1. Director Compensation Philosophy
Oversight of director compensation can fall under the purview of either the governance and nominating committee or the compensation committee, depending on the individual company’s approach to committee responsibilities. However, whichever committee oversees director compensation, the issues will be the same. Establishing director compensation is inherently a little awkward, as the directors are responsible for establishing their own pay levels.
Director Compensation Philosophy
To date, director compensation has not been subject to the same level of external scrutiny as executive compensation. There are likely two main reasons for this. First, director compensation levels are relatively modest when compared with executive compensation levels. Secondly, director compensation programs are not highly leveraged. Much of the controversy surrounding executive compensation stems from concerns about the pay-for-performance relationship or excessive levels of non-performance-based pay. Director compensation is generally not explicitly designed to link director pay levels with performance, aside from paying directors in the form of company equity. While in the past, directors often had non-performance-based pay in the form of perquisites, insurance benefits, or retirement plans, today’s director compensation programs do not generally include significant amounts of special benefits. Unlike executives, directors are generally not participants in retirement plans or covered by severance arrangements. Due to concerns about potential litigation based on excessive director compensation, some companies have established limits on director compensation particularly in their shareholder-approved plans.
To manage director compensation programs effectively, the key objectives that committees focus on are 1) aligning the interests of directors with those of long-term shareholders, and 2) attracting and retaining qualified directors to serve on the board. In practice, the first objective is addressed by ensuring that a meaningful portion of director compensation (50% or more) is delivered in the form of company equity and often deferred until the director retires from the board. With this kind of compensation structure, directors can accumulate a meaningful ownership level over time, which will give them a financial incentive to act in the long-term interests of shareholders, consistent with their responsibilities as directors or stewards of the company.
To address the second objective of attracting and retaining qualified directors to the board, most companies ensure that they establish a competitive target pay positioning for directors. The majority of companies use the same peer group for establishing both director compensation and executive pay levels. This may seem somewhat counterintuitive, as directors are typically drawn from a broader array of backgrounds than executive talent. However, most companies opt to use the same peer group because it sends a message that directors are being treated comparably to executives. Similarly, if executive pay is targeted at the median of the peer group, most companies will target director pay at the median as well to ensure that management does not feel that directors are less rigorous in assessing their own pay.
Director Compensation Design
Director compensation program design is simpler than executive pay but can have a number of different elements and may depend on the role a director serves on the board. When we consider director pay, we often break it down into the following components:
- Compensation for Board Service
- Compensation for Committee Service
- Compensation for Committee Leadership
- Compensation for Board Leadership (Non-Executive Chair/Lead Director)
Compensation for Board Service
Compensation for board service consists of elements of pay that all directors will receive without regard to committee service or leadership roles. The most common pay elements for board service are the annual retainer (which can be delivered in cash, shares, or a combination of each), board meeting fees, and an annual equity grant.
In the traditional model of director pay, a director would receive an annual retainer in cash (e.g., $60,000), board meeting fees (e.g., $1,500 per meeting), and an annual equity grant (e.g., $75,000). Assuming a board had 10 meetings a year, this would result in total compensation of $150,000 for board service per director.
Over the past 5–10 years, many large companies have moved to simplify their director compensation programs by eliminating board meeting fees and/or committee meeting fees and providing a single retainer divided between cash and equity. For example, a single annual retainer of $150,000 may be delivered $75,000 in cash and $75,000 in deferred-equity shares.
Many companies will provide directors with the option to defer receipt of all or a portion of any annual cash retainer and meeting fees until they leave the board. This can provide directors with a useful means of managing their tax liability.
Equity compensation for directors is almost always provided in the form of shares or stock units. In the past, companies frequently provided directors with stock options, but stock options have been heavily criticized for incentivizing excessive risk-taking. Pay critics would prefer that directors be paid in shares outright so they are focused on increasing the value of the stock price while being mindful of downside risk. Similarly, very few directors participate in long-term performance plans because they might be conflicted in establishing goals for such plans and assessing performance levels.
Equity grants for directors are most often established as a targeted annual dollar value, which is converted into a number of shares at the time of grant (often the annual meeting date). In many cases, the directors are granted stock units that are immediately vested but are deferred and settled when the director leaves the board. The rationale for this approach is that a vesting requirement is not critical to retain directors, and the company wants to use equity primarily to align directors with shareholders over the long term.
Compensation for Committee Service
Under the traditional model of director compensation, all members of a committee would receive a fee for participating in meetings (e.g., $2,500 per meeting). The rationale for this approach was that the number of meetings held was a good proxy for the committee workload and time commitment. Historically, the audit committee tended to have more meetings than other committees and often had a heavier workload. In years where the committee had more meetings, compensation would rise, and in years of lower activity, compensation would fall. In addition, board members who serve on multiple committees may be paid more than members who serve on only one committee. A minority of companies provide a committee service retainer in lieu of committee meeting fees.
As mentioned in the section above, many large companies have decided to eliminate board and committee meeting fees. For many of these companies, the rationale is that over time, all board members will make similar contributions through board and committee service and, even if they are not attending meetings in person, directors will review materials and provide input prior to meetings. Additionally, these companies would rather have equitable compensation for all board members. However, even among these companies, they generally differentiate compensation for committee or board leadership roles.
Compensation for Committee Leadership
Most boards recognize that serving as the chair of a committee is a significant step up in terms of responsibility and workload. The chair will typically spend more time working with management or outside advisors to develop meeting agendas and reviewing meeting materials, and may be called upon to vet ideas with other committee members in advance of meetings. In addition, chairs are occasionally required to interact with shareholders. The typical form of incremental compensation for committee chairs is a supplemental retainer to recognize their additional role. The audit committee chair tends to receive the highest incremental compensation among all committee chairs, followed closely by the compensation committee chair. The table below provides typical chair retainers among a CAP analysis of Fortune 100 companies:
|
Audit |
Compensation |
Governance |
|
|
75th Percentile |
$20,000 |
$19,000 |
$15,000 |
|
50th Percentile |
$15,000 |
$15,000 |
$12,500 |
|
25th Percentile |
$10,000 |
$10,000 |
$10,000 |
Compensation for Board Leadership
Depending on the company’s management structure, non-executive board leadership roles can be one of the following:
- Non-Executive Chairperson
- Lead Director (Fixed Individual)
- Lead Director (Rotating)
Non-Executive Chairperson Compensation
In companies where there is not a combined chairperson and CEO, the non-executive chairperson serves as the leader of the board. Given the expansive responsibilities of this position (e.g., has authority to call board meetings, chairs board meetings, shapes meeting agendas, and represents the organization externally), the compensation levels are often close to 2x that of a typical director. The market range of compensation for this role is broad, reflecting the differences in the scope of the role at different companies.
|
Total Director Compensation (Cash + Equity) |
Total Non-Executive Chair Compensation |
Total Non-Exec Chair Comp (as a multiple of total board comp) |
|
|
75th Percentile |
$340,000 |
$570,000 |
2.77x |
|
50th Percentile |
$320,000 |
$522,000 |
2.48x |
|
25th Percentile |
$300,000 |
$473,750 |
2.29x |
Lead Director Compensation
In companies where there is a combined chairperson and CEO role or an executive chairperson, the lead director is responsible for leading the executive sessions of the board outside the presence of the CEO. In most companies, a single director is charged with the role of functioning as the lead director for all executive sessions; in other companies, different directors may take the role in different meetings on a rotating basis. In cases where a single director is charged with the role, they are typically provided with additional compensation to reflect their responsibilities.
The incremental compensation for the lead director is typically provided in the form of a supplemental retainer with the amount of compensation comparable to what is provided to the chair of a major committee (e.g., audit or compensation).
|
Lead Director Additional Retainer |
|
|
75th Percentile |
$75,000 |
|
50th Percentile |
$50,000 |
|
25th Percentile |
$41,250 |
Director Stock Ownership Guidelines
To help ensure that directors have a meaningful financial stake by which their interests are aligned with the interests of the company’s shareholders, many large companies have established director stock ownership guidelines. In practice, most directors find it relatively easy to comply with these guidelines because a substantial portion of their annual compensation opportunity is provided in the form of company equity. The table below summarizes the typical elements of director stock ownership requirements:
|
Program Element |
Market Approach |
|---|---|
|
Basis for Requirement |
|
|
Requirement |
|
|
Time to Comply |
|
|
Shares Counted Toward Compliance |
|
|
Assessment of Compliance |
|
|
Consequence if Noncompliant |
|
Key Questions for Committee Members to Ask:
- Is our compensation philosophy (e.g., peer group, target pay positioning, etc.) for director compensation consistent with our approach for executive compensation? If not, why?
- Could our director compensation program be improved through simplification?
- Does our director compensation adequately recognize the contributions of board members who take on leadership responsibility?
- Does our director compensation program provide a sufficiently high proportion of compensation in the form of company stock?