If nature abhors a vacuum, then it is probably fair to say that regulation loves one. And a vacuum is, in some ways, what we have in the world on executive compensation. While disclosure requirements for compensation of senior public company executives have dramatically increased in the past of couple years, many people outside the boardroom (and a handful inside it) feel there is a lack of genuine understanding about how executive pay is set and what role the board and the compensation committee really play.
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Speaking at the NACD’s recent National Compensation Advisory Council, Robin Ferracone, executive chair of Farient Advisors, an executive compensation and performance consulting firm, said that while the challenge of evaluating and setting CEO and executive compensation is becoming more of a lightning rod, companies that can pass the “red-face test” will have a relatively easy time with the new disclosure and say-on-pay rules. Those that cannot may be treated harshly.
Those attending the meeting highlighted several issues that need to be addressed, both in the fundamentals of setting pay and in the way those pay decisions are communicated to shareholders and to the wider community. Perhaps the most important questions to emerge from the discussion were: Why are some CEOs pilloried for their compensation while others—even those who may make more— are held up as heroes? There is little, if any, consequence for underperformance—in fact, CEO pay never seems to go down. How should directors really measure performance, and how can compensation structures and policies be best communicated to shareholders, the media and the general public? Until these issues are addressed, there can be no meaningful discussion of the role of the compensation committee.
Some participants questioned the premise that the compensation system is “broken,” and even the need to have the conversation. Why is such a dialogue important, they asked?
Ken Daly, NACD president and CEO, answered succinctly: “If we don’t do something about this, then Congress will do it for us. If directors only do what is mandated [in terms of curtailing CEO pay], then we are going to get stronger regulation. Up to this point Congress has generally been happy changing behavior by increasing disclosure, but their patience has run out and they are starting to take a far more aggressive approach. If we don’t get ahead of issues and concerns around compensation— real or perceived—then we will lose control of the discussion.” In short, regulatory overtone is filling the gap in board leadership.
Several hours of sometimes-heated conversation resulted in a handful of steps and resolutions that boards should take in order to take control of the issue and become leaders of compensation strategy.
1. The board must be the leader of the compensation process. While in theory it is the job of the compensation committee (and ultimately the entire board), in reality, many boards feel that the CEO dominates the conversation while the board is reduced to a reactionary role.
The board needs to regain primacy on compensation philosophy, metrics and planning. The compensation committee must set the tone and own the process. This may require the compensation committee to adopt a different tone or approach than other committees that provide oversight and work collaboratively with management. The compensation committee should be less collegial, and realize that this is one of the few areas in which it has total responsibility. They shouldn’t act like dictators but, as one chairman pointed out, “You should remember that the CEO is really just an employee. This will assist greatly in setting the tone for compensation conversations.”
2. Tie pay to performance and define the metrics. Ferracone cautioned that assessing pay and performance is tricky. Perhaps the most common mistake made is looking at the grant value of long-term incentives rather than the value of long-term incentives after performance has happened. To achieve the Holy Grail of pay—i.e., tying it to long-term performance— use forward-looking metrics rather than backward-looking responses to past performance. The board should conduct a robust discussion of how pay aligns with strategy. This should be a formal agenda item. Nonfinancial metrics should also be considered because they can have a tangible impact on both short- and long-term value. Broaden the scope of what is considered value creation and sustainable growth. Consider the impact the company has on the wider community. Some companies are including metrics such as workplace safety, reliability of service and customer satisfaction.
Stephen Brown, director of corporate governance at TIAA-CREF, suggested linking any increase in CEO pay to pay within all levels of the organization. “You could match the CEO compensation story with employees, shareholders and others,” he said. “If CEO pay goes up 20 percent but general employee pay only goes up 2 percent, you are likely to have a problem.” In other words, it can be very difficult to justify this type of increase, not just to the media but also to the workforce.
The board must also create a structure that outlines negative consequences for poor or nonperformance. Variability in executive pay is acceptable. The compensation committee should not be constrained by legacy metrics. It is easy to get trapped in a steady stream of upwardly ratcheting pay—CEO pay never really seems to go down. Noted Arthur Martinez, director at AIG, PepsiCo, IAC/Interactive, Liz Claiborne and International Flavors & Fragrances, there is a “lack of true variability in pay at top levels. It is very hard to have the conversation that we can’t tell them their bonus will be 75 percent lower than last year. CEOs don’t always take that well. It’s the responsibility of those of us on committees to have that discussion and to introduce a real sense of variability.”
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Strong leadership by senior executives responsible for managing business are critical to our capitalist system and in tern to our democracy. The movement by Government to convert Board members into bureaucrats and cause management leadership to athrophy is the greatest issue facing Corporate Boards today.Oversight of CEO pay for performance has always been the fundamental responsibility of Compensation Committees. However, when Compensation Committees or Boards, in the name of fiduciary responsibilty, excessively involve themselves in fundamental management issues which deplete a CEO’s ability or incentive to lead, they have committed a serious disservice to the shareholders who elected them. Isn’t it time for Directors and our NACD to begin to understand the clear lines between oversight and overinvolvement? Or should we do nothing about the bureaucracy that we are fostering and imposing upon our free enterprise system and our American way.
Top executives keep getting increases by using methods that have become common practice in Corporate America. They get their boards of directors to give and give and give. How do they do it?
The executive compensation committee of the board and/or the VP or Director of Executive Compensation (a fast growing occupation) review market data of energy peers at the 25th, 50th and 75th percentile for annual cash compensation, bonuses, long-term incentive compensation, and perks. Of course these boards and compensation executives also hire outside consultants, who are paid handsomely to help out by also benchmarking and conducting competitive assessments. So as one CEO’s compensation goes up, other CEO’s in the same industry demand that their compensation must go up and then another and another.
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