The economic storm of 2008-09 has been tumultuous for everyone, and the compensation committees of publicly traded companies are not immune. Precipitous drops in the equity markets, the failures of some of the most storied financial institutions in history and unprecedented controls on executive compensation make for rough sailing. Now, the economic stimulus package places reins on executive compensation, and that puts enormous pressure on compensation committees.
In fact, compensation committees have already had nearly 10 years of turbulence in which to learn how to adjust to constantly changing conditions. Consequently, the most effective committees are well-prepared for what lies ahead.
Background
In 1999, a series of crises — including accounting scandals, high-profile bankruptcies, and a stock market shaken by insider trading and analyst collusion — started to alter dramatically how compensation committees functioned. When the stock market declined in 2001, it exposed a number of scandals (including Enron, WorldCom and Tyco) and generated bankruptcies that led to a crisis of investor confidence. Next came a stock options backdating scandal.
With the spotlight on corporate governance in the early 2000s, shareholders began to sue and many management practices were called into question. The result was increased regulation, more self-monitoring and greater third-party scrutiny of public companies (see Figure 1).
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Figure 1.
Responses 2002 to Present: Action on Three Fronts |
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Government/Regulatory |
Companies |
Third Parties |
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• Increased SEC authority and staffing |
• More conservative financial forecasts |
• Revised exchange listing requirements (2003) |
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• Sarbanes-Oxley enacted in 20021 |
• Greater transparency and communication with Wall Street |
• More prominent institutional investor voice |
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• Increased SEC disclosure requirements adopted in 20062 |
• New/revised governance policies |
• Third-party proxy advisory services opining on governance and pay practices |
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• Section 409A final regulations published in 20073 |
• More stringent board of director selection and training |
• Analyst conservatism |
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• Shareholder Vote on Executive Compensation Act ("say on pay") proposed in 20074 |
• Executive pay redesign |
• Medial spotlight |
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• Inquiries on consultant independence, present and future |
• Greater CEO churn and focus on succession planning |
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Notes:
1 The Sarbanes-Oxley Act established new or enhanced standards for all U.S. public company boards, management and public accounting firms.
2 Securities and Exchange Commission (SEC) rules adopted in 2006 required, among other changes, fuller narrative disclosure through the Compensation Disclosure and Analysis (CD&A) report filed each year with the SEC, describing the process and procedures used by the compensation committee in setting executive and director compensation.
3 Section 409A of the Internal Revenue Code regulates the tax treatment of nonqualified deferred compensation paid to executives and other employees.
4 The Shareholder Vote on Executive Compensation Act would empower shareholders to express their views on their company’s executive compensation practices (i.e., "say on pay").
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Source: Sibson Consulting |
Compensation committees had to adjust to this new environment proactively and reactively. With the world embroiled in an unprecedented economic crisis, compensation committee members will have to learn again to work within new parameters and must continue to adjust and improve. To help keep them heading in the right direction, here are eight strategies for highly effective compensation committees.
The Eight Strategies
To continue to evolve and adjust to a changing environment, compensation committees must take steps to:
- Maintain recent advancements. Most of what has changed over the past decade has been good, albeit expensive, for most companies. Many positive trends have emerged (see Figure 2). These core competencies must be maintained and further refined to accommodate the continuing evolution and increased scrutiny of executive pay, not to mention new rules and legislation. It is important not to lose momentum.
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Figure 2.
Trends in Compensation Committee Operations |
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People |
Practices |
Policies |
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• Service limitations for active executives |
• More thorough due diligence and approval processes |
• Validation and compliance (charters, policies and decision rights) |
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• Greater scrutiny in director selection |
• Proactive agendas |
• Increased education on laws and regulations |
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• Formal evaluation at the board, committee and individual level |
• Frequent ad hoc meetings |
• Greater director accountability and risk management |
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• Board and committee succession planning |
• Robust meeting materials and more timely distribution |
• Improved transparency (with the board and to shareholders) |
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• Greater clarity in pay philosophy and design |
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• Tally sheets1 and internal equity assessments |
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Note:
1 A tally sheet is a breakdown of the total director compensation of named executive officers.
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Source: Sibson Consulting |
2. Compensate role, activity and risk. Committee members need to be compensated for their role (serving on the board, as well as the compensation committee), their activity (the amount of time they spend on board- and committee-oriented work) and their risk (the legal and personal reputation exposure is high).
Prior to 1999, most directors would attend an average of five board meetings a year, read the briefing book and approve the recommendations made by the chair. Today’s directors are expected to accept much more responsibility (along with increased legal and financial exposure) and devote up to 300 hours per year to board activities. The average number of board meetings has increased to nearly seven per year and will probably continue to rise. In addition, every director sits on a committee and is expected to maintain regular contact with other committee members, board members, pay consultants, and others who have a stake in the compensation and performance of the company’s executive officers.
Total director compensation rose nearly 50 percent between 2002 and 2007, from $130,600 to approximately $194,300 per year. (All data is cited under an agreement with Equilar, an information services firm. Total compensation assumes that a nonemployee director serves as a member of the audit committee and the governance committee and attends five board meetings, seven audit committee meetings and five governance committee meetings annually.)
Rather than being paid for each meeting, most board members are now compensated largely by retainer, including cash and equity in the form of full-value shares (which have grown in popularity) and stock options (which have declined). All directors, especially those on the compensation committee, are under extreme pressure from institutional shareholders and outside activist groups. Their executive compensation decisions will have a direct impact — not only on the company, but also on the shareholders who have significant investments in the company — that can expose them legally and personally. That exposure, combined with the additional amount of work involved, is driving director pay to new levels. The ability to recruit and train directors is problematic at best, and it will become an issue for most companies in the highly regulated environment of the new economy.
3. Work beyond the boardroom. An increasing amount of work is being done outside of the board and committee meetings. Members need to be in touch with each other regularly via informal meetings, phone calls and e-mail. Every board member should have a relationship with every other board member and draw on his or her expertise as needed. Nothing at a board or committee meeting should come as a surprise. Members should have been informed of what was to be covered and should have discussed it thoroughly among themselves. This is especially important today. With changes being proposed daily, the committee’s compensation advisors should be fully aware of any possible changes and should be in regular contact with the committee chair.
4. Remain internally focused but externally sensitive. Successful pay programs are driven by internal requirements and are affected by external practices. Of course, it is important to focus on instituting programs that align with the company’s mission, culture and operating dynamics, but compensation committee members must remain open to alternatives. This requires examining pay levels, vehicles and design mechanics constantly and evaluating the strategic and operational effectiveness of current pay programs. Committee members should monitor industry and broader market best practices and emerging trends and keep an eye on the compensation programs at competing companies. The best compensation committees do not wait for programs to become ineffective before exploring alternative approaches. All of this should be built into formal agendas by the committee’s advisors and management. Evaluation is a continuous process.
5. Build rapport with management. There needs to be a continuing dialogue among members of the compensation committee and the CEO, the heads of HR and finance, the general counsel, and all business unit heads. Such relationships improve the committee process and create a collaborative environment that fosters transparency. They lead to greater insights and better decisions that help the company fulfill its needs and meet its challenges. These relationships can be particularly helpful in selecting performance metrics, setting goals and calibrating the pay program. Additionally, having compliance and reporting issues front and center will speed the decision-making process. It is important to remember, however, that building rapport with management and applying proper oversight does not mean managing the company.
6. Commit to director development. Investments in education will optimize director contributions. Many new directors have never been in this position before, and even those with experience might not have served on a compensation committee. A formal onboarding/integration process along with continuing director education on practices, regulations and trends will expedite the new director’s contribution to the committee. Education can be informal, including briefings on current practices, prevalence and regulations as well as mentoring. Rotating committee members every three to five years brings new perspectives and knowledge. Workshops and conferences on governance provide advanced education and offer excellent networking opportunities.
7. Build a talent portfolio. Many boards plan for succession by keeping a list of qualified individuals who could take a director’s place if necessary. Profiles that highlight the competencies of potential directors will ensure that the board maintains the right mix of skills. With many boards, this is overlooked. Finding the right director is difficult, as is convincing that individual to join a board, considering the massive responsibility that goes with the job. In addition, for a board to function properly, committee members must have diverse backgrounds and experience and an understanding of executive compensation.
8. Broaden the scope of responsibility. Expanding the committee’s roles and responsibilities to include additional talent management elements will turn it into a "human capital committee." The committee must work with a variety of issues beyond pay, including talent management, leadership and succession planning, career planning, strategic recruiting, and performance management. All of these components go together. Committee members should be knowledgeable about external talent as well as what is available within the company. The committee should create and maintain a backup plan for the top five executives in the company, with the CEO as the most critical position.
Conclusion
There is no denying that these are difficult times for compensation committees, and the continued public focus on executive compensation is not going to dissipate anytime soon. Committee members have, however, been through tough times before. Those who apply what they learned the last time around and practice these eight strategies will have the basic tools they need to cope with the sea change that is affecting executive pay in every industry.
Richard V. Smith is a senior vice president and Rewards Practice leader in the New York office of Sibson Consulting. He has extensive experience advising compensation committees of publicly traded companies. Jason Adwin is a vice president and consultant in the New York office of Sibson Consulting. He offers specialized expertise in compensation strategy, design and performance management, creating programs targeted at all levels of the organization.
Reprinted by permission of The Segal Group, parent of The Segal Company and its Sibson Consulting Division. ©2009. All rights reserved.
Related Articles:
Nonqualified Deferred Compensation Plans: Code Section 409A Imposes New Requirements, SHRM Online Compensation Discipline, November 2007
Deferred Comp: Analysis of Final Section 409A Regulations, SHRM Online Compensation Discipline, April 2007
HR’s New Role in Executive Pay, HR Magazine, November 2006
SEC's New Exec Comp Rules: What's Required Now, SHRM Online Compensation Discipline, September 2006
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