Strategic Issues in Executive Pay
“The Informed Compensation Committee”

• a company’s LTI program is likely the key element in its ability to attract and retain top talent – those individuals who develop and implement strategic business plans.
• an LTI plan is costly and creates significant multi-year liabilities; in short, LTI plans are long-term commitments.
• an LTI plan is highly visible. No board wants to be in the position of defending compensation practices similar to excessive arrangements that were recently found at some well-known and respected organizations.
   

Disclosure. While most companies made reasonable efforts in 2007 to comply with the enhanced proxy disclosure requirements for executive compensation, a dominant theme of the subsequent comment letters from the Securities and Exchange Commission (SEC) was that many organizations did not adequately explain why executive compensation decisions were made or how the practices fit into the overall strategy of rewards. SEC staff observed that more analysis often was needed in the compensation discussion and analysis (CD&A) section – seemingly indicating a belief that the strategic foundations of the program were weak. Indeed, a speech by John White, the director of the SEC’s division of corporate finance, not only stressed the need for “analysis” but implied that enforcement actions could follow.

Also clear in SEC comments was that the old paradigm of adherence to a stated “compensation philosophy” may not be sufficient. Most traditional pay philosophies are founded on the concept of providing “competitive pay” within a selected market or peer group. While the SEC disclosure rules do not require any particular approach to executive pay, whatever method chosen must be appropriately described, discussed, and analyzed – especially the “how and why.” Being competitive may not be a sufficient analysis. Regardless of SEC actions, well-governed companies should have a comprehensive compensation strategy, not just a philosophy, and each element of the pay structure should support that strategic view.

Compensation Committee Accountability. How then should a compensation committee approach the strategic design of executive pay? As a first step, the committee needs to be actively engaged in the compensation decision process, rather than simply providing oversight. The committee next needs to consider the current position of the company in the competitive market. It can be difficult to plot a course forward if the committee does not understand the organization’s current situation.

• A compensation committee should be expected to know not only the organization’s competitive position in base salary, total cash and long-term incentives relative to the competition, but to understand the material features of executive benefit and retirement programs, as well as the total “walk-away” values on potential termination events. What programs do we have in place…and why?
• In past years many compensation programs were developed using a piecemeal approach. For example, one year the market may have focused on SERPs, so the compensation committee looked at that vehicle; another year the market trend was enhanced change in control protection, so the committee considered that issue. Until recently, many committees may never have seen a summary that clearly disclosed the full value of potential executive compensation payouts under various scenarios – the now familiar “tally sheet” analysis.
• Similarly, prior practice in competitive assessment focused primarily on the current year. Going forward, committees increasingly will consider the accumulated wealth being created.

In developing a strategic approach to executive pay, the compensation committee needs to understand the resources available in plan design, and the likely outcomes of company performance. Key questions might include:

• How many shares are available?
• When will the pool of shares expire?
• What is our current overhang and what is appropriate?
• How accurate is our forecasting process and do we know how much cash we are committing?
• What has been our history of payout relative to target?

Finally, the committee needs to understand the company’s executive population. A critical element of strategic thinking about compensation is the concept of succession planning and development of future leadership.

Addressing Issues. Once the compensation committee is fully prepared, there remains the task of navigating through current issues and trends. Once again, market practice cannot be the only factor used. Each material pay component must be viewed in the overall strategic context as to its value for the specific company, with the committee asking “why are we doing this?” Topics that compensation committees should consider in the overall context of strategic thinking include:

• Are we using a reasonable peer group?
  • Is it being challenged with rigorous analysis each year?
  • Has the committee established appropriate criteria for selection other than “similar size and market”?
• What is the correct mix of cash and equity compensation – taking into consideration the accumulated and potential value of prior grants?
  • Does it provide additional motivation and/or retention value to grant more options when the executive already has a significant stake in the business?
  • Are share ownership and retention guidelines/requirements appropriate for our company?
• How long is long-term? Should we continue to use stock options with a traditional ten-year term or explore a shorter (e.g. 5 to 7 year) term as some companies are doing?
• Are additional performance requirements a fit with our equity approach? Recent surveys indicate a significant increase in the use of performance shares and/or unit plans.
• Are “claw-back” provisions necessary or appropriate to reinforce our objectives? If so, what criteria should be applied?
• Should severance programs be reduced (or even eliminated) for an executive after a few years in the position?
  • Have the circumstances changed so that severance protections – implemented when the executive was recruited – may be no longer needed?
     

None of these questions necessarily has a correct answer, a “best practice” that fits all companies and situations. However, these are issues that compensation committees will need to face during 2008 and beyond as they address compensation on a strategic, business focused perspective. Stakeholders, watchdog groups, and regulators all expect committees to take on the challenge, which is no small feat.