–  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)

Ken Lewis started at Bank of America 40 years ago, working his way up from junior credit analyst to the CEO suite. His employment contract at the nation's largest banks obviously predates the government's bailout of Bank of America. Yet pay czar Kenneth Feinberg may have a say on whether he cashes in on retirement benefits and accumulated compensation worth $125 million.

Some argue it is simply inappropriate for Feinberg to try to tackle Lewis' retirement package.

"A fair reading of the situation would be he is getting what he is entitled to and game over," said Alan Johnson, a Wall Street compensation consultant.

But to many, Lewis is a poster child for the crisis that struck Wall Street banks last year, nearly collapsing the financial sector and resulting in taxpayers spending hundreds of billions of dollars to bail out firms like Bank of America.

"The Obama administration has to use every tool at its disposal to fix the pay problem, particularly the golden parachute for failed executives," said Richard Ferlauto, director of corporate governance and pension investments for the American Federation of State, County and Municipal Employees, one of the largest U.S. labor unions.

Should Lewis get his retirement package in full? Leave your answer in the comments section.

– James Pethokoukis is a Reuters columnist. The views expressed are his own –

For the populists who really, really want to make Wall Street pay by slashing their pay, Treasury Secretary Timothy Geithner certainly isn’t giving them what they want.

Yes, the top executives of the remaining TARP firms seem destined to be salary serfs to the “pay czar”, Kenneth Feinberg.

Of course, it’s hard for even the most die-hard free marketeer to feel sorry for financial firms that mismanaged their businesses terribly, took government bailout money and now find themselves under Uncle Sam’s thumb.

But as for everyone else? Well, here’s how Geithner put it: “We are not setting forth precise prescriptions for how companies should set compensation which can often be counterproductive. Instead, we will continue to work to develop standards that reward innovation and prudent risk-taking, without creating misaligned incentives.”

Even worse for those who wanted the Treasury secretary to bring down the hammer, he went on to highlight how the financial sector is already making changes on pay and how he looks forward to a “continuing conversation”. Yes, self regulation in action! Hardly what the torch-and-pitchfork crowd craved to hear.

That’s just too bad. To his credit,  Geithner seemingly understands his goal isn’t to punish, but to play a constructive role in nudging financial industry compensation in a direction that better connects risk and reward.

Ultimately, it is shareholders and management who should decide what executives make. Indeed, Geithner’s recommendations centered on empowering the Securities and Exchange Commission to give shareholders a stronger say over executive pay.

And changes are taking place. Firms like Credit Suisse, Morgan Stanley and Goldman Sachs have tried to rework pay systems by allowing bonus clawbacks, for instance.

Good thing, too. Government has a terrible record in rejiggering executive compensation. Example: Legislation back in 1993 intended to rein in corporate pay by eliminating the tax-deductibility of executive compensation above $1 million unless pay was linked to performance.

But one unintended effect of the law, academics James Wallace and Kenneth Ferris have found, “was that executives’ total compensation actually increased in the post-1993 period” thanks in big part to the use of stock options.

Not surprisingly, executive pay issues moved back into the spotlight earlier this decade after Enron and other corporate scandals. One part of the 2002 Sarbanes-Oxley Act prohibited executive loans. As with the 1993 law, corporations responded in ways perhaps not anticipated by legislators.

Signing bonuses and fatter severance packages became more popular — just the sorts of things now being frowned upon.

What sort of compensation might work better to align executive compensation with long-term shareholder interests? A group of academics — Alex Edmans of Wharton, Xavier Gabaix and Tomasz Sadzik of New York University and Yuliy Sannikov of Princeton — have devised an approach based on what they call “dynamic incentive accounts.”

Unlike bonus clawbacks, this system doesn’t try to recoup money already sent out the door.

Here is how it works, according to their new study: Executive pay is escrowed into an account, a fraction of which is invested in the firm’s stock and the remainder in cash. The account would be rebalanced each month according to company guidelines — rules would certainly also vary by industry — and by how close the executive is to retirement.

The gradual vesting of the account — cash from a sold stock cannot quickly withdrawn — even after retirement, “allows the CEO to consume while simultaneously deterring myopic actions.”

In other words, the goal is to promote long-term thinking over short-term manipulation.

For instance: If company’s stock soared, the executive could sell, though the proceeds would say in the account. If the stock then dropped, that money would have to be used to buy more stock. He couldn’t just take the money and run.

Is this the best system out there?. Maybe, maybe not. Or maybe for some firms or sectors and not for others. But that is why you don’t want a one-size-fits-all plan devised in Washington, particularly one with political rather than economic goals. That is a pothole that Barack Obama and Timothy Geithner have so far avoided.