compensation committees

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

Executive Compensation: See the Forest and the Trees

Posted by Jeff McCutcheon on January 20, 2014  /   Posted in Compensation Committees

forest and treesFor executive compensation, achievement of corporate strategy is the destination; pay levels, pay programs, and metrics provide the route. As inevitably as the Cubs missing the playoffs, the end of the year swiftly approaches and compensation committees must reflect on the year’s actions and re-check their route. With media scrutiny, regulatory oversight and the specter of derivative litigation ever-increasing, we all need to ask ourselves some pointed questions about our compensation strategy.

Consider the environment:
• Executive compensation represents one of the Board’s principle responsibilities in executing company strategy. Mistakes are costly. Pay-for-performance alone is insufficient for driving successful strategy. Investors expect more.

• Derivative litigation continues to plague companies. Even the most specious claims require extensive board time, distract management, and represent wasted profits in the form of direct and indirect legal expense. This growing litigation shark tank feeds on seemingly minor compliance errors, obliging committees to conduct their own independent audits. (If in doubt as to the potential scale of this problem, ask counsel to brief your committee on the Clorox1 case.)

• As executive pay regulation accumulates such as the expected 2016 CEO pay ratio disclosure, committees need to anticipate public and investor reactions to pay actions through the lens of current disclosure regimen. In 2013 we saw an increase in activism from historically quiet institutional investors. As many large institutional investors have brought their proxy analysis in-house the relative reach of ISS and Glass-Lewis have diminished, also diminishing the assumed “safe harbor” found with the proxy advisors’ formulaic approval process. Committees that overstep expectations may find themselves suddenly initiating investor outreach programs, directly explaining their actions to key institutional investors.

There are no clear-cut answers to every issue, and no one-size-fits-all approach that will automatically place a company beyond reproach. Instead, compensation committees must reflect on both the exigencies and opportunities facing their company, and act accordingly.
By following a methodical approach to committee compliance, compensation committees will equip themselves to make informed, careful, strategic decisions that will serve their companies well in 2014 and beyond.

We suggest an internal review along three major themes:

Pay Strategy.
(How the Compensation Committee uses pay and employment terms to advance the company’s strategy.)

• “The Compensation Story” – Is there a succinct narrative that can consistently and compellingly be used by each board member and affected management?

• Value Creation – Is it readily apparent to all that your executive pay plans promote shareholder value creation in a manner consistent with investor presentations and your investors’ expectations?

Pay Effectiveness.
(The degree to which the actual value delivered supports the strategy.)

• Simplicity – Are the various plans understood and embraced by executives? How do we know? (“I don’t understand all that stuff” = Low ROI.)

• Wise Risk – Does the overall program encourage appropriate risk? Discourage unwise risk?

• Impactful – Is it suitably motivational and does it promote retention?

• Defensible – When described in the media, are you proud or embarrassed?

(Safeguarding the company from nuisance litigation through disciplined compliance.)

• Achievement – Did the committee complete all responsibilities laid out in its charter?

• Compliance – Is the company in full regulatory and exchange compliance with plans and filings?

• Advice – Are external advisors competent? Do we have sufficient confidential contact with them?

1 Mancuso v. The Clorox Co., No. RG12-651653 (Cal. Super. Ct. Alameda Cnty.).

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© 2014 Board Advisory.
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