executive pay

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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Executive Pay Practices: The Road Not Taken

Posted by Paul McConnell on August 17, 2014  /   Posted in Compensation Committees

Two RoadsThe evolution of current executive pay practices may require more and more companies to take the “road less travelled by” in order to provide superior returns to shareholders. Pay practices continue to create heated debates among executives, boards, institutional investors and their proxy advisories (e.g., ISS and Glass Lewis). Underlying the debate are two contrasting views about executive pay and the economy in general – zero sum economics and expanding wealth.

Zero sum economics simply holds that one person’s gain, is another person’s loss. To wit, if the board pays their managers more, there is less for shareholders. The current metrics employed by ISS to assess pay-for-performance are really cost control measures that seem to reflect ISS’s view that executive pay is a zero sum game. While zero sum may capture the economics of trading pork bellies or oil futures, it does not describe how an economy creates wealth and how managers should share in the wealth they create.

The view of expanding wealth is embodied in the likes of Steven Jobs, Meg Whitman, Jack Welch and many others — business leaders who created substantial benefits for consumers and in the process created substantial wealth for themselves. In short, the pie got bigger and owners shared in the increasing size of the pie. It would be rare to find an investor who would begrudge the wealth these superstars have earned. Interestingly, among this illustrious group, some would likely fail today’s proxy advisor screens.

Rewarding managers for wealth creation is a “value sharing” approach to executive pay. The model dates back to the industrial giants who emerged prior to WW II. GM, JC Penny and others paid a share of the profits (after a fair return to investors) to the senior managers. After the War, public companies migrated to a “competitive pay” model that pays managers what other managers earned in the same sector and adjusted for size.

Unfortunately, with the exception of significant collapses in performance, competitive pay is often “memory less” — regardless of performance, the CEO gets what the CEO’s peers get. It should be noted that private equity has pretty much retained the “value sharing” approach to incentive pay, a potential source of competitive advantage in attracting talent.

While competitive pay addresses retention risk (if everyone’s paid the same, no one will leave for more money), it may not address performance. High leveraged plans pay out more as performance increases, but could run into the immoveable code of the proxy advisors. While no board member wants to be voted off the island, boards may unknowingly be taking the road to mediocrity by de-levering the compensation plan in order to assure favorable votes from investors.

Yet if ever there was a time to avoid mediocrity, this is it. Mediocrity, is what puts a company on the short list of potential takeover targets. In a world where the economy creates new wealth, “value sharing” compensation programs do matter. They matter not only to attract and retain talent, but also to encourage managers to pursue all value-adding investment opportunities. The biggest impact on shareholder wealth from the competitive pay approach may well be the opportunities foregone.

It’s time for boards to take a stand against mediocrity. Start with strategy – management must make a compelling case for their strategy and how it will create value for investors. The board must support the strategy (or change it). In supporting the strategy, the board must adopt a compensation program that is aligned with the strategy and allows managers to participate meaningfully in the value they create for shareholders. Finally, boards and managers will need to explain to institutional investors and their proxy advisors how they intend to create value (strategic intent) and how they will allow managers to “share” in the value created. In short, the road less travelled by may not be an easy road; but then it may make all the difference. BoardMember 2014 Q3 The Road Not Taken

Aligning Tax Policy with Sound Executive Compensation Practices

Posted by Paul McConnell on May 26, 2009  /   Posted in Compensation Committees

If we want executives to act and be rewarded like investors, we should tax them like investors.

As the chorus of public outrage over executive compensation rises to a new crescendo, it is understandable why the populist approach to “solve” executive pay is through regulatory pay limits. However, executive compensation experts and investor representatives alike agree that rather than limiting pay, the best thinking on the subject is focused on creating plans where executive wealth is tied to that of long-term investors – where they are unable to profit (or limit losses) from short-term changes in company performance or company stock price. There is much agreement that this linkage is best accomplished through executive equity arrangements with provisions such as “hold-till-retirement” requirements. However, in implementing these provisions boards of directors are now finding that federal tax policy is not aligned with what is arguably in the best interest of the public, not to mention shareholders.

We believe that minor changes to the tax code could facilitate these ownership provisions, thus providing greater alignment of executive pay with public interests. Further, these changes will also increase federal revenues by increasing the effective tax on executive pay without the adverse economic effect of broad rate increases. Simply put, we recommend that the tax code cease treating certain long-term executive equity incentives as annual “compensation”, and instead treat it like an investment.

Current Tax Law Rewards an Early Exit

The table below shows the current taxation of various popular executive equity compensation vehicles:

Vehicle Form of Income Timing
Restricted Stock or Performance Shares Full value is Compensation Vesting
Nonqualified Stock Option (NQSO) Gain is Compensation Exercise
Incentive Stock Option (ISO) Gain is Capital Gains Sale of shares

Any compensation value from an executive equity grant is also deductible to the employer (subject to the limits and performance rules of section 162(m)) and is subject to Medicare taxes (1.45% rate) from both the executive and the employer.

The net effect of this approach is that today’s executives have a powerful incentive to exercise stock options during favorable market cycles, then liquidate their positions to provide cash flow to execute the exercise, including withholding taxes. Since there is no further tax liability and typically little obligation beyond perhaps modest stock holding requirements, a rational executive/investor would clearly sell their ownership position and interests to diversify their overall portfolio. The existing tax treatment does not encourage long-term executive ownership nor penalize sale of stock during the executive’s career.

Alternative Tax Approach Creates Value from Holding to Retirement

An alternative approach is to treat executive equity awards as a sale of company stock on the date of grant, similar to any other investor purchasing shares for cash. Where there is a discount element (e.g., restricted stock or performance shares), the discount at grant would be treated as compensation to the executive and deductible to the company (subject to 162(m)). However, the tax on this compensation would not be due until it was both vested and sold. Thus a company could create a very favorable tax situation for its executives (and an incentive benefiting investors and the public alike) by requiring that they hold the stock until after they leave the company. Like other investors, any post-grant gain (or loss) would be taxed as a capital gain at the time of sale. Similarly, any dividends paid would be taxed at the 15% rate (under current law).

Vehicle Form of Income Timing
Restricted Stock or Performance Shares Value at grant is Compensation, any post-grant change is Capital Gain (Loss) Sale of Shares
Stock Options [1] Gain is Capital Gains Sale of shares

These proposed tax rules create a strong incentive for executives and Boards to design equity plans utilizing hold–till-retirement provisions. For example, without a hold-till-retirement provision a performance share grant would trigger immediate taxation for the full value at vesting. The executive would typically then sell shares to satisfy the withholding tax. With the benefit of a hold-till-retirement provision, the executive would not be liable for any tax until the shares were sold – at some point after retirement. This will result in more net shares remaining in the hands of executives, presumably providing a more significant incentive for delivering long-term results for investors and the public at large.

Curiously, although the executive would receive favorable tax treatment, the tax revenue gains to the government would be significant. Currently, the executive’s ordinary income tax and the corporate deduction largely offset each other. As a result, the executive’s basis in the stock is stepped up to the price at the date of vesting (for full value shares) or exercise (in the case of an option). Thus the net tax received by the federal government is limited to the capital gains tax calculated on any stock appreciation subsequent to vesting/exercise – and there is little incentive for executives to hold shares after vesting/exercise.

Under the proposed approach, the executive’s capital gains would be measured from the grant date price – as is the case with an investor purchase – with no offsetting tax deduction by the corporation. While this results in a lower tax rate for the executive, the effective taxation is increased by eliminating the employer’s tax deduction. Furthermore, the combination of hold-till-retirement covenants and supporting tax policy better aligns the executive performance incentive with the interests of investors and the public over time, rather than allowing an executive group to be rewarded for short term results. With a broad definition of equity incentive plans (i.e., including non-public company equity and equity-like vehicles), this approach can successfully apply regardless of company size or ownership structure (e.g., small businesses, joint ventures, subsidiaries, private equity and start-ups).

We believe this is an easily achievable first step toward aligning federal tax policy with public policy interests regarding executive compensation and corporation accountability. If we want executives to act and be rewarded like investors, we should tax them like investors.

– Paul McConnell

Paul McConnell works with a number of Board Advisory clients within the banking and related financial services arena on executive pay alignment, performance measurement, and executive performance issues. You can view Mr. McConnell’s bio here. If you have any question or comments on this article, or want to speak with Paul about any executive rewards, performance, or succession issue, he can be reached at pmcconnell@board-advisory.com, or at (407)876-7249.

[1] The tax code changes proposed in this article could be achieved by simply modifying existing ISO provisions in IRC sections 421 through 424, to reflect contemporary executive pay programs and hold-till-retirement obligations.

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© 2009 Board Advisory.
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