We often need to determine reasonable compensation amounts for executives, attorneys, charity managers, trustees, or retirement plan service providers. This is an important process and should not be taken lightly.
At first blush, it is tempting to assume that the market establishes reasonableness. Hence, we often use benchmarking, which involves comparing one person’s pay level to amounts paid by other companies.
Surveys or collections of actual compensation amounts are known as comparability data. The idea is that, “If similar companies paid their CEOs $x, then that amount must be reasonable for our CEO.” This is a way of letting the market decide what is reasonable. Here are some words of caution, however.
It is always interesting to see what others have been paid, but we should not be too quick to draw conclusions. First, let’s ask whether all incumbents provided the same value. Carefully consider these questions: Do all doctors provide the same service? Do all attorneys provide their clients the same value? Do all consultants perform the same work? And do all executives do the same tasks and accomplish the same results?
The point is – be careful when benchmarking. Do not be too simplistic in the approach and don’t make careless assumptions.
Of course, it would be great if we could get some exact matches. This would mean finding similar-sized companies in the same industry and the same geographic area that had a similar growth rate and comparable profitability, and where the individuals being benchmarked had the same duties and performed at the same level. Finding exact matches is usually not possible. Therefore, we often use surveys or compilations of amounts paid by companies in the same or similar industries.
Below are a few examples of sources of compensation comparability data, although the fact that they are listed here should not be considered to be an endorsement. Each has its own strengths and weaknesses, and none of them are a perfect fit for every situation.
Publicly traded companies file financial information with the United States Securities and Exchange Commission (SEC.gov). The SEC then publishes some of that information, including total compensation amounts for each company’s top officers, on its EDGAR database (Electronic Data Gathering, Analysis and Retrieval). The Summary Compensation Table shows compensation by person, by year and by type. The data goes back for years. Compensation amounts available through EDGAR can be helpful in certain situations, although publicly traded companies tend to be much larger, more diversified and have more layers of management than closely held companies.
The United States Department of Labor’s Bureau of Labor Statistics gathers and publishes wage data on its website: www.bls.gov/ncs (NCS = National Compensation Survey). The data is available by state. In addition, the DOL's Occupational Employment Statistics (OES) program produces employment and wage estimates annually for over 800 occupations. These estimates are available for the nation as a whole, for individual states, and for metropolitan and nonmetropolitan areas. National occupational estimates for specific industries are also available at www.bls.gov/oes. In addition, the Department of Labor’s Employment and Training Administration sponsors America’s Career InfoNet at www.acinet.org. This website offers free salary information by zip code or state for 800+ occupations. Some people who want to consider DOL data find it helpful to use a service that sorts and compiles that data based on their own facts, such as Reasonable Compensation Reports (www.RCreports.com).
Trade associations often conduct surveys of their members and share the results with their members. These surveys usually include questions about officer compensation. Non-members can often purchase these surveys as well, although the price may be higher for non-members.
GuideStar collects financial data from non-profit organizations and publishes that data on its website (GuideStar.org). The data comes from annual reports filed by the non-profits with the Internal Revenue Service (IRS Form 990). Form 990 asks charities for a considerable amount of information about officer compensation, including explanations of how the compensation amounts were determined.
There are also ways to obtain data from multiple sources. Commercial services obtain large amounts of data from multiple compensation surveys and compile that data into their own databases. For example, ERI Economic Research Institute (ERIERI.com) conducts their own surveys and purchases other surveys. They also pull data from EDGAR and GuideStar. ERI officials have told me that they believe their database to be the most robust collection of compensation amounts available. Regardless, by using their database, we can draw compensation amounts from many different sources at one time.
Comparability data may also include compensation amounts paid to the same individual in an earlier year. The theory is: if her services were worth $x in earlier years at a previous employer, then her services must be worth at least $x now. Prior pay can be especially helpful if it came from a company that the subject employee did not control at the time. In other words, it is more telling if the prior pay came from a third party and not from a company where the subject had the ability to set his or her own pay level. But even then, it is usually not that simple.
The Tax Court has examined this issue in several cases, including Choate Construction Company, T.C. Memo. 1997-495.
More words of caution: When it comes to finding comparability data, try to ensure that the industry data comes from reliable sources and apply careful judgment.
After carefully making market comparisons, you may find that your subject was paid above the average market amounts. But this may not necessarily mean that he or she received unreasonable compensation. After all, someone has to be above average, or it’s not an average.
Rather than focus entirely on paying median or mean market rates, I suggest focusing on some other questions: Did he or she provide above-average results? Or below-average results? Are we getting what we pay for? Does the value we receive equal or exceed the cost? Could we somehow get more for our money?
If an individual is truly unique because of special skills, duties, or spectacular results, then his or her compensation may need to be set by means other than comparability data. Some people are simply off-the-chart.
Please remember that executive compensation is a complex matter. To be fair, many factors must be considered. What appears to be unreasonable compensation may not be once all factors are considered. Rules of thumb can be dangerous. There is often an answer that is simple, and wrong. It usually takes expertise, thoughtful analyses, and judgment to arrive at reasonable compensation amounts for those with broad ranges of duties.
Note: This article is provided to stimulate discussion and not to give advice for any specific situation.