Executive
and Director Compensation Reference Guide
A Perspective on Executive
Compensation
A
Perspective on Executive Compensation
Yale D. Tauber
Independent
Compensation Committee Adviser, LLC
New Canaan, Connecticut
Introduction
The spotlight of public attention has been focused on the issue
of executive compensation for some time now. On the heels of recent corporate
and accounting scandals, observing and commenting on executive compensation has
become a national pastime. Criticism of senior executive paychecks and unkind
comparisons to lower-level executive pay scales have even surfaced in
legislative hearings and international relations.
Seemingly endless groups scrutinize the executive compensation
system. Proactive institutional investors and other shareholders, the media, the
government, employee organizations, customers, and even vendors are all asking
increasingly tough questions about how much senior executives are paid. Tax,
accounting, and regulatory requirements have proliferated and grown more
complex.
The recent corporate and accounting scandals have prompted a
flurry of congressional activities aimed at, among other things, reforming the
way corporations, executives, and boards of directors conduct themselves.
The Sarbanes-Oxley Act of 2002 contains numerous provisions
expanding the responsibilities and liabilities of executives and directors.
Among these are provisions requiring chief executive officers and chief
financial officers to disgorge certain bonuses, other incentive- or
equity-based compensation and profits on sales of employer stock received
before certain accounting restatements, and a ban on most loans made to
officers or directors by the company. Regulatory interpretation will be
necessary to clarify these provisions.
Additional proposed reforms percolating in Congress would affect
executive compensation and executive responsibilities in a variety of ways. For
example, news of failed companies where rank-and-file employees have lost their
retirement income, while executives have reaped millions, may cause Congress to
target perceived abuses in the constructive receipt, funding, and other tax
rules pertaining to nonqualified deferred compensation.
Meanwhile, the corporate and accounting scandals have shaken
executives and would-be directors, and the pool of candidates for board
positions is beginning to shrink just as proposed stock exchange listing
standards and other pressures drive companies to seek more independent
directors. The New York Stock Exchange, the American Stock Exchange, and the
Nasdaq Stock Market have each proposed new governance rules that, if adopted,
would profoundly alter board membership, responsibilities, and compensation.
(Ultimately, these proposals will have to be approved by the SEC.)
The proposals would, among other things, require companies to
nominate and elect a board with a majority of independent directors, appoint an
active compensation committee with specific responsibilities and composed
entirely of independent directors, to submit most, if not all, equity plans to
shareholders for approval, and to adhere to certain other corporate governance
standards. In addition, the SEC has already
implemented rules that require disclosure of all equity plans,
including nonshareholder approved plans, and their dilutive effect.
There is also a lot of talk about whether companies should deduct
the estimated fair value of their stock option grants from earnings on their
financial statements. Standard and Poor's will begin to report a new definition
of “core earnings” as an adjustment to “as reported” earnings that takes into
account the value of stock options. International Accounting Standards Board
(IASB) and European Union rules will result in approximately 7,000 European
companies having to expense stock options beginning as early as 2005.
The Financial Accounting Standards Board (FASB) announced plans
to review U.S. accounting standards for stock options to achieve greater
convergence between U.S. and IASB standards. If FASB decides to require a
“level playing field” with IASB, long-term incentive designs are likely to
change. Several companies have announced plans to climb aboard the option
expensing bandwagon without waiting for new FASB reforms.
At the same time, the labor market for critical talent, including
capable senior executives who can lead and manage today's global business
enterprises, is becoming ever more competitive. Of paramount concern to many
companies is how to provide competitive compensation opportunities for
executives and ensure that the level of compensation actually earned is
commensurate with the level of business performance achieved. Accordingly, new
ways to compensate executives continue to increase.
The compensation committee is expected to resolve all of these
issues. This is a difficult job. If pay is too low, executives will leave and
those who stay will be demotivated. If pay is too high, shareholders will
become discontent and public embarrassment may result. The compensation
committee must thus provide a program that will attract, motivate, and retain the
level of executives needed within the context of a sensible business strategy
and a responsible budget.
The committee members are independent directors with many other
responsibilities; board and committee service represents a part-time endeavor.
None of them can be expected to be compensation experts. However, members can
learn to ask the right questions to ensure that pay levels and programs are
appropriate.
This guide provides much of the background information that the
compensation committee and its advisers need when designing the total executive
compensation package to ensure that it is reasonable, defensible, and
appropriate, and to otherwise fulfill the committee's expanding vigilant
oversight role. In addition to strategic uses, all pertinent tax, accounting
and securities, and corporate law considerations are discussed thoroughly.
Special attention is given to the composition of the compensation committee and
the conduct of its affairs.
The guide will help the user assure that the executive compensation
package contains all the right elements—that is, employment, golden parachute
and severance agreements, annual and long-term incentives, and deferred
compensation and executive perquisites and benefits—and that those elements pay
the right amounts in the right circumstances. Both the compensation committee
and individual executives, as well as their advisers, will find helpful
guidance regarding the negotiation of terms and conditions of employment. In
the event of a dispute, the guide is also helpful in reflecting approaches to
litigation, arbitration, and settlement.
This introductory chapter
• provides a brief overview of the context in which executive
compensation strategy is determined and the process that should be followed in
designing executive compensation programs,
• describes the purposes and elements of executive
compensation, and
• sets forth some guiding principles for determining the
appropriate mix of these elements.
Executive
Compensation Process and Its Context
Conflict of interest is inherent in executive compensation
because the pay of the chief executive officer and his or her closest
colleagues is set by directors whose election to the board and perpetuation in
that office rest largely in the hands of the same CEO.
However, the issue is not simply about rational executive pay,
but encompasses the broader issues of competitive, vibrant, and accountable
corporate management. Today, an organization's executive compensation has
become a litmus test regarding corporate governance and accountability.
Commentators, corporate
activists, and regulators have long expected corporations to (1) attract appropriate executive talent, (2) retain well-performing executives, and (3) reward executives based on performance, effort and, more
important, the level of results achieved by the
company. The executive compensation program will not by itself ever achieve all
that is needed. But, a weak program will put an unnecessary obstacle in the
path of success for all concerned.
Most companies have responded well to these expectations, all of
which preceded the Sarbanes-Oxley Act and proposed stock exchange listing
standards. However, in the midst of constant and recurring corporate failures
and consequent investigations and litigation, executive compensation has become
increasingly controversial. Both management and the compensation committee must
remain sensitive at all times to three critical areas of concern:
(1) competitiveness (the traditional focus of attention in
executive compensation);
(2) the relationship between rewards earned and individual
and company performance (currently the most important area of attention), and
3. the “message” delivered by the program to shareholders,
employees, regulators, customers, vendors, and other interested parties in
light of company performance and economic and industry conditions.
To be reasonable, defensible, and appropriate, a total executive
compensation program must
(1) support the company's strategic and operating objectives;
(2) effectively attract, retain, and motivate the executive
talent needed to accomplish these objectives;
(3) appropriately reflect the needs and interests of key
stakeholders (i.e., shareholders, employees, customers, regulators, and
vendors); and
(4) reinforce organizational values with respect to the
importance of individual and team performance and risk and reward sharing and
with respect to the relative importance of various positions and job functions.
The design of a total executive compensation program is the
result of an ongoing review process with input from management, the
compensation committee, and the competitive, legal, and public environment
(shown in Fig. 1).
Figure
1. The Executive Compensation Process
Purposes
and Elements of Executive Compensation
The various plans that make up the total executive compensation
program are structured differently from company to company, reflecting
differences in strategies. Each company chooses a mix of compensation elements
that will most appropriately meet its objectives and reinforce its values
relative to (1) the importance of individual and team performance, and (2) risk
and reward sharing.
However, the purposes of each executive compensation element are
reasonably consistent across organizations and over time. As shown in Table 1,
these purposes may be described from the perspectives of both the company and
the executive.
Table 1.
Purposes of Executive Compensation: Multiple Perspectives
|
Type of Element
|
Company
Perspective
|
Executive
Perspective
|
|
Base Salary
|
Facilitates attraction and
retention of required executive talent
|
Supports basic lifestyle
|
|
|
Provides basic financial security,
enabling incentives to carry appropriate degree of risk
|
Provides basic level of financial
security, allowing incentives to carry appropriate degree of risk
|
|
|
Provides “yardstick” for measuring
magnitude of other pay elements
|
|
|
Short-Term
Incentives
|
Rewards attainment of business plan
|
Rewards performance relative to
others
|
|
|
Encourages incremental progress or
improvement
|
Rewards progressive improvement in
year-to-year results
|
|
|
Focuses organizational priorities
|
Provides regular measure of success
or progress
|
|
|
Reinforces performance-driven
culture
|
|
|
Long-Term
Incentives
|
Rewards growth in real value of
company
|
Balances rewards with risk
|
|
|
Rewards attainment of strategic
goals
|
Provides capital accumulation
opportunity
|
|
|
Encourages appropriate degree of
risk-taking
|
|
|
|
Enhances executive retention
|
|
|
Benefits and
Perquisites
|
Provides tax-effective compensation
|
Protects against financial
catastrophe
|
|
|
Enhances executive retention
|
Provides appropriate secure
retirement income
|
|
|
Conserves executive time
|
Recognizes status
|
Appropriate Compensation Mix
Perhaps the single most important perspective that cuts across
most or all executive compensation elements is the concept of “risk.” Risk is a
function of the likelihood that specified results will not be achieved and that, as a consequence, anticipated rewards will not
be earned (the “and” is critical; a large incentive that is easily earned is
eventually perceived like salary—an expected and secure compensation element).
In some situations, more risk is appropriate (see Table 2).
Table 2. Risk
and Executive Compensation
|
More Risk
|
Less Risk
|
|
Start-up or threshold company
|
Mature, stable company
|
|
Turnaround situation
|
Extra-long investment horizon
|
|
Extremely competitive environment
|
Maintenance environment
|
The appropriate degree of risk should
be structured with realistic time frames. For example, a long-term (three- or
four-year) turnaround might be addressed by providing the following:
(1) a major reward conditioned on
completion of the turnaround, with the form of the reward tied to the
definition of turnaround success (e.g., stock options or stock where stock
price growth is the key focus);
(2) smaller rewards (e.g., annual
bonuses) for making progress against appropriate interim goals, with results
short of goal, even if better than the previous year, generating little or no
reward; and
(3) salaries and benefits set at
reasonably competitive levels, so that paying incentives is not required, that
is, executives are not financially dependent on incentives.
The mix of compensation elements should
also differ by an employee's organizational level based on several factors,
including (1) importance of various job functions in impacting short- and
long-term results, (2) ability to tolerate variations in pay, (3)
organizational constraints, and (4) competitive practice.
Nonmanagement employees usually have a
relatively small individual impact on short- and long-term corporate results
and a low tolerance for pay swings. Accordingly, companies usually place a
heavy emphasis on fixed pay, or salary, for these employees. However, if
individual or team performance is quantifiable, gainsharing or other forms of
variable compensation may be appropriate. A good example is sales incentives
for customer representatives.
First level managers can have a
moderate individual impact on a company's short-term results, but salary is
typically still the primary compensation element. However, with a higher base
salary than nonmanagement employees, these managers have a greater tolerance
for having a portion of their pay at risk and are therefore usually good
candidates for some level of short-term incentive compensation. If long-term
incentives are introduced at this level, it is usually strictly a result of
competitive practice.
Midlevel managers have a significant
individual impact on a company's short-term results and a moderate individual
influence on long-term corporate performance. Therefore, these employees are
typically eligible for higher salaries and have a correspondingly higher
tolerance for risk. Their compensation mix usually places greater emphasis on
incentive compensation, through a higher level of short-term incentives and
introduction of some level of long-term incentives.
Senior executives have the greatest
individual impact on short- and long-term results. Because their fixed pay is
the largest of all the employee levels, their tolerance for variable
compensation is greatest. This means that they participate in both short-term
and long-term incentive plans at the maximum level.
Figure 2 illustrates typical
compensation mixes by organizational level. As salaries increase through the
various levels, so does the impact that employees have on corporate results and
their tolerance for pay swings. Accordingly, variable (short- and long-term
incentive) compensation increases at a faster rate than fixed pay (salary).
Figure
2. Sample Appropriate Compensation Mix by Organizational Level
As Figure 2 indicates, variable
compensation often comprises 50 percent or more of the total compensation
package of senior executives. In fact, for the typical CEO, the portion of the
pay package that consists of salary has been steadily declining to just
approximately 20 percent last year. Long-term incentives—chiefly option grants
and restricted stock awards—now account for about 60 percent of the package.
This heavy emphasis on long-term incentives has been a key factor in the
increase in overall executive pay levels.
Conclusion
During uncertain economic conditions, additional costs to
shareholders must be considered so that increasingly large executive
compensation packages do not diminish shareholders' returns. A balanced approach
asks the following questions:
(1) Is the company paying enough to attract and retain the
critical executive talent it needs to be successful? That is, is the company
successful in recruiting, or are executives leaving for better opportunities?
Alternatively, has the company overshot the mark by paying more than it needs
for attraction and retention purposes?
(2) Does the pay package for key executives contain the right
elements and do these elements pay the right amounts in the right
circumstances?
(3) Do executives get paid more when they build shareholder
value and less when they do not?
(4) Does the pay package stimulate critical executives to
work as hard and as smart as they can?
(5) Do executives understand what they get paid for and what
things they need to do to earn greater rewards?
(6) Are the things that lead to greater rewards for
executives consistent with the company's business strategy?
(7) Do executives have the necessary control over the ability
to achieve the things that lead to greater rewards?
Assuring that the answers to these questions are all appropriate
will help prevent feelings of entitlement to wealth accumulation, ensure that
gains are shared equitably between management and shareholders, and enable
compensation to be earned on the basis of individual and enterprise
performance.
Reproduced with permission from Benefits Practice Center, "A Perspective on
Executive Compensation", http://benefits.bna.com/. Copyright 2003 by The Bureau of National Affairs, Inc.
(800-372-1033)
