CEO Ownership

Annual Executive Compensation Levels: Where We Veered Off the Road

Posted by Paul McConnell on August 30, 2013  /   Posted in Compensation Committees

[Originally published in Board Member Magazine 2013 Q3.]

VeerIn our last article, we noted that somewhere along the way, executive compensation veered off the road.  Executive compensation plans became too complex, isolated from true performance and downside risk, and in many cases, total compensation was just too high.  While there is no shortage of blame to go around, we find one obvious flaw is the prevailing practice of treating executive equity as annual compensation.

Assume that you had money to invest in a business and I was going to run it for you.  I’d get a salary and bonus for my labor.  You might also give me shares of the company to align our interests and ensure I was fully “bought in” to the venture. It would be clear between us that the stock was my “share of the deal” and would remain invested with the company until we parted ways.

As an unintended consequence of the thirty-year effort by the SEC to improve the oversight of executive pay, we have effectively created a bias against the “share of the deal” approach to equity.  To provide greater transparency and comparability, the SEC requires companies to report all remuneration in annual terms – even if it is not an annual event.  Consequently, we stopped thinking about executive equity as a “share of the deal” and we fell into the mindset that it was all annual compensation.

Obviously, equity awards have a compensatory effect, and are a key part of an executive’s total pay.  The best talent will seek opportunities where they can share in the value they help create.  However, by seeing executive equity as a piecemeal annual reward rather than as one’s share of the deal we have created the perception that the equity is indeed a cash equivalent, to be exchanged for cash when needed.

From an owner’s perspective, the critical issue should not be the annual increment of equity, but the total equity commitment necessary for each key executive role to achieve the following investor objectives:

•        Providing an attractive package to recruit and retain the management talent needed;

•        Matching executive performance and wealth more closely to the company risk horizon; and,

•        Aligning executive wealth proportional to investor gains or losses.

Unfortunately, in the current “tail wagging the dog” scenario, we find companies think about equity in annual terms because we report it and compare it on annual terms.  This has the perverse impact of:

•        delaying the formation of a substantial equity position for several years in order to comply with annual compensation practices;

•        rewarding volatility by granting more equity (as a percent of outstanding stock) when the company does poorly and fewer shares when the company is highly successful; and,

•        thinking of equity as a cash equivalent that can be sold during the term of employment.

It makes far more sense to manage equity decisions using established target equity levels for each of the key executive roles.  Achieving the target ownership may be accomplished in one step (e.g., in a turnaround), or parsed out over time.  The key difference, however, is that executives and investors know the annual grant is not a bottomless pit of investor dilution.  Periodic grants would represent the execution of a strategy rather than an attempt to chase some market median practice.

With this approach companies, executives, and investors benefit three key ways:

•        We answer the question “how much is enough?” — the elephant in the room nobody currently wants to talk about;

•        We simplify pay by distinguishing an illiquid career investment from annual cash pay.  This change in perspective removes much of the concern driving the Dodd-Frank pay-ratio debate; and,

•        We assure all parties that executive management is a long-term investor in the company, with upside and downside risk, and full accountability for the economic consequences of risks through a sizeable stake held throughout their career.

It is time we begin to think and act like owners and treat equity as if we were making partners out of management – by granting them a piece of the enhanced value of the business over time, not doling out shares simply to reach a “competitive” amount of annual compensation.

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CEO and Executive Pay Plans: Help for a Broken System

Posted by Paul McConnell on May 06, 2013  /   Posted in Compensation Committees

[Originally published in Board Member Magazine 2013 Q2.]

Broken Somewhere along the way, executive compensation veered off the road.  It became too complex, isolated from true performance and downside risk, and in many cases, too high.  The original idea of executive compensation was to pay an adequate and fair wage and good benefits.  Any additional pay was intended to place executives in the same position as owners.  However, with high base salaries, equally powerful short-term incentives, long-term incentives that are treated as income rather than investment and often protect against downside risk, and the potential for golden parachute payments that reward executives when they fail, something went wrong.  The good news is that it can be fixed.  The bad news is that it will require some bold new thinking on the part of boards and management.

Performance.  Before discussing pay, let’s examine performance.

  • More often than not we reward CEOs for luck and good timing rather than for leadership, stewardship and good strategy.  Research has shown that as much as 80% of total return may be based on macro-economic factors and industry trends unrelated to company behavior.
  • Performance against internally-developed goals is important, but may be unrelated to actions that build long-term value for investors.  If a CEO is truly operating at a strategic level, the real impact of their leadership may not be evident for 5-10 years, and in some industries with long development or capital cycles, perhaps 15 years.  Yet for the most part we define CEO performance in terms of annual financial results rather than on more broad indicators of long-term value creation.
  • Current year plan-based targets, ROIC (return on invested capital) and share price are all great dashboard measures, indicating directional progress, but these measures should not be confused with actual success of a strategy or long-term value creation within an organization.  Boards need to think long and broad when it comes to assessing performance.

If we are to improve the pay model, we must first be willing to commit to a longer-term view of performance and articulate exactly what success looks like.

Pay.  Much of the current executive compensation thinking is a product of the 1980’s and 1990’s.  Many of today’s practices are influenced by the SEC efforts to standardize disclosure in an effort to bring more transparency and comparability to executive pay.  Unfortunately, as with many things, there were unintended consequences.

  • We think about and communicate pay in annual terms rather than in long-term outcomes.  If in doubt, read the “compensation philosophy” section of the typical CD&A.
  • We emphasize annual bonuses that pit CEO’s self-interest against investors when negotiating performance targets.
  • We claim that equity is an incentive to create alignment and balance risk, but we allocate it on the basis of “competitive pay” like cash; we too rarely acknowledge an intended career allocation or a targeted ownership objective.
  • We rationalize equity programs as putting executives in the same position as owners, but, in our experience executives rarely lose money. Annual equity awards are typically based on dollar-denominated “target values”, protecting executives from stock price changes, and executive stock holdings are often sold to the extent they exceed minimal ownership requirements.
  • We use “competitive practice” as a synonym for minimum requirement, whether dealing with salary and incentives, terms of employment, or severance.  As a board we seldom exercise leadership in crafting employment arrangements directly supportive of the company’s mission.

To say that executive pay is “broken” may seem overly harsh, but we should at least acknowledge that executive pay often falls far short of delivering on its objective of rewarding executives for long-term value creation.  The first step in the cure is admitting you have a problem.

In later articles, we will examine several solutions to these problems.

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Aligning Executive Pay with Risk Management in Banking

Posted by Paul McConnell on November 01, 2009  /   Posted in Compensation Committees

Originally published in Bank Director magazine.

Recent board director surveys indicate bank directors find current legislative and regulatory actions unwarranted, and that existing bank executive compensation plans do not encourage imprudent behavior or excessive risk. These opinions are diametrically opposed to global public perceptions that a serious problem exists with bank pay practices, and that substantial regulation is required. With governments racing to shape policy around public perceptions, bank directors will soon be left scrambling to retain talent if they do not use this current turmoil as an opportunity for proactive re-evaluation of the entire bank executive pay process.

Let us start by clarifying: executive pay practices did not cause the current crisis. In fact, our research indicates business unit incentives (e.g., trading, mortgage origination) were far more influential in the crisis than executive pay. Regardless, public perception is the board’s reality and, upon closer review, there are some changes that could be made to bank executive compensation programs that would better align pay with sound risk management.

As we have been reminded, banks have an exceptional obligation to operate for the long-term benefit of all stakeholders, not just maximizing shareholder return. Capital safety is the cornerstone of bank performance and the bank’s executive officers are uniquely positioned to manage the balance between risk and reward. These are the individuals (e.g., the CEO, CFO & Chief Risk/Credit Officer, etc.) that develop strategies and monitor risks, and are who the Board counts on to “see around the corner” in balancing current initiatives with long-term financial security.

To reassure the bank’s various stakeholders, executive pay should be revisited starting with a blank sheet of paper. For most of line management, use of salary, bonus and stock pay arrangements are likely still appropriate. But for the limited group of senior executive officers described above, who are directly responsible for managing to the long-term interests of investors and the public, we believe there is a very simple and powerful approach to employment, compensation and incentives that will provide a stronger incentive to deliver results for all stakeholders.

Remove key executive officers from the annual bonus plan, adjusting salaries to provide competitive total cash compensation. Free executives to more objectively set tough but prudent goals for the operating officers that appropriately balance risk and eliminate any perceived moral hazard associated with executives developing their own performance hurdles.

Establish an immediate, one-time equity stake for key executive officers upon accepting their role. Award this one-time grant in an amount comparable to the present value of awards an executive might receive for the role for remainder of their careers (e.g., for a CEO, perhaps 1% of the company in full-value shares), with vesting over the remainder of their careers based on time and relative company performance.

This one-time grant would provide an immediate, substantial financial incentive to operate for the long-term benefit of stakeholders. This approach reflects the investor-perspective, consistent with the practices of many private equity and venture capital investors. By establishing an ownership interest rather than an annual “pay” opportunity, banks can also eliminate the need for supplemental retirement, severance, life insurance and related income protection schemes. Critical to this approach, even vested portions of the award would remain non-transferable until a year or two after the executive’s employment ends, eliminating any opportunity to benefit from market timing or short-term appreciation in company equity.

By eliminating annual bonuses and annual incremental equity awards, and instead offering the executive officer fixed cash salary and an immediate investment stake, boards will recognize the unique role bank CEOs and other key executive officers play in managing toward the long-term health of the organization. Boards will also eliminate a number of performance and ethical obstacles created by existing arrangements. Executives would no longer “earn” their equity based upon annual assessments of short-term performance, the bias in goal-setting and selection of performance measures will be minimized, and the CEO would now evaluate risks and rewards in light of long-term value creation–without the added bias of personal short-term performance payoffs.

Properly communicated, this pay approach–simple, transparent and aligned with investors and public interest–will take an important step in changing the negative public perception of executive pay in financial institutions and signal that the CEO and the leadership team are committed to managing risk and reward for long-term value. While this may not be the perfect solution for any one bank, it provides directional guidance in responding to the justifiable public concerns and investor sentiments regarding managing bank risk.

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© 2009 Board Advisory.
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