Managing Director, Paul McConnell, quoted by Wall Street Journal’s Market Watch on Ford CEO Alan Mulally’s stock award of $56.5 million.
http://www.marketwatch.com/story/mulally-reaps-big-rewards-for-fords-revival-2011-03-08
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.
— Paul McConnell and Jeff McCutcheon are Managing Directors of Board Advisory, LLC
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.
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.
[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:
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.
Executive transitions into new roles and succession planning continue to be one of the greatest challenges organizations face. Regardless of the reason for the transition or the source of the executive, executive transitions fail at an alarming rate, and always at a high cost to organizations. To fully discharge their duty to attract, motivate and retain management, Boards of Directors need to pay more attention to how critical changes in leadership are effected.
The dollar impact of failed transitions is relatively easy to calculate. The primary areas for such dollar impact estimates includes the cost to hire (e.g., search/placement fees, relocation, etc.), total compensation for said executive for the duration of employment, “maintenance” expenses such as administrative support and overhead, severance costs, and impact of mistakes and/or missed opportunities. The total of these costs typically total 10 to 15 times salary for a senior executive and can easily cost a company several million dollars. String together a few of these, and even a sizable organization can be crippled.
Recent executive transition research I led through Alexcel Group and the Institute for Executive Development, using an online survey of more than 150 practitioners in more than 140 different companies, showed that for external hires, 30% don’t meet expectations in the first two (2) years. While slightly better, 21% of internal placements don’t meet expectations in the first two (2) years. These “failure rates” may seem unacceptably high, yet other research in recent years shows failure rates of executive transitions can be upwards of 60% or even more.
When asked to characterize the level of support their organization provides to transitioning executives, 19% of respondents said they provided high support for external hires while 81% said they provided no to moderate support. For internal moves, 15% said high support was provided and 85% said no to moderate support was provided. One surprising result came for the question: What level of involvement does your Board play with executives who are changing roles? Only 1% of respondents said it was high, and 36% said none whatsoever. This contrasts with institutional investors’ interest in executive succession, where a poll of public pension funds indicated they held boards responsible for planning and executing executive succession.
When asked about the reasons for failed transitions, the most frequent response (68%) was due to lack of interpersonal skills, and the second most frequent response (46%) was lack of personal skills. The least-frequently chosen reason for failure at 15% was insufficient technical skills. So while candidates seem to have the functional proficiencies, they most often fail due to the softer leadership competencies. These findings suggest that there are significant gaps in hiring processes, where attention is paid to technical skills at the expense of softer skills that can just as easily derail an executive that otherwise “looks good on paper.”
So what are practitioners doing to assist with executives in transition, and how well is it working? For both external and internal hires, the most common practice (49%) is Mentoring and “Buddy Systems”, but the effectiveness of that practice was judged best for external hires where that was rated the most effective process. For internal moves, Executive Coaching was seen as most effective. While frequently used, the least effective process for both types of candidates was Orientations.
In our opinion, the key take-aways from this and other research include the following:
So what is a company to do?
Executive transitions fail frequently at high corporate cost, andthey simply don’t need to. We’re convinced that if Boards adhere to the above three recommendations, their companies will immediately realize a distinct competitive advantage.
– Kevin R. Hummel, Ph.D.
Kevin Hummel works with a number of Board Advisory clients, across a variety of industries, on executive coaching and leadership development issues. You can view Dr. Hummel’s bio here. If you have any question or comments on this article, or want to speak with Kevin about any executive coaching, performance, or succession issue, he can be reached at khummel@board-advisory.com, or at (954) 783-2585.
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.
For the past three decades CEOs, Boards of Directors and compensation committees have allocated stock options and numerous other equity-based incentive rewards to executives based primarily on the annual competitive practice of peer companies. In an effort to ensure equity rewards were appropriately appreciated by the executives, companies went to great efforts to communicate the value of their annual equity award in present value terms, as part of a total annual pay package. By treating equity as annual compensation, however, companies have created three significant disconnects between investor and executive interests.
First, when boards adopt a policy of providing executives with competitive, annual equity grants based solely upon the present value of the equity, they create the perverse phenomenon where stock price decreases (investor losses) result in granting more shares to management to maintain “competitive pay.” When the stock price appreciates, the opposite result is found, as fewer shares are necessary to create the same “competitive” annual award value. This contributed to the prevalent perception of a reward for failure, particularly evident in 2009. Due to depressed equity values, boards were faced with the prospect of granting 60%-70% more shares just to maintain comparable equity “values” to 2008 [1].
Second, most compensation policies strive to provide competitive equity awards in terms of annual equity grants, but not in terms of aggregate equity ownership. Thus, a new CEO and a very senior CEO, all other things being equal, would be provided comparable equity awards. As a result, we find ourselves in the somewhat irrational position of delaying 5-7 years before a significant level of cumulative incentive is delivered to the executive. Keep in mind the median tenure of a CEO today is 5.5 years.
Lastly, executive stock holding guidelines typically allow the executive to sell vested shares to the extent the executives’ holdings exceed a nominal ownership requirement. This reduces the executive’s wealth ratio (the ratio between a change in company value and the change in the executive’s total wealth), diminishing the overall strength of the incentive and diminishing the alignment with investors. Perhaps more importantly, the ability to sell shares allows the executive to effectively time the markets, potentially capitalizing on excessive risk taking and minimizing losses. In addition, by allowing executives to divest shares prior to retirement, companies reduce or eliminate the shared interest in the orderly succession of management within the company.
One solution for resolving these disconnects can be found by changing our fundamental view of long-term incentives. As an alternative to treating equity as part of a competitive annual reward package, companies can treat equity as a distinct, non-compensation investment incentive. In this sense, annual compensation (salary and annual cash bonuses) is liquid and driven by individual skills and responsibilities and annual results achieved. It is generally managed within the range of easily-established competitive practice at peer firms. In contrast, executive equity is a career-based investment made on behalf of investors for the benefit of the executive, to align executives’ wealth creation goals with the long-term interest of the investor and payable only when investors realize their investment objectives.
To distinguish equity from annual compensation companies can:
This alternative approach to executive pay can correct for the misalignment of actual equity grant practices with investor outcomes – eliminating what is perceived by some as a reward for failure. While this approach may be too aggressive for many organizations, it rightfully places the focus of boards and compensation committees’ attention on determining the appropriate level or strength of incentive necessary to achieve objectives rather than focusing on simply emulating peer behavior. Lastly, by separating equity from the annual “competitive” compensation program, boards can take an important step in changing the public perception that executive pay is a “heads we win, tails you lose” proposition.
– Jeff McCutcheon
Jeff McCutcheon works with a number of public and private Board Advisory clients on executive compensation, succession and performance issues. You can view Mr. McCutcheon’s bio here. If you have any question or comments on this article, or want to speak with Jeff about any executive rewards, performance, or succession issue, he can be reached at jmccutcheon@board-advisory.com, or at (904) 306-0907.
[1] Based upon a 40% reduction in equity values of 40% across the S&P 500, companies had to grant 67% more shares to maintain the same grant value as the prior year.
[2] See Board Advisory, LLC website for “Current Issues for Compensation Committees” for an analysis of proposed tax policy changes in support of “hold-till-retirement” equity programs.
The infusion of hundreds of billions of dollars of taxpayer funds into the domestic financial system has created a fundamental change in the ownership structure of most banks. By establishing the U.S. government as the largest single shareholder in many of the TARP-participating banks, there is a divergence in shareholder objectives. The government as an investor has provided cheap, patient capital in the form of preferred stock that only requires a 5% annual dividend and no price appreciation. The Government has invested in these banks with the intention that these investments would stabilize the financial industry and get credit flowing again to the broader economy. It wants financial recovery, job creation and economic growth. However, historic financial industry practices and the incentive compensation arrangements offered to executives at these institutions may be working directly against the government’s public objectives.
The traditional investor objectives of maximizing economic value through growth in earnings and increased rate of return on capital employed, and the incentives that reward these results, are the heart of the conflict. When faced with difficult economic times such as we are currently seeing, the natural reaction (as motivated by these incentive plans) is to avoid the loss of capital, cut off lenders that don’t meet high credit standards and generally batten down the hatches. It is no surprise that bankers are acting consistent with their objectives and their financial interests.
Alternative Approach
If the “bailout” is to succeed, we need to find some way to reconcile these divergent interests. It wouldn’t make sense to change the incentives for the bank as a whole; The Government’s investment is big, but it is only 10-20% of the total equity in these banks. The other shareholder’s interests must be respected as well. But to clarify objectives and maintain accountability for results within the institutions, one possibility is to build a new organization within the banks that is focused on the needs of this new, unique shareholder. This “Rescue Bank” can be a separate legal corporation or an autonomous division, but it needs special staffing, leadership, and incentives that are attuned to the unique goals of its shareholder. It is likely that the strongest economic impact will come from the small to medium sized businesses that have historically been the engine of job creation. A large number of these are suffering from overextension, a shortage of capital and customers that cannot buy their products due to lack of financing. These accounts could be transferred to the Rescue Bank, along with appropriate loss reserves that will create a level playing field. Then the Rescue Bank could help these companies by utilizing flexible credit standards, refinancing, pools of investment capital and inexpensive financing facilities for their customers.
The Rescue Bank would need to be staffed by seasoned commercial bankers that have been through economic downturns and who are experienced in lending to troubled companies and by investment bankers that can help restructure balance sheets and provide creative secured lending. The management group would comprise leaders that see beyond the bank’s balance sheet to its obligation of providing access to capital and general financial liquidity to the public.
Aligned Incentives: Executive & Employee Pay Plans
We know from experience that employee and management incentives do motivate the behavior that is asked for. But if executive and employee pay plans are built around net income and financial returns, we will not get the kind of actions that this situation or this shareholder requires. Instead, a very significant portion of the employees’ annual compensation should be tied to such metrics as: client revenue growth; job creation or saves; GDP growth within the market area; business startups; and public approval.
We don’t want these bankers to totally ignore the concept of profits, after all the Government money does need to be repaid. Long-term incentives could be designed to balance the annual goals by investing a slice of the parent’s capital along with the government’s money (e.g., $1 for every $5 of TARP dollars). This “common stock” would be credited with any Recovery Bank financial returns in excess of the 5% required on the preferred stock. Grants of book value phantom shares (with conversion rights to the parent common stock) that vest when the TARP money is repaid would provide a powerful leverage to get this troubled economy up and running again. If the Rescue Bank’s annual return on total equity only reaches 7%, these awards would grow by 17% that year – plus any kick from the recovery the parent’s stock price.
Incentives do work. If we create the right ones for this situation, we as a country can more quickly work our way out of this difficult financial situation.
– Paul McConnell