Author Archives Paul McConnell

“Say on Pay”: Paul McConnell interviewed by Marketplace Morning Report

Posted by Paul McConnell on April 19, 2012  /   Posted in Compensation Committees

“Citigroup Investors Push Back on Exec Pay Packages”

Board Advisory’s own Paul McConnell, Managing Director, was interviewed by Marketplace Morning Report on April 18, 2012.

For Full Story & Audio/Video see the Marketplace website:


Bob Moon: Citigroup investors just pushed back on outsized executive pay. Fifty-five percent of the bank’s shareholders voted against pay packages for top execs, including $15 million in compensation for CEO Vikram Pandit. The vote is advisory only, though, and thus doesn’t actually force a change in Citi’s pay practices. So what will it accomplish?

Executive compensation expert Paul McConnell is on the line with his take on the message it sends. He’s managing director at Board Advisory LLC. Glad to have you join us.

Paul McConnell: Thank you.

Moon: I’ve seen stories that Citigroup can go ahead and stay with its pay practices in spite of this vote. If this doesn’t change things, what might?

McConnell:  Well, it is an advisory vote, which means it’s non-binding on the board. But it’s non-binding in the sense that the pay is not going to be taken away as a result of this. The board will react to this; no board is going to take a “no” vote from shareholders and ignore it. If they were — which is, I think, first of all not going to happen –but if they were, the next step with shareholders would be to vote the board members out.

Moon: Do you think the attention this is getting might touch off some kind of shareholder revolt at other companies over these pay packages?

McConnell: I mean, first of all, you’ve got to understand — the Citi corp. pay package is not outrageous in terms of the amount of pay. I think the issue at Citi corp. is more, shareholders are questioning the relationship between pay and performance.

Moon: So these Citi shareholders are basically saying: You want this, you’ve got to earn it?

McConnell: They’re unhappy with that subjective approach. They think the standards are probably not high enough for the amount of compensations earned.

Moon: But you don’t think this reflects general angst among shareholders in general — not just at Citi?

McConnell: No I do not. As a matter of fact, the reason for that is that corporate America has done a pretty good job over the last two or three years in removing most of what are known as “problematic pay practices,” that were really making shareholders irate.

And also you’ve got to understand with Citi, there could be a lot of other things rattling around here. Citi is an organization that’s had its share of troubles over the last few years. And they’re basically telling the board that something is wrong and they want it fixed. And the board will probably make some changes in the pay programs in reaction to this.

Moon: Paul McConnell at Board Advisory LLC. Thanks for your insights.

McConnell: You’re welcome.

Corporate Governance and Board Behavior : The Highs & Lows of 2011

Posted by Paul McConnell on January 03, 2012  /   Posted in Compensation Committees

Paul McConnell of Board Advisory was quoted in Agenda Week Online’s newsletter on corporate governance.

Original Article By: Amanda Gerut (January 3, 2012)

Last year’s hot corporate governance stories tended to describe how boards led the way — or withered — in the face of challenge. Herewith, based on Agenda’s reader statistics, the high and low points of boardroom behavior in 2011.

Hall of Fame:

1. After ISS recommended that shareholders vote against executive compensation plans at Alcoa, Assured Guaranty, General Electric, Lockheed Martin and The Walt Disney Company, their boards regrouped and altered elements of executives’ comp to gain the proxy advisor’s support — and shareholder votes. As Agenda reported in May, Alcoa, GE and Lockheed Martin amended the terms of equity awards previously granted to executives, while Assured Guaranty and Disney eliminated some promised benefits.“Listening to shareholders is always an example of good governance,” says Paul McConnell, a partner with executive compensation and governance firm Board Advisory — although he points out that it’s not clear whether ISS actually represents shareholders or just assumes what they think.


Continue reading the article on Agenda Week Online

Designing Long-Term Incentive Plans in Joint Ventures

Posted by Paul McConnell on August 24, 2011  /   Posted in Compensation Committees

Originally published in The Joint Venture Exchange in April 2011

Company mergerThe CEO of a relatively new joint venture (JV) was struggling with his long-term incentive program (LTIP). His problem? The JV didn’t have one – and some of his best senior managers were now ready to leave for opportunities with a richer upside. Unfortunately, establishing an LTIP required the CEO to overcome some high hurdles.

Unlike a public company, his venture lacked a stock to use as cheap currency for the plan. Likewise, the CEO had to convince six parent companies, each with a separate corporate culture and approach to incentive design, to agree on a model. And he had to come up with a design that reflected the oddities of life in a joint venture – including whether and how parent company benefits not seen on the JV P&L should be included in the plan targets, and how to deal with parent-company imposed restrictions on the venture’s product and market scope that limited the JV’s earnings potential.

Such compensation struggles are typical for joint ventures.

And our work with dozens of JV Boards and CEOs shows that many JVs with LTIP programs find the current design sub-optimal in important ways. In some cases, the program has unintended limitations in its likely value to employees. In other cases, the program does not sufficiently target the outcomes that the shareholders want to incentivize. This might include pursuing synergies with the parent companies, or maintaining plant up-time rather than profitability.

Continue reading article in PDF Format

 Joshua Kwicinski and Paul McConnell (Managing Director of Board Advisory, LLC)

ISS Urges Vote Against Exxon Executive Pay Plan

Posted by Paul McConnell on May 11, 2011  /   Posted in Compensation Committees

A recent WSJ article noted that Institutional Shareholder Services (ISS) has recommended a vote against Exxon’s executive pay plan.  Their key objections were that Exxon’s pay is not suitably correlated with Total Shareholder Return (TSR) on a 1 and 3-year basis and places too much emphasis on time-vested stock instead of performance vested stock.  Exxon is a massive organization that makes very large and long-term capital investments all over the world that are subject to economic and geopolitical risk on a scale that few other companies can appreciate.  The Company makes an excellent defense of their plan in a supplemental proxy filing and the description of their plan from their original proxy filing.  There is no need to repeat the arguments here.

But this incident points out the obvious issues with using a one size fits all set of “objective” criteria to assess executive pay.  Objective garbage is still garbage.  No Compensation Committee wants to see its executive pay program criticized by a proxy advisory firm.  But if your company is different in a significant way than the norm (as is Exxon), it is better to get that “No” recommendation for designing a program that is right for your company, than it is to get a “yes” by going with the flow and instituting a plan that doesn’t address your issues but passes the “objective” tests.  In my experience as an executive compensation consultant, having designed plans for a broad range of industries and company sizes, there is always something unique about each company that must become the lynchpin of their executive compensation program.  The art in this business is finding that unique element and designing accordingly.  Even if it breaks the rules.


CEO Pay Trends in the S&P 500 – 2011 Update & Reactions

Posted by Paul McConnell on May 03, 2011  /   Posted in Compensation Committees

Equilar has just released their latest report, on CEO pay trends in the S&P 500 in 2010… and with the report the findings quoted below.

“After pay declines in 2008 and 2009, CEOs saw their total compensation rise 28.2% from 2009 to 2010, to a median of $9 million. A few other findings:

  • Bonuses were the component of compensation that saw the most growth in 2010, with a 43.3% rise. The median bonus was $2.15 million. 85.1% of CEOs received an annual bonus payout in 2010, compared to 73.6% in 2009.
  • Options are still the most common equity vehicle, but performance shares and restricted stock are on the rise.
  • Both stock-based awards and bonus payouts became a larger part of the pay mix, at 38.2% and 27.2%, respectively, of total 2010 pay.”

Statistics like this are misleading without proper context.  In 2007, the year before the recession/stock market crash, the median S&P 500 CEO had reported total compensation of $8.7 million (i.e., with equity awards reported at expected value, not actual value).  That median declined to $8.0 million in 2008 as the recession began in many industries and $7.0 million in 2009 as the full force of the poor economy hit executive bonuses and stock grants.  The $9.0 million reported for 2010 does represent a 28% increase from the low, but only a 3% increase over 3 years from the pre-recession value.

In order to properly understand trends, you need to look what is happening with each component over time.  What actually happened was that 2008 equity grants were made in early 2008, before the recessions impact was felt – thus the median change was rather small and positive.  The big change in 2008 was cash bonuses, which were down significantly (22%), although the impact varied by industry.  In 2009, bonuses were up slightly (8.5%) reflecting largely performance versus diminished expectations.  Equity awards for 2009 were made at or near the trough of the market – down 18% for options and about flat for stock awards.  But this too needs to be considered in context.  Many companies replaced option grants with full value share awards (i.e., restricted
stock or performance shares), thus the declining price was offset by increased prevalence producing a flat median award.  The decline in the stock market value (40% – 50%) was somewhat masked by the fact that interest rates declined in 2009 and volatility increased.  These factors increase the value of option awards as a percentage of market price, so that the reported decline in option values did not fall as fast as stock prices.  The decline in both types of awards was also somewhat masked by the prevalent practice of granting a fixed value of LTI award (e.g., 300% of salary) despite the nonsensical effect this has of increasing share awards when stock prices decline and decreasing them when stock prices go up.   In 2010, we saw the biggest change in pay in cash bonuses as profits recovered to 2007 levels.  Stock and option awards were up sharply (39% and 16% respectively) as stock prices improved 40% to 50% over awards made at the same time in 2009.

The bottom line is that executive pay performed exactly as it should over this period – flat from peak to peak with significant declines in the trough of the recession.


Dodd Frank: Another Chance for the SEC to Get Pay For Performance Right

Posted by Paul McConnell on October 21, 2010  /   Posted in Compensation Committees

The Dodd-Frank bill contains two new disclosure requirements regarding executive pay: the ratio between the CEO’s compensation and that of the median employee, and the relationship between compensation actually “paid” to executives and company stock performance.

The new pay ratio is flawed on many fronts: it ignores organizational scope and size, it can be biased by outsourcing lower-paid work, it ignores the inordinately large role of benefits in the pay of lower level employees, and most importantly, it ignores the differences between guaranteed compensation and the risk inherent in equity based pay.

In contrast, the disclosure of pay in relation to performance has the potential to present a true picture of executive pay from which shareholders and the public can draw meaningful comparisons.  The key is how the SEC eventually defines “pay”.

The Amounts Shown In The Summary Compensation Table Are Not Pay. Disclosure of executive pay has vastly improved over the last two decades.  We now have accurate data on all the relevant components of compensation.  While this data is extremely useful in designing competitive pay opportunities, the current required format does not show what executives actually earn — or how that pay might relate to company performance.

Cash bonuses are typically paid for financial performance versus targets, rather than for shareholder gain.  Presumably, the cash payment relates to drivers ultimately reflected in stock price, but not necessarily reflected in the current year stock price.

For most executives, the largest portion of their reported pay is the disclosed value of stock awards.  For performance based stock, the disclosed value is a “target” value on the date awarded.  It does not reflect the actual number of shares earned or the realized value of the stock over the requisite holding period.  Similarly, options awards are shown as the expected value from a probability distribution, not the actual realized gains.

These valuations were never intended to represent the actual value the executive would receive, and were only intended to satisfy the accounting world.  Consequently, using current proxy data to explain the link between pay and performance is like using a baseball slugger’s “at bat” statistics to explain the team’s won/loss percentage.

The Best Comparison Comes From a Multi-Year View of Realizable Pay. To best evaluate board decisions regarding pay and to test the overall alignment of executive pay to investor gains, one must compare the value actually realized by the executive to the returns of investors.  For this purpose we look at the cumulative salary and cash bonuses received over a multi-year period (e.g., five years) plus the ending-period value of actual stock awards granted, stock acquired from previous awards, and embedded option gains (e.g., the paper profits).

Such pay comparisons are extremely important when evaluating the relative wisdom of a board and their executive pay decisions.  By looking at the cumulative effect of decisions over a 5 year period – perhaps the shortest time period when executive effectiveness can be reasonably assessed – management and the Board can more effectively establish for investors the degree of alignment between executive rewards, business strategy and shareholder gains.

The data required to perform these calculations are readily available through existing public company disclosure in proxy statements, related SEC filings, and commercial data sources.  The general public could produce these calculations; however, use of multiple data sources and obscure reporting rules makes it difficult and time consuming.

Our investor and board clients have found this longer-term pay comparison to be an extremely effective tool for understanding the compounding effect of compensation decisions over time, and as an aid in calibrating prospective equity and cash incentive decisions.  Perhaps more importantly, the analysis serves to bridge the communications gap between investors, the board and executive management by simplifying pay arrangements in terms everyone can easily grasp.

Conclusion. Much of the public’s understanding (or misunderstanding) of executive pay is driven by the annualized and hypothetical values disclosed in proxies.  Regrettably, the format of the SEC disclosure also shapes how many boards make annual executive compensation decisions.  The SEC will not release new rules until the second quarter of 2011, but regardless of the reporting form eventually chosen by the SEC, forward thinking Boards should supplement their CD&A disclosure with a true pay for performance analysis such as that presented above.  For most boards this can convey a critical story line for investors wanting to understand how and why executives are rewarded.

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Paul McConnell and Jeff McCutcheon are Managing Directors of Board Advisory, LLC

CEO Succession: An Interview with Board Advisory & Bank Director Magazine

Posted by Paul McConnell on March 09, 2010  /   Posted in Compensation Committees

Originially Published in Board Member Magazine

BD: Jack Milligan, associate publisher, Bank Director magazine
McCutcheon: Jeff McCutcheon, managing director and founder, Board Advisory LLC
McConnell: Paul McConnell, managing director and founder, Board Advisory LLC

BD: Federal banking regulators are beginning to focus more attention on executive pay. How will this impact the compensation committee?

McCutcheon: I don’t believe it will substantially change actual pay levels. Historically the government has been extremely ineffective at regulating pay — particularly executive pay. One could even argue that prior attempts to slow executive pay growth have had the opposite effect. However, regulations have been very successful in changing the vehicles used for pay delivery, as well as the form of pay and the governance process around pay. One would expect to see a transition from salary, stock options and annual bonuses to longer term less liquid stock grants. In addition, all the current attention that’s being paid to unnecessary risk taking will likely result in greater focus on relative goals rather than only absolute performance targets, particularly in community banking where a peer institutions with similar business models exists. This has also affected how boards go about managing pay. In the past it has been a management-directed process, where management would look at its strategy and develop pay plans in support of that strategy. This analysis and decision making is very quickly shifting over to boards. Compensation committees are quickly becoming responsible for interpreting strategy and thinking about what pay tools are going to be most effective in executing those strategies.

McConnell: We’ve also seen rampant growth in independent pay advisors like our firm, that work only for the board. It’s our sense that the independent firm is quickly replacing the older model of the multi-line consulting firm, where executive compensation was one of many services that were provided. For large, public companies, the market share held by the traditional large consulting firms has dropped from 73% to 58% in 2010 alone. This is a dramatic shift that recognizes the actual board advisor and the board advisor’s relationship rather than the geographic footprint or sheer size of the specific firm.

Boards of directors are now more focused on advisor independence. One of the first questions we are asked by boards is “How independent are you?” The challenge for boards and advisors is to strike the right balance between working with management as opposed to for management. I think one of the things you’re going to see as a result of the increased federal oversight is much more board independence. In the current environment boards cannot afford not to engage their own advisors.

BD: Will increased scrutiny of executive pay mean that bank compensation committees will have to look at pay practices for the entire organization rather than just the CEO and his or her senior team?

McCutcheon: In well-run banks the compensation committee has always been involved in compensation strategy down through the organization. Under current regulation this practice will need to become a standard process of the committee. In a lot of ways it’s a good thing, because that’s where a lot of the problems occurred that led to the financial meltdown in 2008. The problems were not necessarily originating at the top of the house. The excessive risk taking was occurring further down in the organization. However, I think the board’s primary focus will remain with executive management pay. The board’s charter is largely to hire the CEO, who in turn hires the rest of the management. And I don’t think anyone wants the board involved in the day-to-day operations of banks, least of all, boards.

BD: Is the role of the compensation committee is changing? And if so, does that mean that firms like yours will also have to change?

McCutcheon: The role of the committee advisor is changing very quickly, just as the role of the compensation committee is changing. Compensation committees are now held far more accountable for managing the executive leadership risk – whether we are talking about succession, new CEO selection criteria, or the choice of performance measures used to link strategy execution and value creation with executive performance and wealth accumulation. Each decision requires fairly active management of business risks involving executive leadership.
At our firm, and I imagine this also applies to our peers, we are far more involved in working with committees to develop their executive leadership strategy. Our client committees are spending far more time defining performance, managing succession risk and understanding investor expectations. We no longer see committees spending the majority of their time interpreting market median compensation practices or implementing the most tax or accounting-efficient incentive arrangement. Instead, committees are investing their time in the actions that move the needle – both in terms of improving management’s underlying performance results and in terms of clarifying the message to investors, influencing market valuations.

BD: In today’s environment, where profitability is under pressure and stock prices are low for most organizations, what’s the best way to compensate the executive management team?

McConnell: One thing they shouldn’t do is emulate the large banks, where in my opinion the basic compensation process is flawed. They don’t have any long-term incentives. Let me explain. What they currently have is a series of one-year plans that have a portion paid out in restrictive stock or options — and that’s the root of the problem. Most of the fixes the federal regulators have talked about would essentially space out the payment to create a “long term orientation,” but a well-designed executive pay plan involves balancing long-term and short-term objectives. There’s no balance in these plans. By focusing so much on the annual bonus pool they’ve created a what-have-you-done-for-me-today mentality that encourages the kind of excessive risk taking we have seen. In a well designed plan, top management – and top management in a large money center bank might extend down to a couple hundred people — would be paid primarily through large equity grants that are earned over time through sustained performance on a couple of contrasting measures that are not easy to achieve simultaneously. It could be growth and profitability, growth and safety or profitability and safety. Achieving sustained performance on those two dimensions in a manner consistent with the strategy, and doing so over a period of time, would be the primary basis for stock rewards. That’s how you create a long-term compensation orientation. Then your annual plan can be much more tactical in nature: It can be a reward for a good year. It can be a reward for achieving certain key objectives. In a small organization it might be a reward for achieving a key component of that long-term strategy such as installing new operating systems or completing a merger. But the executive focus should be first with the long-term piece and then secondarily with the annual bonuses.

BD: Will there be a role for stock options in the dawning era of increased government scrutiny, or are we going to seem them becoming increasingly unpopular with a shift towards restricted stock grants?

McCutcheon: I think there’s an absolute role for options but we will have to rethink how options are used. Historically, options have been extremely liquid and they provide the holder with both the opportunity and incentive to time the market. When an executive times the market, they liquidate their holdings when the stock is at a peak — and their gain is essentially financed by all other investors in the form of dilution. If options are going to continue to be used in the future as executive rewards, I think to a very great extent that ability to time the market will be limited, not so much as to the date of exercise, but specifically to the date of sale. It’s my sense that future use of stock options will be restricted through a specific holding requirement, where net shares would have to be held for something like 10 years from exercise. This allows the company to reap the benefit of the compensation leverage of the option without pitting the executive against other investors.

McConnell: The real problem with options as a long-term incentive vehicle is the heads-I-win-tails-I-don’t-lose kind of mentality that can lead to excessive risk in building a company because option holders don’t lose anything if the company fails. There is no cash value in the options when granted and holders don’t lose anything if they fail. That leads to a swing-for-the-fences mentality. Used alone, and particularly in large quantities, options can lead to excessive risk taking. I think where options will have a role in compensation plans going forward is as a balancing mechanism. If you have a sound annual bonus plan and a good long-term performance plan that’s focused on sound metrics, an option can still be used to sweeten the deal on the up side, making the overall program more lucrative and responsive to gains in stock prices.

BD: Is the skill set for a successful bank CEO any different today given the difficult environment that we’re in?

McConnell: Well, first they need a tougher hide. The underlying skill set required to run a bank is essentially unchanged. However, if we look a decade into the future bank CEOs are going to be operating in a far more complex regulatory environment and the required skill set may be -influenced by that. There is also the question of scale. A large and complex banking organization requires a fundamentally different skill set than a smaller community bank. As banks plan for their next CEO they should be mindful that some of these institutions are more than five times larger than they were 10 years ago.

BD: What’s the biggest mistake that boards make in terms of managing the CEO succession process?

McConnell: In a nutshell, it’s delegating the responsibility for doing it to the CEO.

McCutcheon: CEO succession is the most important single task that boards have, but it’s one that has been really delegated away in many instances. If we look at just the large banks, Equilar (an executive compensation and board research firm) found 28% of the CEOs at the beginning of 2009 weren’t there at the end of 2009. Certainly 28% of those people didn’t have planned retirements with carefully chosen successors in place. Perhaps Bank of America might come to mind. CEO succession is a known and very real risk that directly impacts investors. Simply put, boards cannot assume any CEO will want to undermine his or her own personal negotiating power by developing a stable of competent successors to take the reins the first time he or she stumbles. Succession is something that boards have to own and manage as part of their risk management obligations.

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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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Executive Compensation: “Heads We Win, Tails You Lose”

Posted by Paul McConnell on August 27, 2009  /   Posted in Compensation Committees

[Originally published in Board Member Magazine.]

It is not surprising the public perceives that executive compensation is a “heads we win, tails you lose” proposition. For the past three decades, executive pay plans have grown like kudzu in a muddy Georgia field. In an attempt to balance performance, competitiveness, risk and rewards we have also increased the complexity of pay. Given our lack of success to date, it may be time we fundamentally rethought this process.

Each year, compensation committees spend a great deal of time determining appropriate levels and establishing incentives to provide executives wealth consistent with expected future investor gains. But the reality is that much of the eventual executive gain is determined by business cycles and the timing of option exercises and stock sales — items essentially independent of the long-term investors’ gains.

Recently, there has been a movement to reduce the impact of the timing of sales on executive pay by requiring that executives hold stock received until retirement. This is a powerful tool for aligning executive and shareholder interests, but it only solves part of the problem. In too many cases, the size of annual awards is largely driven by competitive considerations where a specific dollar amount of expected value is used to determine the number of shares or options granted annually. This produces the nonsensical result of increasing the number of shares granted when stock prices decline or decreasing them in response to superior performance.

A better and simpler approach would follow the lead of private equity and venture capital firms, where executive compensation is largely dictated by individuals with substantial personal capital at risk. In this approach executives would receive a one-time competitively sized grant of full-value shares when hired or promoted. This grant would vest over a long-period of time like a typical career (10 years) or until retirement – based on time vesting and/or by achieving performance goals. No further grants would be contemplated unless a promotion or significant business combination occurred. Thus, we introduce two concepts not frequently used by most companies: 1) one-time grant of full-value shares based on a percent of the outstanding shares of the company (rather than projected value), and 2) long term vesting and holding requirements that ensure management has an ongoing stake in the company.

This one-time grant approach to equity compensation, by definition, has a perfect correlation with shareholder wealth over the same period. In contrast, the competitive annual award process mutes the relationship by annually adjusting poor performers up and strong performers down. For example, looking back at the 10-year performance of companies that are currently still in the S&P 500, we find that a one-time grant would produce total wealth for executives in companies that perform at the 75th percentile that is about 3x that earned by the 25th percentile. With competitive annual awards, that ratio is about two times.

This one-time grant of full value shares approach has a number of other advantages:

  • Executive would have an appropriate level of “skin in the game” from day one instead of waiting 5-10 years until cumulative equity awards provided adequate net shares.
  • Illiquid full value shares balance risk and reward consistent with long-term investor, TARP and emerging Obama administration pay objectives. Options and other leveraged grants don’t have the same element of “loss” to balance risk-taking.
  • It would eliminate the need to provide severance if terminated without cause or following a change in control. Contractual vesting of a portion of the shares would provide executives with adequate security in a more shareholder friendly manner.
  • When tough economic conditions occur (like we are currently experiencing) reported compensation would be limited to base salary and bonus earned (if any). This would likely show a much clearer link between pay for executives and employees – particularly if companies annually reported the change in the market value of executive holdings.

By eliminating the concept of an annual “competitive” equity award, we will take an important step in changing the public perception that executive pay is a “heads we win, tails you lose” proposition. We believe that by isolating the ownership interest of management as a discrete, contractual incentive, boards of directors can better manage the cash incentives and salary of executives, providing a more coherent and transparent oversight process. If we want executive management to think and act like owners, we should pay them like owners – long-term owners.

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© 2009 Board Advisory.
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