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Aligning Pay to Value Creation and Performance

Compensation is a very emotional subject for executives. And it is personal, sometimes inspiring competition, greed, wrongdoing, or even feelings of self worth. The legacy of the financial crisis will not be as much the quantum of compensation, but rather ensuring that boards and shareholders are more involved, and that pay is more tied to performance and risk-taking. Regulators have stepped in to ensure that shareholders have a vote; compensation committees and consultants are independent; and that, in expected regulations to come, pay is more linked to performance and compared to the compensation of the average worker.  The intent of compensation reform should not be a compliance exercise dominated by consultants and lawyers, but rather a re-thinking by the compensation committee of linking compensation to value creation for shareholders, and listening to their concerns. This is the heart of the issue.

In my review of the evidence and work with investors, boards and compensation committees, here is a list of opportunities for linking pay to performance and shareholder value:

  1. According to a study by an advisory firm, 95% of equity vesting in the US top 250 firms are time-based rather than performance-based. If this is the case, this is a serious lapse in oversight and alignment with shareholder value by boards. Non-executive directors should receive performance-based restricted stock also.
  2. University of Delaware researchers claim there is a 17% structural annual increase in CEO compensation simply by virtue of peer groups being used that are based on size rather than value creation, coupled with CEO compensation being awarded at the 50th, 75th or 90th percentile. This structural increase occurs irrespective of performance. As long as the current system of awarding pay continues, this ratcheting will continue.
  3. Increased disclosure of compensation has resulted in compensation consultants devising multiple vehicles, methodologies and time periods that are complex for investors to understand. There is a case to be made for the simplification of key value drivers associated with shareholder value, coupled with high wealth maximization for executives. Private equity firms do this very well.
  4. An independent advisor to a compensation committee should be one who has not done, nor is doing, nor seeks to do in the future, any non-committee related work for management. This restriction should apply to the firm as well as the person. If an advisor’s colleague has a relationship with management, then he or she does as well.
  5. There are examples of equity vesting when ethical transgressions have occurred. This should not be the case. Malus clauses should be used rather than clawbacks. The compensation committee or an independent advisor who has no relationship to management should draft the clause and the conditions. A clause properly drafted will be adverse to the interests of management.
  6. The periods covering pay and performance should be aligned and simplified. Right now there is overlap among intended, earned and realized compensation. This causes confusion in assessing compensation. Companies should do this on their own, and if they are incapable or refuse, regulators should clarify.
  7. Research studies suggest bonuses are not based on stretch goals in many companies, but are forms of disguised salaries. Bonuses should be discretionary and awarded by the committee over time as performance effects are realized and risk tails assessed.
  8. Despite the high say-on-pay approval rate, the controversy over executive compensation is not a blanket “CEOs are overpaid,” but is based primarily on two factors: examples of pay for non-performance, and the internal pay inequity (both officers and the average worker). Boards should take a look at these two issues specifically.
  9. Researchers have found no causal relationship between stock ownership by executives and firm performance. This should be kept in mind for target ownership plans. Large equity positions could promote entrenchment, asset misuse, and accounting and grant manipulation.
  10. Compensation committees need to make greater progress on adjusting compensation for risk, including incorporating risk into performance metrics and allowing equity to vest after risk has been assessed. There is much progress to be made here and regulations are emphasizing this.
  11. Greater progress needs to be made by boards on CEO succession planning, which affects compensation and firm performance. Survey data according to Stanford researchers have found that the board spends only two hours a year discussing CEO succession, and that 39% of boards do not have an internal successor. Outside successors cost more and there is considerable evidence they perform worse than internal successors.
  12. Proxy advisory firms should not be overly influential as they are now. Weak governance systems are associated with excessive compensation, research suggests. However, in considering recommendations of proxy advisory firms, they neither assess governance quality nor predict shareholder performance, the research also suggests. Compensation committees and boards should not necessarily amend practices to suit proxy advisory firms if their reliability cannot be established.

Conclusion: The compensation landscape for 2012 and 2013 will include all of the above touchpoints. They will require most importantly compensation committees with courage and expertise, particularly if there are systemic problems or questionable linkages to performance and value creation for shareholders.

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