Talking Points: Back to Basic Pay-for-Performance (10/12/06)

George Paulin is Chairman & CEO of Frederic W. Cook & Co., Inc.

Problem With Executive Compensation

At many US public companies, pay for performance is little more than words in a pay philosophy statement.  The focus of executive compensation program design has become pay delivery and employment retention, not rewarding results.

Evidence of the Problem

Executives generally have an entitlement attitude toward earning incentive compensation that is supposed to be at risk, and this is too difficult for most board compensation committees to confront.  The problem is evident in several ways. 

One example is goal setting for annual cash bonuses, which typically pay at or above competitive “target” amounts unless something goes seriously wrong.  Another example is the structure of long-term incentives. During the 1990s when the stock market was rising, awards were predominately in the form of options.  Now, in a less certain stock market, the single most dramatic trend in executive compensation is replacing options with risk-free, time-based restricted stock. 

A further example is the substantial “fringe” compensation that has no intended relationship to performance, often is ignored in determining total compensation value, and until next year has gone largely undisclosed.  Here, I am referring to perks like personal use of corporate aircraft at shareholders’ expense, defined-benefit supplemental executive retirement plans (“SERPs”), above-market interest on deferrals, and severance benefits that potentially reward failure.

Proposed Solutions

There is no easy solution, but six basic and simple steps would go a long way:

  1. Design incentives with real performance risk and leverage, and look for this relationship in the new proxy disclosures. Annual cash bonuses should relate to annual operating results.  Changes in unvested, unexercised, and deferred equity values should relate to total shareholder return.  Goals for earning annual bonuses should reflect absolute results and peer comparisons, rather than just internal budgets that are notoriously sandbagged.  Heavy reliance on time-based restricted stock at the executive level should be avoided.  If a company has a low-risk structure designed to deliver compensation regardless of performance, then it should pay low relative to peers and vice versa.
     
  2. Hold CEOs accountable.  I have yet to see a company with excessive CEO compensation where the CEO did not want it, ask for it, and refuse to give it back.  Institutional investors are misguided in withholding votes only from directors on the compensation committees in these instances.  They should withhold votes from the CEOs too.
     
  3. Demand that board compensation committees have INFORMED independence.  All important committee decisions involving judgment should pass a two-pronged test.  First, the judgment should be reasonable relative to market practice, which admittedly varies so widely that there is little guidance and the second test becomes critical.  The second test is that the judgment should be appropriate in terms of a business rationale.  For example, if a company wants to be the highest payer in its peer group, then it should have the highest performance as evidence that high pay is being used to attract and retain the best talent.  (As an aside, the most important work that I do as an advisor to compensation committees is making sure that their judgment is tested in these two ways.)
     
  4. Grow your own.  The single biggest factors contributing to executive compensation inflation are outside recruiting, and negotiating with someone who you cannot afford to lose because there is no replacement.  Succession planning is a critical part of executive compensation and should be a higher priority on board compensation committee agendas.
     
  5. Total-up all of the pieces.  A defined-benefit SERP is another form of long-term capital accumulation, no different than restricted stock except in cash.  If you have such a plan, then the value should be offset from ongoing long-term grant values.  The same is true for above-market interest on deferrals.  It has compensation value and cost, which should be taken into account in setting other pay elements.  Under the new proxy disclosure rules, we should have the total pay numbers that we need to support this direction.
     
  6. Take CEO compensation out of management’s hands. Compensation committees should make decisions on pay increases, bonuses, and equity grants for the CEO based on analyses and recommendations by their own advisors, recognizing that internal staff are potentially conflicted.