1. Key Lessons & Looking Forward
While executive compensation is subject to considerable external scrutiny, and any compensation committee is potentially at risk for criticism regarding their decisions, we believe that executive compensation is a key tool that — when used correctly — can help an organization achieve its goals. When the pay design goes awry, however, pay levels can become a distraction for members of the board and the management team.
Key Lessons
Our position as compensation advisors has provided us with a unique vantage point to view the evolution of the role that compensation committees play within an organization. While in the past, the committee may have been too closely aligned with management, today’s committees take their independence and objectivity seriously. What many critics of executive compensation practices fail to understand is that even with the best intentions, it is almost impossible to create an effective compensation design that will be embraced by everyone. Compensation committees must balance competing objectives in compensation design and prioritize the concerns of the many different constituencies that will weigh in on said design, whether their input is solicited or not.
Some of our peers in the consulting profession have raised concerns that executive compensation practices run the risk of evolving over time to a “one-size-fits-all” approach. They fear that, due to the disproportional influence of shareholder advisory firms on executive compensation design, compensation committees will cave to compensation designs dictated by the policies of these firms. For example, since ISS uses total shareholder return (TSR) as a key component in its pay-for-performance model, the risk is that compensation committees may move to long-term incentive designs based on relative TSR to mimic ISS’s quantitative tests. Similarly, a compensation committee that is overly concerned with ISS may select peers based less on their own definition of the competitive market for talent and more on the basis of whom ISS views as appropriate peers.
We believe these fears are overstated. We agree that ISS and Glass Lewis tend to evaluate compensation programs using a “one-size-fits-all” approach that may fail to recognize that organizations might have good reasons for using compensation designs that do not comply with their policies. However, in our experience, compensation committees function as an effective bastion against the prescriptive policies of shareholder advisors. Most of the committees we see in action recognize that ISS and Glass Lewis are influential over a portion of the company’s shares, but in most cases only influence the voting of a minority of shareholders. The committee understands that doing something only for the purposes of pleasing ISS can significantly diminish the effectiveness of the compensation program in achieving its objectives as an overall management tool.
For example, many companies continue to use the same performance goals in both their short-term and long-term performance plans. ISS and Glass Lewis each view this as a problematic pay practice that puts excessive weight on a single performance measure. However, compensation committees recognize that while ISS and Glass Lewis may have a point in certain circumstances, there are plenty of situations where using a single measure for both the short-term and long-term performance plans makes a great deal of sense. For example, many companies that use economic profit as a performance measure will use it in both the annual and long-term performance plans. Organizations that use economic profit effectively understand that using other performance measures will dilute the company’s focus on its true definition of performance. Compensation committees in such an organization would need to work to ensure that other aspects of the compensation program address the concerns of shareholder advisors.
Successful committees do a great job of balancing the concerns of multiple constituencies. They will pick their battles with shareholder advisers or with management over fundamental principles that the committee views as critical to the compensation design. Wisely, committees will cede ground on more minor points that may run against the committee’s preferred approach but will ultimately help the committee win other battles with management or shareholder advisers elsewhere.
Looking Forward
If we scroll forward to what the next few years hold for compensation committees, we expect to see a continued movement toward more effective review and refinement of the pay-for-performance relationship. We expect that it will be standard practice for compensation committees to conduct an annual evaluation of the prior year’s compensation to see how well the company’s pay levels aligned with the company’s performance. While many compensation committees already do this today, we expect to see a higher degree of sophistication in the future with compensation reviewed not just from the perspective of the Summary Compensation Table, but also from the perspective of realizable pay. We also expect committees to review the pay-for-performance relationship over a three- to five-year period, in addition to a year-over-year look at compensation changes. Sophisticated committees will review the company’s performance from multiple perspectives beyond total shareholder returns to examine top-line and bottom-line growth, as well as financial returns on capital.
While a retrospective review is important for understanding how well the pay program has worked in the past, in order to ensure the program works well going forward, the selection of performance measures linked to forward-looking strategic objectives and shareholder value creation will be critical. Compensation committees need to ensure that management uses performance measures in the annual and long-term incentive designs that effectively measure success against strategic objectives and implementation of such objectives.
Beyond selecting the right performance metrics, the committee and management must work together to make sure that goals are set at the right levels to satisfy both internal and external stakeholders. Many companies rely heavily on an internal budgeting process to establish performance objectives. This approach can lead to goals that fall short of external expectations for performance. Management and the compensation committee should review shareholder expectations for performance along with peer historical performance levels to assess the rigor of budgeted performance levels. Shareholders are likely to be underwhelmed if the company achieves its internal performance objectives but falls short of industry standards. Setting performance goals with adequate rigor will be a leading contributor to appropriate pay-for-performance connections in the future, along with incentive vehicles that provide appropriate linkages to shareholder value creation.
To date, the annual Say on Pay vote has been a non-issue for most companies with very high approval rates. However, there has been an enhanced focus on shareholder outreach and engagement with shareholders on the subject of executive compensation. We expect this trend to continue in the future. At times, committee chairs will be called upon to speak directly with shareholders to explain the rationale for the company’s compensation decisions. This type of communication, when combined with the clear disclosure in the CD&A, can help to keep the Say on Pay vote a non-issue.
We hope that this book has provided helpful guidance on compensation committee processes that can help you to be successful in your committee service. We believe that this book can serve as a valuable reference tool to provide you with a baseline understanding of key aspects of compensation design.