristics organizations who use

employment contracts are likely to have. As with those who use consultants, there was no

significant difference in the volume of assets held by organizations that use contracts and those

who did not. The average employee count, however, fell at 2,433 for organizations that used

employment contracts and 1,484 for organizations that did not (p < 0.05).

To discern whether employment contracts are associated with higher CEO pay, we

regress the log of total pay with respect the log of employee count, the log of assets, and an

indicator variable for whether a CEO employment contract was used. As Table 5 shows,

employment contracts are associated with higher executive pay (p < 0.001). Column (3) shows

that this association held true for the four-year sample period, but is mitigated when I control for

the changes in each individual organization as shown in Column (4). Note however that when I

control for the organization indicator variables, there is no significant difference in total pay in

years a contract was used and years no contract was used.

32

Table 5

Log of Total Pay Regression accounting for use of a contract,

assets, and employees.

(1) (2) (3) (4)

Contract 0.37*** 0.35*** 0.35*** 0.05

(0.07) (0.06) (0.06) (0.03)

Log of Assets -0.08*** -0.08*** 0.02

(0.03) (0.03) (0.03)

Log of Employees 0.21*** 0.21*** 0.08*

(0.01) (0.01) (0.03)

Constant 5.96*** 5.07*** 5.07*** 5.44***

(0.04) (0.21) (0.22) (0.26)

R-squared 0.0605 0.3329 0.336 0.89

Time Indicators NO NO YES YES

Organization Indicators NO NO NO YES

N 441 441 441 441

Note: *** significant at 0.01, ** significant at 0.05, * significant at 0.10. Standard

errors in italics.

These findings are consistent with H3 and show that all other things equal, organizations

who use employment contracts tend to pay more among this sample population. The coefficient

on the indicator variable was 0.35 in Column (1), indicating that controlling for the number of

employees and assets, organizations that use employment contracts pay 35% more than those

that do not. As with the consulting indicator variable shown in Table 3, this is large and merits

additional research.

33

Section VI – Discussion and Concluding Remarks

Because of heightened media and watchdog group scrutiny, reasonable executive

compensation is of paramount importance in America’s largest charities. These organizations

must not only pay their CEOs compensation that meets the unique governance requirements of

the American nonprofit setting, but also compensation that is deemed reasonable in the eyes of

donors. Amidst these concerns, organizations must also offer compensation that is fair as to

retain high-performing executives.

The IRS began requiring nonprofit organizations to disclose the resources they use to

determine executive compensation in 2008, which gives us unique insight into what practices

charities use to determine the pay of their top officers. I have shown that there is a significant

association between the use of compensation consultants and higher CEO pay in the largest

American charities. Furthermore, I have shown that this relationship holds true even when

controlling for organizational size as measured by assets or number of employees. I have also

shown a significant relationship between the use of employment contracts and CEO pay. As with

consultants, this association holds true even when controlling for measures of organizational

size.

Like previous research on nonprofit compensation, this study was limited by a lack of

available data. Only the information provided on organization’s Form 990 tax returns was used

for our calculations, and all of these data were entered manually and is subject to human error.

Furthermore, a lack of clear instructions to nonprofits on what level of consultation requires

them to “check the box” for using a compensation consultant on the Form 990 may have led to

reporting inconsistencies among the sample population.

34

Further research is necessary to explain why the use of compensation consultants and

employment contracts is associated with higher CEO pay, and whether this association can be

explained by organizational differences other than organizational size. A formal analysis of the

practices used by consultants and provisions of nonprofit CEO employment contracts could help

explain why this association exists, and whether donors should perceive it as problematic. In

spite of these limitations, the results of this study help inform our understanding of pay in the

charitable sector. Compensation consultants and employment contracts tend to be associated with

higher CEO base salaries and bonuses and higher total pay in organizations that use these

resources.

We know that there is enormous pressure for nonprofit institutions to maintain public

trust. When the IRS began requiring charitable institutions to disclose which resources they used

to determine CEO compensation, organizations may have felt compelled to use all six of the

listed resources to signal to donors that they have a thorough executive compensation

determination process. Perhaps organizations that use all of the listed practices have more

capable managers and therefore pay more – or perhaps indicating the use of compensation

consultants and employment contracts should signal a red flag rather than reassurance for donors.

35

Appendix

Organization Name Observations

Alzheimer's Association 4

American Cancer Society 4

American Civil Liberties Union Foundati 4

American Diabetes Association 4

American Heart Association 4

American Kidney Fund 4

American Museum of Natural History 4

Art Institute of Chicago 4

Arthritis Foundation 4

Big Brothers Big Sisters of America 3

Billy Graham Evangelistic Association 4

Boy Scouts of America 4

Boys & Girls Clubs of America 4

Brother's Brother Foundation 4

CARE USA 4

Catholic Charities USA 4

Catholic Medical Mission Board 4

Catholic Relief Services 4

Children International 4

Children's Hospital of Chicago - Lurie 1

Children's Hospital of Philadelphia 4

Children's Memorial Hospital 3

Christian Aid Ministries 4

Christian Broadcasting Network 4

Christian Foundation for Children and A 4

City of Hope 4

Cleveland Clinic Foundation 4

Combined Jewish Philanthrophies 4

Compassion International 4

Conservation Fund 4

Conservation International Foundation 4

Covenant House 4

Cystic Fibrosis Foundation 4

Dana-Farber Cancer Institute 4

Direct Relief International 4

Disabled American Veterans 4

Doctors Without Borders USA 4

Ducks Unlimited 4

Easter Seals 4

36

Educational Media Foundation 4

Father Flanagan's Boys' Home 4

Feed the Children 4

Focus on the Family 4

Food for the Poor 4

Greater Chicago Food Depository 4

Habitat for Humanity International 4

Heart to Heart International 4

Humane Society of the United States 4

In Touch Ministries 4

InterVarsity Christian Fellowship 4

International Fellowship of Christians 4

International Medical Corps 4

JA Worldwide 4

Jewish Federation of Metropolitan Chica 4

Jewish Federation of Metropolitan Detro 4

Juvenile Diabetes Research Foundation 4

Kids in Distressed Situations 4

Kingsway Charities 4

Leukemia & Lymphoma Society 4

MAP International 4

Make-A-Wish Foundation of America 4

March of Dimes Foundation 4

Marine Toys for Tots Foundation 4

Matthew 25: Ministries 4

Mayo Clinic 4

Medical Teams International 4

Memorial Sloan-Kettering Cancer Center 4

Mercy Corps 4

Metropolitan Museum of Art 4

Metropolitan Opera Association 2

Mission to the World (PCA) 4

Mount Sinai School of Medicine and Hosp 4

Muscular Dystrophy Association 4

Museum of Fine Arts, Houston 4

Museum of Modern Art 4

National Audubon Society 4

National Cancer Coalition 4

National Multiple Sclerosis Society 4

National Public Radio 4

National Wildlife Federation 4

Natural Resources Defense Council 4

Nature Conservancy 4

37

New York Public Library 4

New York-Presbyterian Hospital 4

Operation Smile 4

PATH 4

Paralyzed Veterans of America 4

Planned Parenthood Federation of Americ 4

Project HOPE 4

Project Orbis International 4

Public Broadcasting Service 4

Robin Hood Foundation 4

Rotary Foundation of Rotary Internation 4

Samaritan's Purse 4

Scholarship America 4

Scripps Research Institute 4

Shriners Hospitals for Children 4

Smithsonian Institution 4

Special Olympics 4

Teach for America 4

Trinity Broadcasting Network 4

Trust for Public Land 4

UJA/Federation of New York 4

United Negro College Fund 4

United States Fund for UNICEF 3

United Way 4

Volunteers of America 4

WETA 4

World Vision 4

World Wildlife Fund 4

Wycliffe Bible Translators 4

YMCA 3

Young Life 4

Total observations 443

38

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