Compensation Committees

Jerry Jones Has a Point, But the Wrong One.

Posted by Paul McConnell on November 18, 2017  /   Posted in Compensation Committees

Much has been written about NFL Commissioner Roger Goodell’s contract extension and Dallas Cowboys President Jerry Jones’ objections to the amount he can earn and the lack of rigorous performance criteria.  While Jerry might be right, I think the bigger issue is a classic example of misalignment between owners and the executive.

Owners earn a healthy annual return on their investment.  But the serious money is made from the growth in the value of the franchise.  The franchise value grows tax-free over time from enhanced TV contracts, merchandising, stadium deals, operating management and keeping the stadiums filled.  When the franchise is sold, the gain is taxed at favorable long-term rates.

From press accounts, it appears that the contract being discussed is a collection of bonus arrangements designed to reward the commissioner for improvements in the various metrics that drive the franchise value.  One of the arguments is whether the performance goals are sufficiently difficult or if the bonuses are just disguised salary.  This is a typical “managerial” approach to compensation – pay me for the things I can control and I’ll “manage the hell out of them”.  Its not a contract compatible with the group of entrepreneurs that own the place.  In a public company this would be like paying the CEO huge annual bonuses, but no stock.

Here is an idea for a better approach.  Scrap the bonuses entirely.  Pay the Commissioner a nice high salary consistent with what the top players make – maybe an average of the top 5 players in each position or a fixed percentage of the cap.  The Commissioner represents the players too and he should have something in his package tied to their welfare.  But the true wealth from this contract should come in the form of something like a Stock Appreciation Right (SAR) tied to the increase in the aggregate franchise value.  Forbes Magazine, an objective third party, conducts a study each year.  The values they compute may not be 100% accurate, but the trend is consistent with the trend in the Owners’ value.  The SAR would only pay out at the end of the Commissioners term to ensure a long-term alignment with the Owners.  NFL Commissioners serve a long time – Rozelle served 30 years, Tagliabue 17 and Goodell has already served 11.  It’s a long-term job.  The pay should be too.

“Pay For Performance” Made Simple

Posted by Paul McConnell on August 12, 2016  /   Posted in Compensation Committees

With the introduction of shareholder “Say on Pay” votes, an entire industry formed to demonstrate the degree of alignment between executive pay and corporate performance or to challenge the result (the underlying assumption being that the two should be directly, causally, related).  Few Compensation Committees, however, really consider the definitions of what constitutes “pay” and “performance”.  Moreover, even assuming a perfect linear relationship between, for instance, SEC-reported total pay and total shareholder return (TSR), where your company’s pay is dead-on with performance, you still don’t know if that pay is appropriate or if any causality exits.  At best, all you can say is that you are no worse than anyone else – which fails to inspire anyone.  What is missing in this analysis is whether shareholders are getting a fair return on the value of the equity that they have granted to employees.

Our analysis of Fortune 1500 companies indicates that salaries and “target” cash incentives are generally predictable based on company size.  Level of salary is strongly linked to company size and the amount of the annual incentive (generally a percent of salary, with notable exceptions in certain industry sectors) is typically tied to annual financial performance.  In very basic terms, cash buys the talent.

Most of the disparity in the relationship between pay and performance arises from equity incentives.  Equity is powerful. It constitutes 60%-70% or more of the pay package in the largest companies.   Because it takes many forms, it is difficult to compare many types of equity in terms of the value delivered to management and in terms of direct comparison to any “market” standard.  The matter is further complicated by governance programs and a regulatory/reporting framework that often considers peer practice comparisons more important than any judgement regarding reasonable sharing-of-value creation.

For Compensation Committees and executives, it is beneficial to stand back from the process and think in more broad terms about what incentive equity in executive compensation should achieve.   In a start-up, equity incentives represents a trade-off for current compensation and a shared risk in the venture, with earlier employees (higher risk-takers) generally receiving the more lucrative terms.  As the existential threat of downside company risk declines, the relative ownership stake awarded to management as a percent of the company generally declines through successive funding rounds, IPO’s, etc.  In private equity situations (leveraged buyouts, going private), an up-front sharing of 10%-12% of the company in the form of an option is intended to align management to an expected time horizon (i.e. 4-6 years) and a new, focused strategy.  This dilution is explicitly built into investors’ expectations, and management’s potential gain is calculated based on the expected returns of the specific investment thesis.   However, in most public companies in corporate America, we see a different practice.  Executives are awarded “long-term” equity on an annual basis which is then valued, reported and viewed by executives as part of their annual compensation.  We effectively shift from a value-sharing arrangement to a competitive annual pay arrangement, where in most instances the competitive pay target is hypothetical and only loosely related to value sharing.

We think it is a better approach to think in terms of a competitive level of value to be shared with management based on the relative importance of capital and labor (knowledge) in the creation of that value.  Industries or situations where capital is the primary driver (e.g., utilities, heavy industry, etc.) require less value shared.  Industries where intellectual capital is paramount warrants proportionally larger ownership interest to attract the necessary talent.  Once a competitive ownership level is defined, Boards and their Compensation Committees should think about how quickly to allocate the equity.  If it is a potential breakthrough situation or a turnaround, a front-loaded award of equity makes sense.  If the strategy is more akin to hitting lots of singles and doubles (to use the baseball analogy), annual awards tied to incremental achievement might make more sense.  In either instance, the level of sharing is not in question, only the time required to realize the full allocation.

A shared-value approach to equity also addresses the “elephant in the room” – how much equity is enough?  By operating with a value sharing target, the conversation shifts to how quickly the target can be allocated.  Long-term vesting, distinct from the award, remains the key to retention and liquidity, and limits the company’s exposure from a premature executive exit.  More importantly, the value sharing approach automatically aligns executive and shareholder interests through shared expectations, without the need for elaborate charts and graphs.  At the end of the day it’s about value sharing – the more value you create, the more wealth you get.  Committees need to avoid distractions from excessive peer comparisons, proxy advisor edicts and SEC & accounting rules.  It is only through a shared, “mature” view of the executive relationship that we can quell the critics and clear the air on executive pay.

Click here to download a pdf of this article.

Compensation Committees and Stock Buybacks

Posted by Jeff McCutcheon on June 02, 2015  /   Posted in Compensation Committees

Share repurchShare buybackase arrangements (stock buybacks) are expected to top $600 billion in 2015, up from an estimated $550 billion in 2014. In fact, at the current rate of growth, share buybacks will soon represent a return of capital twice the size of aggregate dividend payments. Critics (including Blackrock CEO Lawrence Fink) argue that this large return of capital is evidence of short-sighted management eating the seed corn rather than investing within the business. In contrast, companies (and many activists) view their stock repurchase arrangements as rational, tax-effective decisions in reaction to a lack of attractive internal investment alternatives. Regardless of the reasoning, given the magnitude of share buybacks, we believe it is worthwhile for compensation committees to review closely the relationship between buybacks and incentives and carefully consider the role of unintended consequences within the executive performance management process.

Share repurchases use cash (capital) to reduce the number of shares outstanding. This reduces the aggregate value of the company (market capitalization) in rough terms by the amount of the repurchase, net of any indirect increase in share price. By reducing the shares outstanding, earnings per share increase. By reducing the capital employed, return measures also increase (ROE, ROA, ROIC, etc.). If the share repurchase is reflected in the setting of goals, this may not be an issue. If the buyback is determined after annual goals are set, the repurchase has the potential to distort performance compared to goals.

The excess capital used to repurchase shares may be the result of performance, but the act of repurchasing shares does not create value. Short-term investors surely benefit from any bounce in share price, and proxy advisers may embrace the impact on total return to shareholders (again, calculated on a per-share basis), but it is a return of capital, not the creation of real operating value. For this reason, compensation committees are advised to consider whether the performance management process–in terms of defining individual executive success and in terms of determining incentive payout–is accurately discerning between intended performance (e.g., increased aggregate earnings) and unintended results (increase in EPS attributable to a decrease in shares outstanding).

In reviewing individual and corporate performance measurement and payout arrangements, compensation committees are advised to look at both cause and effect with respect to buybacks. Does the performance measurement process create an incentive for the company to repurchase shares rather than invest in the business at an acceptable rate of return? Do incentive payout formulae distort performance in the event of a repurchase? If the intent of the incentive is to reward performance, is an adjustment for the impact of share repurchases warranted? These are all questions that are best raised during the plan design and goal-setting discussions rather than waiting until year-end to address.

Compensation committees should also be mindful of the bias that may be created toward inadvertently rewarding the return of capital through buybacks compared to the return of capital through dividends or the investment of capital in the business. Directors and critics generally agree incentives should not create any bias–the use of capital should be based on expected returns, strategic plans, and opportunities, not maximizing compensation. Unfortunately, many plans have the unintended impact of rewarding the buyback. Some programs, such as EPS-based annual cash plans, may do this directly. Other programs, such as CEO scorecards that are based on simple, as-reported financial results, may achieve the same unintended bias in a more indirect manner.

Companies with both large buyback programs and EPS-based incentive arrangements are at risk, as are their compensation committee members, of adverse scrutiny when proxy disclosures indicate that the impact of a buyback has a greater influence on CEO incentive payout than actual changes in performance. As a result, a growing number of companies now disclose in their CD&As their policy toward adjusting incentive payout calculations for the impact of share repurchases. As buybacks continue to increase in size and frequency, statements to shareholders clarifying this communication will become increasingly important. It may only be a matter of time before incentive payments resulting from buybacks result in derivative litigation.

We find there is nothing wrong with earnings-based measures or per-share-based measures, just as there are many good reasons to execute a share repurchase. However, we caution compensation committees to take into consideration and control any unintended bias resulting from this increasingly popular capital program.

To download a pdf copy of this article, click here.

For additional insight into share buybacks, click here to see S.L. Mintz, Institutional Investor, February 2015.

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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Simple Incentives to Improve CEO Succession Planning and Results

Posted by Jeff McCutcheon on February 03, 2015  /   Posted in Compensation Committees


Board members have an obligation to protect the company from gaps in executive talent by ensuring leadership continuity, particularly during times of CEO succession. While we find numerous commentaries addressing best practices surrounding the planning for succession, we believe incentives should be considered that focus on the succession result.

Most boards recognize that they must rely on the CEO for much of the insight into potential internal and external successors and risks. Unfortunately, the CEO is perhaps the only individual who typically has no financial interest in the actual success of the succession effort.

Through our work with boards of directors, we have identified three types of obstacles to a CEO effectively planning for his or her own succession:

  • Socially, it may be difficult to discuss succession with a CEO who perceives that a ready and able successor diminishes the CEO’s relative power with the board;
  • Culturally, there may be a history within the organization whereby the CEO has controlled the pace and timing of succession based on the CEO’s own plans for retirement; and,
  • Economically, there may be incentive programs and employment terms that clearly exclude the CEO from accountability for the succession result.

While we do not believe these obstacles prohibit effective succession management, we do recommend boards and committees responsible for succession consider the impact these factors may have on their efforts to mitigate business risk related to CEO succession.

Board Advisory LLC reviewed 50 recently filed CEO employment agreements to identify current practices with respect to CEO succession. We were looking to identify contractual employment terms that support successful succession of the CEO role. What we found was that CEOs typically have little, if any, financial stake in the ongoing success of the company during the 12-18 month period immediately following their termination of employment. In almost all situations, executives were allowed to fully liquidate their ownership in the company upon leaving. Moreover, CEOs often negotiated accelerated vesting of time-based, and sometimes even performance-based, equity incentives in the event of terminations without cause or for good reason (i.e., a “good leaver”).

In evaluating contemporary pay practices in light of CEO succession, we have identified several interesting arrangements that can align interests between the outgoing CEO and the ongoing organization through the most critical portion of the succession process. The concepts may be far easier to implement when recruiting a new CEO than when renegotiating with a current CEO, but we believe they are worth discussing in both situations.

  1. Establish at the beginning of the relationship that the CEO is the leader of the organization and thus is obligated to ensure continuity in leadership under all circumstances. Whether as a result of voluntary or involuntary termination, the CEO is expected to have plans in place to protect the organization—and will be held accountable to some extent for the success or failure of these plans.
  2. Recognize the CEO’s obligation to the organization extends beyond the last day worked. We find that over 90% of CEOs already have post-employment covenants such as non-compete/non-solicit arrangements, but only one CEO in 50 had a stock ownership obligation that extended beyond the last day worked. Requiring CEOs to retain their target ownership for 12-24 months beyond the termination of employment helps maintain a real interest in leadership continuity and success.
  3. Do not accelerate equity vesting upon “good leaver” terminations. Construct 409A-qualified arrangements whereby shares continue to vest over time and are retained by the former CEO through the succession period, adding to the former CEO’s financial alignment with continued organization success.

We propose that compensation committees consider requiring CEOs to have “skin in the game” for a brief post-employment period to shift the focus from the process of succession planning to the actual succession result. After all, a principal responsibility of the board is to manage the succession risk, not the succession plan.

Jeff McCutcheon and Rich McGinley.    This article originally appeared in Corporate Board Member magazine, Q4 2014.

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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

Incentive Plan Design for Compensation Committees

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

four pillarsBoard 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?

GoldenRatioWard: 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

Are You Paying for Performance or Just Paying for Results?

Posted by Jeff McCutcheon on February 08, 2014  /   Posted in Compensation Committees

Performance reportPaying for performance is assumed to be the objective of most executive and employee pay plans. A quick read of a handful of proxy statements will likely find the phrase “pay for performance” prominently used. The Dodd-Frank Act expressly instructs the SEC to require companies to describe their pay-for-performance program. However, we find many of these programs simply pay for results.

Let us explain. Paying for performance infers that the reward is somehow  linked to actual contribution, whether as individuals or as a team. It requires some level of cause and effect. In the context of a management long-term incentive arrangement (LTI), this might be achieved by linking the number of shares vesting to achievement of a key strategic objective, like successful diversification into a new business or developing a pipeline of new products to sustain a higher gross margin.

Paying for results is simply managing incentive payments to an outcome, whether the direct result of performance or not. For example, a company’s stock may rise for many reasons, including factors well outside the impact of management. This approach is typical of many total shareholder return (TSR)–based long-term incentive plans. The plans are defensible on the basis of their alignment with shareholder returns over the same period of time. However, let’s not lose the distinction here—paying for results is not the same as paying for performance.

Investors support long-term incentives primarily because they believe the incentive will both reduce the risk inherent in strategy execution and decrease the eventual investor cost to realize the strategy. The LTI should reward successful strategy execution and serve to complement and, at times, counterbalancethe short-term nature of the annual incentive. It’s about providing a financial incentive to create future value through execution of a strategy, which may require an extended period of time to achieve.

For these reasons we argue that performance—causality to results—is critical to maximize the valueof the incentive investment. If you simply pay for market-based returns using absolute or relative  TSR, the LTI may serve more as a lottery ticket than an incentive. By this we mean actual payout is viewed  more as chance than contribution. This hardly serves to motivate any change in behavior on the part of the executive or help guide the executive team in navigating tactics and priorities. While such programs are often lauded, they may in fact diminish or delay accountability for a poor strategy by rewarding (or punishing) for events reflected in stock price that are unrelated to changes in long-term franchise value.

The LTI should address two equally important objectives—deliver the strategy (paying for performance) and create value for investors (paying for results). The former is an often difficult, uncertain, and time-consuming effort. Yet, achieved thoughtfully, it produces a resilient and successful organization. The LTI should also reflect performance risk. A business-as-usual strategy (or lack of strategy) should provide no more than “caretaker” rewards, even if shareholder returns are exceptional. Similarly, an exceptional strategy that does not produce above-market returns for investors cannot be granted superior rewards. However, the exceptional strategy that is duly rewarded over time by the market should deliver superior rewards to the management team

As we saw in 2013, institutional investors are beginning to migrate from simple, standardized, and often poorly conceived metrics dictated by the proxy advisers (e.g., ISS and Glass Lewis) to a more nuanced dialogue with managers and board members regarding pay. As institutional investors trade the “pass/fail” approach for dialogue, it is critically important for managers and boards to speak clearly to their shareholders about how the LTI is integrated with both successful strategy execution and rewards to shareholders. By clearly articulating the detailed link between enterprise strategy and executive rewards, companies will benefit from not only more effective executive efforts, but also greater investor support.

Are You Paying for Performance or Just Paying for Results? from BoardMember Magazine, Q1, 2014

© 2014 Board Advisory.
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