Reasonable compensation is a critical component of a credit union’s success

Over time, paying executives too little risks starving the credit union of critical managerial talent. Paying too much wastes assets and risks embarrassing the board and sowing discord among employees and with members. This article reviews the reasonableness standard and how board members, who constantly walk this tightrope, can reach the right balance of paying enough but not too much.

For federal credit unions, the Federal Credit Union Act empowers the board to hire and compensate officers and employees. NCUA regulations then empower credit unions to provide employee benefits, but the “kind and amount of these benefits must be reasonable given the federal credit union’s size, financial condition, and the duties of the employees.”

The NCUA Examiner’s Guide then picks up the baton. In the chapter on “Management,” the Guide tees up the issue:

While examiners generally should not require changes to compensation arrangements in healthy credit unions, they should note, when appropriate, unsafe and unsound compensation practices.

The Guide then provides a dirty-dozen list of practices that “may constitute unsafe and unsound practices.” Chief among them:

Compensation arrangements that significantly exceed compensation paid to persons with similar responsibilities and duties in other insured credit unions of similar size, in similar locations, and under similar circumstances, including financial health and profitability.

Therefore, reasonable compensation is a safety and soundness issue that is resolved by paying for executive services only what similar credit unions are paying similar executives.  The challenge lies in identifying similar credit unions and similar executives, and determining how much the credit unions pay those executives.

Fortunately, credit unions can learn from the experiences of other organizations in different industries that face even greater scrutiny on this issue. The NCUA test of similarity is the same that the IRS applies to non-credit union charitable organizations that are tax-exempt under Section 501(c)(3) of the tax code, such as hospitals. These organizations, however, are subject to additional restrictions.

A 501(c)(3) organization executive who receives unreasonable compensation personally incurs significant “intermediate sanction penalties.” Additional penalties are also imposed on decision makers at the organization that approved the compensation.

Given these penalties, 501(c)(3) organizations have become very good at ensuring they pay only reasonable compensation.  Their best practices, together with lessons learned from specific credit union failings, are a road map for credit unions to follow to achieve that same assurance:

• Board-driven process—The board should direct the process by overseeing those who are collecting the comparability data and retaining any consultants involved. Findings should be reported directly to the board without filtering by the executives whose compensation is being determined.
• Independent body—The compensation decisions should be made only by those who have no family, employment, business or other relationship with the executives that could taint their decisions. Deliberations should be in executive session, excusing those whose compensation is being determined.
• Data sources—Published surveys can be the single most helpful source of compensation data.  To supplement or assist in fine-tuning the data, additional sources for comparable employer compensation data include IRS Form 990s (filed by state-chartered credit unions), private inquiries to other credit unions, and written job offers from other credit unions.
• Recordkeeping—The board should keep careful, contemporary records of the comparability studies and surveys used, the analysis for selecting the proper peer group, the process for determining total compensation (see below), and who participated in the deliberations.
• Similar credit unions—While perfect matches may be difficult to find, most surveys aid in coming close by reporting data based on asset size.  In selecting size, the board should use the credit union’s actual current size, not the size the credit union wants to become.  For example, some boards say, “We’re $750M now but we want to grow to $1B, so we will use the data from $1B credit unions.” The problem with this approach is every $750M credit union wants to grow to $1B, so the growth objective is already built into the compensation $750M credit unions are paying.
• Total compensation—The comparison should be based on total compensation, consisting of salary, bonus and benefits. A comparison based only on total cash compensation (salary and bonus) can result in a total compensation package that is significantly lower or higher than the peer group depending on the strength of the benefits package.  Surveys become more helpful as they address the prevalence and amount of key benefits such as nonqualified retirement plans and paid time off.
• Nontaxable benefits—The benefit comparison should include all elements of compensation whether or not the element is taxable.  For example, loan regime split dollar may result in no taxable income for the participant, but it provides an economic benefit that should be valued and included in the comparison.
• Prior under-compensation—The IRS allows a 501(c)(3) organization to pay higher than the peer group currently if the organization previously under-compensated the executive. A credit union seeking the same treatment should follow the requirements articulated by the IRS and courts addressing the issue—quantify the amount by which the executive was undercompensated in the past, determine when and how the employer will make up the shortfall, and include the information in formal board or compensation committee minutes.

A credit union board that follows these best practices in setting executive compensation will have greater comfort that it is neither under- nor over-compensating executives, and will be able to demonstrate compliance to its examiners, members and executives.