Executive Compensation Front and Center

Evolution, not revolution, is the best approach to reforming executive pay

BY JEFF DIERMEIER, CFA

My recent participation in the Harvard Business School (HBS) executive education program— “Compensation Committees: New Challenges, New Solutions”—provided an opportunity to reflect on the role of compensation and corporate governance from the board perspective in the for-profit world.

            Say on Pay

This practice, already in place in the United Kingdom and Australia, gives shareholders an advisory vote on compensation. In the Netherlands, these votes are binding. Both the United Kingdom and Australia have had positive experiences with say on pay. After a rocky start—shareowners of Glaxo SmithKline rejected a plan in 2003—boards have tried to avoid problems by improving their communications with large shareowners.

            As a traditionalist, I view compensation as a critical role of the board. It is sufficiently complex that many investors do not have the training or perspective to add much to the equation. Of course, investors should be able to communicate their views to management and the board. Also, investors can abstain from voting for director nominations, particularly those of the compensation committee, if they believe directors are failing in this vital function—a blunt instrument, but it can capture attention.  Dialogue is a better avenue. Many believe the greatest benefit of say on pay is to promote dialogue.

            So far, say on pay has not won universal favor in the United States, where plurality voting continues to impair shareowners’ ability to send effective messages to company boards. Nevertheless, the issue has been one of the most frequent proxy proposals of recent years, and that trend is expected to continue into next year’s proxy season. This coincides with views our members expressed in one of our surveys last year, which really surprised me. Most who responded were sufficiently upset over what has happened in executive compensation to want say on pay and for boards that treat these votes to be more than merely advisory.

            New U.S. SEC rules requiring disclosure in companies’ compensation discussion and analysis (CD&A) have focused boards on compensation, which may prevent egregious abuses. This reform applies only to the United States, where pay abuse is believed to be most excessive.

            Pay for Performance

Where investors like to see the rubber hit the road is in those unfortunate circumstances where performance is poor. They want to see reduced pay, hopefully with an appropriate horizon. If you believe this is the critical issue, I recommend looking at last year’s CD&A for Bank of America to see how their cuts fell. Compensation committees everywhere are trying to match pay with performance. U.S. companies have been required to do so since 1993 (or face tax consequences).  As a result, most executive pay is heavily incentive weighted.

            Some may question the execution by boards generally and compensation committees specifically.

            The Fundamental Issue

A fundamental issue remains. Compensation estimates for the average U.S. executive range from 180 times to more than 500 times that of the average employee. This is an issue of fairness, morale, and motivation within the firm itself.

            One argument is that outstanding people merit outstanding pay. (Proponents draw analogies to actors and sports figures.) But HBS professor Jay Lorsch argues that there is not a functioning market for a Jack Welch. Instead, pay packages are negotiated agreements, and the onus is on the board chair or compensation committee to negotiate an appropriate deal. In my mind, those negotiations should tie in to the company’s strategic plan and performance measures should relate to discounted cash flows that describe long-term value creation (which would include caps to prevent unlimited upside). In this context, it appears that nonfinancial measures reflecting a company’s fundamental drivers are underused in most executive compensation schemes.

            A related problem has been described by Warren Buffett as “ratcheting.” If everyone wants the best and will pay in the top quartile, can anyone be average? Candor about realistic performance is sorely needed. In particular, boards should address a concept we know very well in the investment world: the separation of alpha and beta. Our academic colleagues need to bring this concept to bear on executive compensation.

            Other common-sense tools and techniques are needed as well, including systematic review of the ratio of CEO pay to top executive pay, the share of total profits paid to management, and awards created by financial results that are ultimately restated. Note that I am not against great pay for great performance. I’m only suggesting that some context be regularly provided for the pay granted at the time of the grant. The media often get this wrong, but as an investor, you care most about the pay “when granted,” including fairvalue estimates of securities or awards of pseudo-securities.

            Other Takeaways

On the issue of succession or “insiders versus outsiders,” HBS professor Joseph Bower argues that the best future leaders are insiders who are outside the inner circle because they have a broader view of the company and its markets and can avoid the tunnel vision of an inner circle. While many firms use the “balanced scorecard” approach for business operations, rarely do these tools make their way into executive compensation. This reinforces my belief that executive compensation often lacks strategic intent. Finally, the CD&A reform is in its first year. Early issues should be seen as startup problems that hopefully will improve with time (and enforcement).

            No one will ever be able to declare “the end of history” on these issues. Instead, we should expect an evolutionary process leading to better governance in general and compensation practices in particular.

© 2008 CFA Institute.