Beyond Options: Compensation Committees Look to Link Pay and Performance

Published: July 18, 2007 in Knowledge@Emory

The Goizueta Directors Institute (GDI) is a group of directors and officers of publicly traded companies who meet annually at Emory University’s Goizueta Business School to examine issues of corporate governance. This year’s event, titled “Creating a New Culture: Balancing Director Oversight and Management Entrepreneurship,” focused on the effects of Sarbanes-Oxley and how corporations should address issues in the new climate of heightened governance.  Panelists discussed the issue of executive compensation in a session titled “Designing Executive Compensation Programs: Appropriate Considerations in Setting Executive Pay.”

 

Executive compensation is perhaps the most visible issue facing companies. Richard Rawson, panel moderator and senior vice president, general counsel, and corporate secretary for Lucent Technologies began, “We’ve all seen the corporate scandals. The golden parachutes in the middle of layoffs and restructuring have combined to create [a] very charged atmosphere.”

 

According to the panelists, much of the ado could be traced to an over reliance on stock options. Until the mid 1990s, pension plans were the reward du jour for executives, but the first wave of corporate governance reforms erased that opportunity. Instead, compensation committees began to load executives up with stock options, which looked great because options provided a powerful incentive for success and didn’t even touch the bottom line. Everyone was happy—until the darker side emerged.

 

Patrick McGurn, senior vice president and special counsel for Institutional Shareholder Services, explains: “Many of those scandals began as business issues. Companies sat down and made a concerted effort to hit those consensus numbers quarter after quarter,” he says. “As long as the market was going gangbusters and the economy was going strong, that worked. But the executives were unable to keep up with the treadmill. People started managing earnings expectations. Slowly that slipped into managing earnings, and then into a felony.”

 

McGurn’s firm, Institutional Shareholder Services, is one the world's leading provider of proxy voting and corporate governance services. He and his colleagues analyze proxies and issue informed research and objective vote recommendations for more than 10,000 U.S. and 12,000 non-U.S. shareholder meetings each year. “Incentives work,” he adds. “So when you put a pay package together, you’ve got to watch out—what exactly are you incentivizing people to do?”

 

What compensation committees really want to do make executives feel personally invested in a company. Quoting one of his firm’s studies, John England, Eastern U.S. Head of Towers Perrin’s Compensation Group, points out that “Options don’t tend to lead to increased ownership.” He explained that with the economy steamrolling forward, nobody stopped to think about the other possibilities. Executives met their goals, stocks inflated beyond their worth, and those options were quickly liquidated into cash. Since Sarbanes-Oxley, options have fallen from favor, especially with regulators moving toward a requirement that they be expensed, directly affecting the bottom line and corporate earnings.

 

Panelists at the GDI recommend that options, despite the abuse of a few, remain part of a well thought out remuneration plan. “Companies became stock option junkies because the accounting treatment of stock options provided literal invisibility for purposes of financial statement,” says McGurn. “It’s not surprising that companies put all their eggs in that one basket. Going forward, I think the key to individual CEO pay packages and top executive pay packages is a balance, a number of different types of awards and pay vehicles that provide the right mix of incentives. In some cases, they’ll counter balance each other.”  England concurred, noting  “What we are advising is a slice of options, a slice of restricted stock, usually with very long retention and very long vesting, and then a performance plan.” 

 

There are no hard and fast rules for corporations to adopt, says McGurn. “We’re looking at experimentation right now, and giving companies credit for things that may not be perfect, but they show at least some sign of intelligent design being involved in the process.”

 

Another issue affecting compensation has been image. Every corporation wants to project itself as an industry leader. “Everybody likes to benchmark, everybody likes to do compensation surveys, and when you read proxies, it seems like everybody wants to pay their executives at that 75th percentile,” says Rawson. Of course, by placing everyone’s salary at 75 percent of the market, the numbers shifted upward. “Most companies, at least our surveys say, are trying to attempt to be at the median,” says England.

 

There is a movement that questions the over-reliance on survey data to set industry benchmarks. “I’ve heard from numerous compensation committees that are getting different cuts on the data,” says McGurn. “Using that data as a tool rather than as a yardstick, saying ‘Okay, let’s compare to this peer group and then let’s slice it and dice it and take it out over one, three, and five years and longer term payouts to really find out how you’re stacking up against the peer groups on the basis of pay.’”

 

“It was rare that we saw compensation committees reports and other documents indicating that the committee had sat down and said, ‘What are the key drivers of shareholder value at this firm? Let’s key off our performance measures to those value creators,’” he continues. “Instead, people said, ‘Well, options are vogue in this industry, all the surveys say so, and so we’re going to pay a competitive level of equity pay with options at this level.’ It really made the design of the pay package dependent upon what was the norm in the industry as opposed to what actually drove value creation at that particular firm.”

 

McGurn and other GDI members dispute the adage that you have to design outrageously high salary packages to retain talented executives. “…the vast majority of executives, even at senior levels, are really company lifers,” says Rawson. “You don’t have to worry so much about retention of that talent as you have to worry about helping them feel fairly treated.”

 

“I’ve always said the best pay policy is a good executive succession planning process,” McGurn says. “You’re always going to pay more when you have to go outside the company for talent, period. The corporations and board members need to figure out who can play the key roles for driving value within the corporate structure, and focus on retaining those talents. This may mean substantial retention pay, or it can mean a much longer vesting period on a stock award or other things that encourage people to stick around. But you’ve got to give people an idea.” If younger executives can see their future, they are much less likely to bolt and leave the company to woo replacements.

 

“You’ve got a strong labor market out there with real competition for talent, and it’s going to drive up your cost exponentially…It’s a different situation for sitting CEOs. They just don’t move around laterally. I think in the last five years we’ve seen two situations where the CEO of one Fortune 1000 company left to become CEO of another Fortune 1000 company, in absence of some terminal event such as a merger, acquisition, or something along those lines,” notes McGurn.

 

There has been a lot of attention placed on the spread between the average worker’s pay and CEO’s pay. “Towers Perrin used to do a survey called the Worldwide Total Remuneration Survey,” says England. “Every year up to 2000, we presented this chart showing the spread between the average worker’s pay and the CEO’s pay. And in that year we pronounced that in the U.S., the average spread was 548 times. The uproar was significant, so we decided to drop that chart.  A lot of that, of course, came from the very subject we [just] talked about, stock options. ” 

 

There is now a leveling of pay, the panelists indicated, mostly due to curtailing the use of options. Huge salary differentials can be a signal of other problems, says McGurn. “If you find a large multiple between the CEO’s pay and maybe the two, three, four, or five top officers, it’s sometimes a leading indicator that you might have an imperial CEO on your hands. It may also indicate a major disconnect power-wise between the board of directors of that particular CEO, typically CEO-chairman.”

 

GDI members are also hesitant to support the concept of employment contracts for executives. “Take any problem that we’ve seen in pay over the last decade where the CEO gets excessive severance pay, for example, and it was always spelled out in a contract,” says McGurn. “So if you’re going to negotiate contracts with senior executives, make sure that you have someone sitting across the table who is ready, willing, and able to negotiate at a real arm’s length.” That someone should not report to the executive at question. That may sound silly, but it happens all the time. It’s becoming more and more common for compensation committees to hire outside consultants for the job, as opposed to relying on the general counsel or vice president of human resources.

 

Two years after Sarbanes-Oxley, the public is still hearing about outrageous corporate salaries on a regular basis. This is primarily due to the playing out of past contracts. Things are getting better, assures McGurn. “It’s not necessarily reflected in the numbers that we saw in this year’s proxies because it reflects past pay practices, but we’re seeing much more time and attention being put to these issues by compensation committees. They realize that they are in the spotlight. They also realize that if they don’t take care of this problem, we will get Sarbanes-Oxley II. The number one section in that bill will be reforms for compensation committees and corporations, and we will get regulation in the place of responsible action.”

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