Author Archives board-advisory

Executive Pay: Agree on the “How” – “How Much” Will Solve Itself

Posted by board-advisory on February 03, 2015 / Posted in Compensation Committees

The typical discussion regarding executive pay among boards, investors, proxy advisers, and management has tended to be on how much to pay. Executive pay comparisons relate total compensation to both peer companies as well as total shareholder returns. While the “how much” analysis is helpful in assessing relative pay levels, the more critical discussion is how to pay. The “how” discussion describes the way management participates in value created for shareholders. The upshot of this discussion is that if there is agreement on how to pay executives among key stakeholders, then how much to pay is determined by actual performance over time.

The almost exclusive focus on how much to pay is in some respects an accident of history. Prior to WW II, incentive pay was often based on profit sharing. After the war, the market migrated to a competitive pay model that determined compensation based on position, industry, and company size. This had the effect of keeping a lid on pay inflation during the rapid economic expansion and with the elimination of price controls on wages following the war.

Unfortunately, the competitive pay approach led to excesses usually driven by inappropriate peer comparisons. In response, institutional investors have come to the forefront on say on pay. Large institutional investors like Vanguard and Fidelity have established internal groups to evaluate and vote their proxies. Other institutions rely on proxy advisory firms, such as ISS and Glass Lewis. Both the internal groups and the proxy advisers tend to evaluate pay almost entirely on the basis of how much is paid, not on how the pay was determined. Their quantitative models are designed to work across a variety of industries but usually fail to do that (one size fits all doesn’t fit anybody) and often fail to adequately address special situations (e.g., turnaround, companies with few peers, etc.).

The path forward for the say-on-pay evaluators is unclear. The internal groups may face a challenge from within trying to maintain relevancy in an organization whose objective is to generate respectable returns compared to other fund managers in order to attract investors’ savings. It’s a bit odd when a company that makes the fund look good is told its pay is out of line by the proxy group of the same fund. In short, do these groups represent merely an 18-month hitch for a rising executive, or do the Vanguards and Fidelitys of the world see an opportunity to influence investor returns through better pay practices? The proxy advisers have seen their influence diminished through direct institutional involvement. Do these firms morph into IT-driven proxy processors while they rejigger their models to identify only the most egregious offenders of poor pay practices?

In this evolving environment, boards and compensation committees still face the real challenge of ensuing that their compensation program meets with shareholder approval. In response to investors’ concerns about pay and performance, many boards adopted programs with specific metrics and targets that drive both the annual plan and absolute or relative total shareholder return (TSR) performance-based, long-term equity programs. More recently, many companies have developed outreach programs to their large investors.

The challenge that boards face may also be their opportunity. In short, they should create a new discussion about pay practices. Our suggested approach is to define for all shareholders how managers share in the wealth they create for investors. Note the focus is on how, not how much. The former defines the target leverage the program employs—i.e., how does management’s wealth change with a change in the company’s TSR relative to the market or peers? What is the appropriate leverage for an industry, and should the board consider a higher or lower leverage ratio than the company’s peers? This is the right discussion to have with the company’s investors.

When shareholders and directors agree on how managers get paid, then how much they get paid depends only on actual performance. If managers deliver entrepreneurial returns to shareholders, they earn entrepreneurial rewards for themselves; conversely, modest performance produces modest rewards.

– Mark Gressle and Paul McConnell. This article originally appeared in Corporate Board Member magazine, Q1 2015.

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Incentive Plan Design for Compensation Committees

Posted by board-advisory on June 17, 2014 / Posted in Compensation Committees

Board members bring of wealth of talent and experience to the companies they serve, but often have no practical exposure to the basic building blocks of effective compensation design. Before new compensation committee members jump into aligning incentives with company strategy, discussing “best practices” or considering accounting and tax implications, it can be very beneficial to review the concepts typically used by compensation professionals in incentive design. In our experience over the past 30 years, we have seen countless successes and failures of incentive arrangements. As our experiences accumulated at Board Advisory, we found a distinct pattern for successful incentive plans which we have distilled to the four “pillars” shared below.

In general, the most successful Board member incentive plans strike a balance between four pillars that support the entire incentive design structure; the plans work when Board participants:

1. Know what is expected of them.

If the performance metrics are not a “household word”, do not tie pay to them. Companies and boards often get excited about new concepts and measurements that drive organization value, but if those measures are not part of the 24/7 fabric of the participant’s work life, the plan likely won’t work. Thus transitioning to new concepts requires training and retraining, until the concepts sink in, before tying pay to the measure. As we develop and select new measures to better reflect execution of company strategy, the trick becomes ensuring that the measure is also understood and embraced, much like the strategy.

2. Believe it is achievable.

Oftentimes, companies place unrealistic targets in front of participants (e.g., $4.00 EPS when $2.50 is the rolled–up budget). There has to be a degree of buy-in to the goals, or the plan will be ignored or at the very least be ineffective. Many firms have moved away from such top-down goal setting, but several still use this approach and their incentives do not incent. If you want to reward for a 16% ROIC and the enterprise is currently only generating 12%, a roadmap showing how the goal can be achieved is mandatory.

3. Track progress during the performance measurement cycle.

Participants need to see the goal line regularly. During the performance measurement period (say, monthly for an annual goal) tracking performance is crucial to plan effectiveness. Modern enterprise data solutions make this issue fairly moot in many cases, but newer goal concepts at many firms have resulted in performance tracking lag times that render the plans ineffective. For example, not seeing the results versus goal for Q1 until the end of Q2 is not highly motivational for annual plan participants. If the metric is important enough to be rewarded, it is important enough to be a part of timely, transparent communication.

4. Earn a meaningful amount for achieving the goal.

In most executive pay plans, this is also a moot issue so long as we regularly set competitive target bonus opportunities, but many firms don’t. Also, in certain industries, the bonus plans often roll down to lower levels in the firms. Experience has taught us that at least one-month of pay (e.g., 8% of base salary), is the minimum target opportunity for the lowest level. At executive levels, we seldom see targets below 30% of annual salary. Participants are incented by pay amounts that can make a difference in their lives. Working hard to achieve meaningful goals that earn merely enough to take one’s spouse to dinner after a long year, is probably not really a meaningful amount.

The Take Away

Compensation committees are responsible for bringing the company’s strategy into focus through the use of executive and employee incentives. In addition to all the other critical elements in addressing compensation matters, members are advised to keep in mind these four simple pillars to ensure the resulting incentive design for Board members is effective.

BoardMember 2014 Q2 – Incentive Design for Compensation Committee Members

CEO Pay Ratio Disclosure, Rules & Regulations

Posted by board-advisory on April 29, 2014 / Posted in Compensation Committees

Matt Ward’s comments below are excerpted from a Mini-Roundtable on CEO Pay Ratio Disclosure published in the April-June 2014 issue of Risk & Compliance Magazine.

RC: What are the key issues and arguments in the debate over CEO pay disclosure?

Ward: Probably the biggest challenge is defining who the median employee is and calculating their pay. The rule is deceptively simple at first glance, but implementation can be fraught with complexities depending upon the company. Timing is crucial, and despite what looks like a long lead time, the wise firm would act sooner than later on this issue. Under the proposal, a company would be required to disclose the pay ratio with respect to compensation for its first fiscal year commencing on or after the effective date of the final rule. Companies would be permitted to omit this initial pay ratio disclosure from their filings until the filing of the annual report on Form 10-K for that fiscal year or, if later, the filing of a proxy statement following the end of that year, provided the proxy is filed in a timely manner – within 120 days after the end of the fiscal year. For example, if the final requirements were to become effective in 2014, a calendar-year company would be first required to include pay ratio information relating to compensation for fiscal year 2015 in its proxy statement for its 2016 annual shareholder meeting. Thankfully, the proposal would also provide a transition period for newly public companies. For these companies, initial compliance would be required with respect to compensation for the first fiscal year commencing on or after the date the company becomes subject to the reporting requirements. As a result, pay ratio disclosure would not be required in a registration statement on Form S-1 for an initial public offering or a registration statement on Form 10.

RC: In 2013, the SEC proposed new pay ratio rules, including rules governing the disclosure of CEO compensation. Could you provide a brief outline of these rules, and when companies can expect their implementation?

Ward: Under the proposed rule, the SEC to amend its executive compensation disclosure rules to require disclosure of the ratio of the CEO’s ‘total compensation’, as disclosed in the proxy statement, to the median amount of total compensation for employees of the issuer. Under the proposed rules, all employees of the issuer and its practically all employees of the company must be included in identifying the median employee’s annual total compensation. This includes all full -time, part-time, seasonal or temporary workers employed by the company or any of its subsidiaries “Aside from union pension plans and a small number of other, investors seem to be largely indifferent to the rules.” as of the last day of the company’s prior fiscal year. Despite concern over the compliance costs of including foreign employees in the determination, the proposed rule extends to non-US employees of the company and its subsidiaries. Workers not employed by the company or its subsidiaries, such as consultants or temporary workers employed by a third party, will not be required to be included in the determination. Again, most importantly, the proposed rule will only apply to those employees employed by the company on the last day of the company’s prior fiscal year.

RC: What factors are behind the introduction of these new rules? How have they been received by businesses and investors?

Ward: The rules, promulgated as required by the Dodd-Frank Legislation, took quite a while to come about. The SEC likely had hoped that the legislation would be repealed or amended. The pay ratio provision of the legislation came about from a longstanding criticism that CEO pay in the US was unreasonably high as a multiple of employees, especially when compared with other countries’ practices. Critics used to cite Japan as an example of successful and powerful companies that managed to keep pay of the CEO at a much lower multiple of the typical worker. However, savvy observers pointed out that indirect CEO pay at Japanese companies such as numerous servants, private jets and mansions around the world was not measurable and quite considerable. Despite this, the criticism was a regular part of annual executive pay disclosure cycles ever since. After the financial collapse of 2008, the groundswell of support for anti-CEO pay legislation was unstoppable. It is safe to say that, like the SEC, businesses and investors had hoped that the legislation would be repealed or amended, but so far no such luck.

Timely manner

RC: What steps can firms take to prepare for the proposed rules? What guidance has the SEC provided?

Ward: We think that companies should not procrastinate on this issue and should at least run some initial calculations now to get ahead of the curve on choosing a methodology. While it is obvious for very large multinationals to address this, even a mid-sized firm with far flung operations needs to act in a timely manner. In fact, it is the small to mid-size firms that could be blindsided by waiting too long to address this calculation.

RC: In determining pay ratios, companies must first determine the salary of the ‘median employee’. What methods can firms use to determine this value? What sampling methods have been approved by the SEC?

Ward: The SEC permits public companies to select a methodology for identifying the median employee under the proposed rule. The proposed rule does not set forth a methodology that must be used to identify the median employee and permits companies the ability to select the method that works best for their own facts and circumstances. For example, the company could identify the median by calculating the total compensation per employee under existing executive compensation rules or through a statistical sampling of its employee population. To address commenter concerns about the compliance costs of calculating total compensation per employee under existing executive compensation rules, the SEC will also permit the usage of a ‘consistently applied compensation measure’ in identifying the median. For example, companies could identify a median employee by using more readily available methods such as total direct compensation – such as annual salary, hourly wages or other performance-based pay – or cash compensation and then calculate that median employee’s total compensation in accordance with executive compensation rules. Compensation for a permanent employee who did not work a full year – such as a new hire or an employee who took an unpaid leave of absence – would be permitted but not required to be annualized. However, the company would not be permitted to annualized compensation for temporary or seasonal workers. The company would be given the flexibility to measure compensation by choosing a method that best reflects the way it pays its employees, as long as that method is consistently applied.

RC: What impact do you believe the new rules will have on business practices, particularly in terms of structuring compensation packages? Do you expect the rules to significantly impact levels of executive pay?

Ward: We don’t believe the rules will have any meaningful impact whatsoever on pay levels for CEOs or median workers. The flexibility for companies in choosing methodologies and determining the median employee’s pay essentially renders peer-to-peer comparisons useless, even in industries with very close comparability of firms, such as oil companies, airlines, and so on. When coupled with the cost to comply, hopefully there will eventually be support for repealing the legislation. We have had clients estimate they will need to add full-time equivalent employees just to gather this data.

RC: What final advice can you offer to companies on the proactive steps required to address the issue of CEO pay ratio disclosure in today’s business world?

Ward: The SEC has provided great flexibility in applying the proposed new rules in each specific company. However, there are still going to be data collection issues and meaningful choices to be made in carrying out the calculations and choosing a methodology. We recommend that companies exercise the due diligence up front to form a task force of accounting and compensation professionals from both inside and outside the company to make the most well-informed choices. Thereafter, the annual calculation will be much easier and subject to change only to comply with rule changes or industry trends in making the calculation.

For a full copy of the article, download here: R&C CEO PAY RATIO DISCLOSURE

Executive Leadership Transitions: “PAVE” the Way to Success

Posted by board-advisory on December 04, 2012 / Posted in Compensation Committees

We’ve been involved in Transition Coaching more than ever before because of the importance rightfully being placed on improving the assimilation of new leaders into organizations. In recent years, the failure rate of transitioning leaders (whether external hires or internal promotions) has been surprisingly and unacceptably high—anywhere from 30%-60%, depending on who’s research and metric you’re using. And the cost of a mistake at senior levels typically runs 10-15X salary. Indeed, Boards and Executive Teams are “owning” this crucial challenge, as they should.

Executive transitions are complex affairs, so we try to simplify things with a few basic concepts and a guiding framework. The foundational concepts are (a) transition success is a function of followership; (b) followership stems from trust, and (c) trust comes from two types of credibility—professional credibility and personal credibility. Professional credibility means that people will trust and therefore follow a leader because they believe she knows what she’s doing… she has the experience, the credentials, the track record that gives others confidence that they will be led to the right place. Personal credibility means that people will trust and therefore follow a leader because he cares about me… he behaves in a manner that gives me confidence that I matter and will be led in the right way. In the transition window, the leader can take steps that are primarily transactional or activity-based to build professional credibility, and steps that are primarily relational or behaviorally-based to build personal credibility.

Furthermore, transition steps can be targeted to four (4) primary “targets”—Boss, Team, Colleagues and Self. Most transitioning leaders pay attention the first two, at the expense and peril of the second two. But all four need concerted attention. The boss tends to believe they’ve solved a big organizational problem when the new leader takes the reins, so they turn their attention elsewhere. That’s why they’re paying them the big bucks, right? Compounding that erroneous assumption is that the new leader wants to prove her independence. But if the new leader and the boss aren’t fully lock-step not only on exactly how success is defined in the leader’s role, but also how the two of them will operate, with frequent check-points on both, the new leader is driving this change blind-folded at best.

The team dynamic could be the most intense. After all, the new leader landed in their lap, and possibly in the role a few of them wanted and thought they deserved. While making quick change in this space is tempting, due diligence and patience could be what’s most needed. The new leader will only be as good as his team, so getting this right is paramount to a successful transition.

As alluded to above, many transitioning executives are vertically oriented, paying attention to the boss and taking care of the team. Yet lateral and diagonal relationships in the rest of the organization could well be the most important of all, since multi-faceted support is required in today’s complex organizations, and lack thereof can torpedo things fast. Besides, the new leader’s peers are the bearers of the current culture, which often has a strong immune system and thus by design rejects foreign bodies. Deliberation and considerable finesse is often required to navigate this minefield.

Last but by no means least is oneself, as neglect here can be an easy and very costly mistake. If the new leader is not at the top of her game—mentally, emotionally, and physically—her odds of failure increase exponentially. Conversely, attention to self will ensure the new leader has the sharpness, stamina and fortitude to effectively lead potentially the biggest challenge of her career through to fruition.

The acronym and action matrix below is one way to be mindful and purposeful in the transition window.

Prime yourself.

Align with your boss.

Vector your team.

Engage the organization.

Executive Transition Matrix

	ACTIONS
	Transactional (activity based) *Professional Credibility*	Relational (behaviorally based) *Personal Credibility*
TARGET
Self	What you do with Self Health & Wellness Coach and/or Mentor Other	How you conduct Self Integrity Authenticity Other
Manager	What you do with your Boss Scorecard Work Plan Other	How you align with your Boss Communication Accountability Other
Team	What you do with the Team Assimilation Talent Review Other	How you affect the Team Motivating Others Building Talent Other
Organization	What you do Organizationally Networking Stakeholder Input Other	How you influence Culture Collaboration Relationship Building Other

We find that being deliberate in this manner can help transitioning leaders bolster credibility, build trust, and gain the followership required for a successful transition.

– Kevin R. Hummel, Ph.D.

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Recommended Business Books : October “Board Break”

Posted by board-advisory on October 19, 2012 / Posted in Compensation Committees

The Power of Habit: Why We Do What We Do in Life and Business by Charles Duhigg

Duhigg divides the book into three sections: The Habits of Individuals, The Habits of Successful Organizations, and The Habits of Societies. This is a very, very informative and entertaining book. It reminds me a great deal of The Checklist Manifesto: How to Get Things Right by Atul Guwande, in that the ideas contained in both are “duh, why didn’t I think of that?” simple but profound. He uses hundreds of examples of how we develop good and bad habits and how we can improve by simply understanding the science behind our habitual behavior.

George F. Kennan: An American Life by John Lewis Gaddis

This is the best biography of 2012 and perhaps of the last several years. Kennan was, of course, known as the architect of the Cold War, through his “long telegram,” autonomous letter from X, and other writings that influenced policy makers and gave the blueprint for the containment of the Soviet Union. Gaddis, the author of several books about the Cold War, tells us about the human side of Kennan but also brilliantly covers an important and challenging time for the U.S. You will enjoy this book even if you are either already versed in 20th century foreign relations or simply don’t think you would want to know this much about it. It is that well-done.

Interim CEOs Make Sense For Unexpected CEO Departures & Succession

Posted by board-advisory on May 27, 2011 / Posted in Compensation Committees

In response to Equilar Article “CEO Succession in Bunches – An In-Depth Look at S&P 1500 Companies with Multiple CEO Turnovers between 2007 and 2010“

On the topic of using Interim CEOs for unexpected CEO succession: For a company to have an immediate and well-thought-out leadership answer in the case of sudden CEO departure, I believe it’s a strong sign of responsible thinking and preparation rather than an indictment of a firm’s succession planning, particularly when the current (departed) CEO had plenty of runway expected. Like other significant organizational risks, you want to be prepared for unexpected, even tragic scenarios. Not having an immediate solution to those circumstances is irresponsible. The succession solution doesn’t necessarily have to be a permanent CEO (which ties into my next comments), but there must be a solid solution.

Indeed, an existing Board member is a typical source for interim CEOs, but it can also make good sense to go with another person from the Executive Team. Sudden CEO departure can shock an organizational culture, which in turn has negative ripple effects. What the organization needs is an instant stabilizing influence, including and interim CEO that the troops know, trust, and want to follow. Often times, there is a such a highly credible person who has been there a long time, has many deep relationships, clearly cares about the company and its people, and has a proven track record of success. Bingo. That person can be the parental influence that helps the family know that everything is going to be all right.

Why, you ask, isn’t the previously-described person just anointed permanent CEO. Couple of reasons. First, this person is typically on the tail-end of their own career, very likely planning to retire in a couple of years. They’re honored to take the reins on an interim basis, but have no desire (or ability) to significantly alter their retirement projection. Second, the CEO of the future might require skills and experience the interim CEO doesn’t have. This interim CEO can adequately manage the current business challenges for a relatively short period of time, and as importantly will serve a crucial emotional role for the organization. But they don’t have the right stuff to take the company to the next level and/or to handle what’s coming down the pike.

In short, interim CEO succession planning makes sense. It’s like a life insurance policy—you’d rather not have to use it, but are glad you have it if you do.

As for the piece of the article that covers the unexpected short tenure of new CEOs, these finding are consistent with previous research we’ve cited that shows that senior-level transitions fail more often than they succeed. The primary reasons for this trend include (a) a solid blueprint for success wasn’t really nailed down before the search, so the search was misguided, (b) assessment of the degree of fit between candidates and the role requirements was less-than-rigorous, essentially allowing a mis-hire, and/or (c) inadequate onboarding or assimilation was provided, which otherwise could have accelerated traction and value addition. These mistakes can be minimized, but that’s probably another blog discussion.

– Kevin Hummel, Ph.D. is a Managing Director of Board Advisory, LLC

Executive Transitions: Treacherous Waters That Don’t Have to Be

Posted by board-advisory on June 16, 2009 / Posted in Compensation Committees

Executive transitions into new roles and succession planning continue to be one of the greatest challenges organizations face. Regardless of the reason for the transition or the source of the executive, executive transitions fail at an alarming rate, and always at a high cost to organizations. To fully discharge their duty to attract, motivate and retain management, Boards of Directors need to pay more attention to how critical changes in leadership are effected.

The dollar impact of failed transitions is relatively easy to calculate. The primary areas for such dollar impact estimates includes the cost to hire (e.g., search/placement fees, relocation, etc.), total compensation for said executive for the duration of employment, “maintenance” expenses such as administrative support and overhead, severance costs, and impact of mistakes and/or missed opportunities. The total of these costs typically total 10 to 15 times salary for a senior executive and can easily cost a company several million dollars. String together a few of these, and even a sizable organization can be crippled.

Recent executive transition research I led through Alexcel Group and the Institute for Executive Development, using an online survey of more than 150 practitioners in more than 140 different companies, showed that for external hires, 30% don’t meet expectations in the first two (2) years. While slightly better, 21% of internal placements don’t meet expectations in the first two (2) years. These “failure rates” may seem unacceptably high, yet other research in recent years shows failure rates of executive transitions can be upwards of 60% or even more.

When asked to characterize the level of support their organization provides to transitioning executives, 19% of respondents said they provided high support for external hires while 81% said they provided no to moderate support. For internal moves, 15% said high support was provided and 85% said no to moderate support was provided. One surprising result came for the question: What level of involvement does your Board play with executives who are changing roles? Only 1% of respondents said it was high, and 36% said none whatsoever. This contrasts with institutional investors’ interest in executive succession, where a poll of public pension funds indicated they held boards responsible for planning and executing executive succession.

When asked about the reasons for failed transitions, the most frequent response (68%) was due to lack of interpersonal skills, and the second most frequent response (46%) was lack of personal skills. The least-frequently chosen reason for failure at 15% was insufficient technical skills. So while candidates seem to have the functional proficiencies, they most often fail due to the softer leadership competencies. These findings suggest that there are significant gaps in hiring processes, where attention is paid to technical skills at the expense of softer skills that can just as easily derail an executive that otherwise “looks good on paper.”

So what are practitioners doing to assist with executives in transition, and how well is it working? For both external and internal hires, the most common practice (49%) is Mentoring and “Buddy Systems”, but the effectiveness of that practice was judged best for external hires where that was rated the most effective process. For internal moves, Executive Coaching was seen as most effective. While frequently used, the least effective process for both types of candidates was Orientations.

In our opinion, the key take-aways from this and other research include the following:

organizations don’t provide executive transition support that is commensurate with the importance of that event;
the best onboarding practices in the world will be of little value if companies don’t get the hiring right in the first place;
even with accurate hiring, executives can fail if they aren’t given needed support;
the type of support being provided often isn’t what will best facilitate executive success.

So what is a company to do?

First, make it a priority and invest resources accordingly, starting with Board oversight of the whole process, from methods used to hire and onboard candidates in general, to what is being done to ensure a new executive’s success in particular.
Second and related, make sure the hiring process is comprehensive and accurately gets at ALL competencies, not just technical proficiency and experience.
Third and also related, ditch the traditional Orientation material for onboarding, and instead use more hands-on approaches such as Mentoring, Executive Coaching, and/or other assimilation practices that are personalized and get better traction.

Executive transitions fail frequently at high corporate cost, andthey simply don’t need to. We’re convinced that if Boards adhere to the above three recommendations, their companies will immediately realize a distinct competitive advantage.