Prepare for changes in executive compensation practices

October 20, 2009

Patrick R. Dailey–  Patrick R. Dailey is a human resources executive and specialist in executive compensation. The views expressed are his own. –

The Obama administration is moving aggressively to reform executive compensation practices and impose more stringent governance regulations. These policy and regulatory initiatives are a result of the administration’s publicly stated beliefs that the global financial crisis of 2008 was in large part a result of executive compensation programs that were too highly-leveraged and short term, thus providing incentive for operating executives to engage in excessive risk taking – the corporate version of always swinging for the fences.

Without question, all public corporations will soon implement more stringent regulations and practices governing executive compensation.

Significant change is emerging in five areas of executive compensation and its governance.

Compensation Committees will have more clout

The Treasury Department seeks to raise the level of confidence among shareholders regarding executive performance targets and fairness in plan design by “beefing up” authority of the Compensation Committee to act in the interests of long term shareholders. Changes may likely include:

-  Strengthened independence requirements for Committee members.
-  Increased decision-making authority and accountability.
-  Committee duties and reporting requirements will be more specifically-defined by SEC regulations.

Compensation plans must pass new tests for shareholder alignment and risk

The Administration is seeking to end the era of “heads I win big, tails I lose just a little” executive compensation practices.

While performance-based rewards clearly remain “in favor”, Treasury seeks to rein in those performance-based plans which have too often rewarded short term “wins” while seemingly ignoring long term failure. Design changes will likely include:

- Highly leveraged incentive plans will fail to pass risk management tests and be constrained.
- Incentive compensation will become more complex in design and earn-out.
- Incentive plans will have hold-back features.
- Executives will be mandated to hold more equity for longer time periods.

Shareholders will have more to see and more to say

The administration seeks to reduce shareholder surprise and indignation.

Both the SEC and the Treasury Department propose that shareholders be provided more information about executive compensation by companies plus increased participation in decisions about executive compensation plans.

The communication challenge around executive compensation will be formidable -compensation plans are complex in design and conditions of settlement—and will likely become more complex.  Complexity combined with information overload will likely leave shareholders frustrated, largely unenlightened and perhaps unwilling to vote “yes” for compensation plans. This condition places increasing power in the hands of shareholder advisory groups to explain and influence individual and institutional shareholder vote. More “see” and “say’ will likely include:

- Annual non-binding shareholder vote on executive compensation plans (expected in 2010).
-  Continued pressure from the SEC for increased simplicity in language and clarity of discussion in the proxy disclosure

The requirement that companies would annually present plans and explanations on compensation matters represents a government tactic that seems intent on leading companies to capitulate to the governance standards held by the administration without the imposition of pay cap guidelines and explicit pay policy regulations.

“Managing the optics” becomes a prominent matter

Executive compensation has clearly entered the realm of “public matters” a company must well-manage. Anticipated changes include:

-    Committees must know more about peer group companies and best practices.
-    Executive compensation “messaging” must be thoughtfully crafted for a variety of audiences
-    Companies will significantly strengthen shareholder relations.

Managerial compensation will tighten-up

Managerial compensation will be largely defined by changes in executive compensation. Companies should prepare now to deal with downward pressure on pay structures, incentive plan leverage; limitations on job offer/hiring packages and severance terms.

-   Adapt managerial compensation to the new philosophy and design of executive compensation.
-   Document and have a rationale for compensation exceptions.

Wrap-up

Arguably, the Obama administration has been a necessary protagonist for the better alignment of executive decision-making with long term shareholder interests. With the current CEO pay ratio (highest paid executive to lowest paid employee)  at 411:1 compared to a 42:1 ratio in 1980, shareholders, reformists and legislators perceive ample room for improvement in design, governance and the optics of executive compensation.

Pay for performance remains the foundational design principle but executive compensation plans will most likely be required to pass “tests” for alignment with long term interests of shareholders and risk management standards.

Compensation has become a much more public matter for companies with increased scrutiny from shareholders, shareholder advocates, politicians and the media. Companies must decide how to tell their compensation stories realizing that those trailblazers will be heavily scrutinized by shareholders.

Time will tell whether current government-led “corrective action” will strengthen or muzzle the impact of executive compensation plans to focus and drive innovation and achievement in U.S. companies…and ultimately reward those competitors that get to the future before their global competitors.

Link to full article (.pdf)

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