Best Practices from Institutional Investor Perspective

Paul Hodgson is Senior Research Associate of The Corporate Library

The first issue is that pay growth has not been reined in since any of the corporate scandals at the beginning of this millennium. It has shown consistent increases from 2000 onwards. Indeed the pace of increase is picking up. According to my findings, it went from a median increase of 10 percent in 2002 to 15 percent in 2003. The average rate of increase in total compensation for that period went from just over 55 percent to an increase of almost 90 percent.

Base salaries rose, annual bonuses rose in value, the profit from stock option exercises increased, the value of restricted stock awards increased and the value of performance share awards also went up.

One element of pay, and one element only, has shown a decrease – the value and number of stock option grants. My valuation of option grants showed that, for CEOs who received a grant in both 2002 and 2003, the size of those grants fell by just over 8 percent. The number of CEOs receiving grants fell only slightly, but it still fell. The main, probably the only influence on this was the threat of option expensing. If we have to recognize this expense, we better make sure it’s not too big an expense. As we have seen/will see, though, this is the element of pay that has seen the highest increase in the last few decades, so there is a long way to go before we return to moderate levels.

But the value of all these elements of compensation was not the only thing that went up. The number of bonuses awarded went up. The number of options exercised went up. The number of restricted stock awards went up. The number of performance share awards vesting went up.

With all this, it is hardly surprising that total compensation levels went up. And if compensation levels can’t go down in this atmosphere, it would seem impossible for them ever to go down. But this cannot remain the case.

It’s not all bad news, however. Actually, what I want to stress in this panel is that there is progress being made. There are three areas I want to talk about where this is happening:

1. Long-term incentive practice
2. Benefit policies
3. Severance policies

Long-term incentive best practice

As I said earlier, long-term incentive practice is on the move. The value of stock option grants and the number of stock option grants being made both went down. In contrast, the number and value of restricted stock grants went up.

As far as I know, neither the investment community nor the corporate governance community think that granting restricted stock instead of stock options is not an improvement. It is a sideways step at best. OK, full value awards, like restricted stock, use less shares, but restricted stock is even less related to performance than market-priced stock options.

Fortunately this is not the only development. There is another change afoot in long-term incentive plans – the increase in the number of plans that tie the vesting of all stock awards to performance.

You have probably all heard about IBM’s decision to award most of its stock options at a 10 percent premium price – not the most challenging performance condition ever put on a grant, but at least it’s a start. But other companies have gone further.

The potential for performance-related stock options is part of plans that have been introduced in the last 12 months by Symbol Technologies, JDS Uniphase and National Semiconductor, among others.

But even this is not the only element of best practice being introduced in new long-term incentive plans, there are others:

• most new plans disallow repricing or exchange of options without stockholder approval;
• many new plans expand the range of possible awards from the single stock option, to a whole range of performance-related awards;
• many new plans suspend the automatic vesting of all stock awards on a change of control, instead making sure that awards are converted to awards in the new entity’s stock;
• stockholding requirements and stock retention requirements with real teeth are also being introduced. Stock retention requirements are those that require executives to hold on to vested stock for specified periods of time, often into retirement.

If a few companies can make these changes, then many can.

Benefits best practice

There are two issues here – disclosure and policy.

There are also two movements for change here.

1. There are companies improving disclosure levels in advance of SEC disclosure changes that are being talked about elsewhere at this conference.
2. There are companies changing or affirming policy so that executives are not receiving “executive” benefits, but only those that are offered to all employees.

Let’s start with disclosure. Companies improving disclosure include Honeywell which, in its latest proxy statement, itemized ALL the benefits received by named officers, regardless of value. These included:

Legal fees

Personal use of company aircraft

Personal financial planning

Cash flexible perquisite payments

Temporary housing

Excess liability insurance

Personal use of company car

Executive auto insurance

Security

Tax reimbursement payments

Make whole payments

Above market interest

Matching contributions to deferred income plans

Executive life insurance

Above plan relocation payments

Amounts accrued in connection with resignation, retirement or termination

It’s quite a list, and probably not an uncommon one. . .if only we knew. The fact remains that while stockholders may be unhappy about paying executives’ income tax bills, their legal fees and their financial planning fees, at least here they know that they ARE paying for them.

Other companies are either eliminating executive perks or are affirming their policy not to pay for such benefits. These include Bank One, which eliminated over a number of years:

• subsidies for club memberships, automobiles and similar perquisites; 
• split-dollar insurance programs; 
• corporate matching 401(k) contributions for senior management and highly compensated employees; 
• they reduced covered 401(k) earnings to the maximum qualified plan limit; and
• and they eliminated special executive severance policies.

Other CEOs have terminated their contracts – Ken Lewis of Bank of America, and JJ Mulva of ConocoPhillips most recently. This removes their guaranteed eligibility for severance benefits.

Bank of America has also terminated special retirement benefits for executives.

Other companies have never offered such executive benefits and state this clearly in their proxy statements. Companies like this include Kinder Morgan, Cisco Systems and Autodesk.

Cisco’s most recent proxy says:

We also refrain from offering exclusive perquisites to any employee or group of employees, including senior executives. We do not offer country club memberships, private use of corporate assets (such as aircraft, apartments or luxury boxes), supplemental retirement funds, tax-sheltered accounts or any similar perquisites to any segment of our employee base. Senior executives at Cisco have the same components (base salary, annual cash bonuses and stock options) of total compensation as do all Cisco employees.

It’s something to be able to say that.

Severance best practice

Severance benefits are supposed to protect executives from financial harm after a termination through no fault of their own, much like unemployment insurance for other workers. But the level of insurance has gone beyond protection to become a significant form of compensation in itself.

Even here there are signs of change. As I’ve said already two high profile CEOs have terminated their employment agreements. But even more significantly, findings from surveys I have conducted indicate that the level of benefits provided on a no fault termination have gone down in aggregate.

The proportion of companies providing three years of salary, bonus and benefits continuation as severance went down by over 12 percentage points between 2001 and 2003. Most of these companies have reduced benefits to a two times multiple. Similarly, many companies have moved from providing two times salary, bonus and benefits to offering one year’s severance benefits.

More importantly, nearly two-fifths of CEOs in the S&P 500 have no formal severance arrangements at all. While this does not necessarily mean they will not receive any severance benefits – a separation agreement may be drawn up on termination that is every bit as generous as a formal employment agreement – most will not.

The ultimate messages from these findings are that:

1. it is no longer standard, expected  practice to offer three years salary, bonus and benefits on termination;
2. compensation committees do not automatically have to enter into employment agreements with CEOs;
3. compensation committees can negotiate with existing CEOs to terminate employment agreements that may offer excessive benefits – JJ Mulva’s certainly provided for excessive benefits.

This is all good news. And it means that you CAN turn that "Holy Cow Moment" into an "Oh, that’s not so bad" moment.