Boards’ New Year Resolution: Linking Pay with Performance

With executive compensation in 2007 expected to climb almost as much as it did last year, boards can count on the media to continue its unrelenting coverage of corner-office comp, and on shareholder activists to devote even more attention to pay practices than they did in 2006.
“We’re not against executives getting pay, and getting a lot of pay,” says Clark McKinley, information officer at Calpers. “But [it can’t be] because of some kind of back-slapping kind of thing that they have with board members. They have to actually be making a difference and be able to show it.”
The SEC’s new compensation disclosure rules will give directors the opportunity to demonstrate just that. Paul Dorf, managing director at Compensation Resources, expects the new rules will allow directors to create “a more realistic picture of what actually goes on with the compensation committee, and why they took the actions they did.”
That means demonstrating a clear link between pay and performance — something boards started to do more of in 2006.
One of the big reasons for that change has to do with the IRS, says Alexandra Higgins, senior compensation analyst with The Corporate Library. In 2006 the IRS announced it was going to examine more closely companies’ compliance with a specific section of the tax code. That section allows companies to deduct more than $1 million a year of certain executives’ compensation if that remuneration is performance-based.
“In the past, the IRS has had a very relaxed approach toward executive compensation and tax deduction, so companies used lots of boilerplate language,” Higgins explains.
If investors are as adamant about executive compensation as they were in 2006, shareholder activism should serve as an equally motivating force when it comes to aligning executive pay with performance.
Last year two Pfizer compensation committee members received 21% withhold votes due to investor dissatisfaction with the company’s executive pay practices, according to Institutional Shareholder Services’ 2006 Postseason Report. The board members of several other blue-chip companies were targeted for the same reasons. Given the excessiveness of some executive compensation packages — and the media’s predilection for publicizing the plans’ most salacious details — it’s no wonder.
The median total compensation of 1,400 CEOs included in the sample used for The Corporate Library’s 2006 CEO Pay Survey was approximately $3 million in 2005, and media reports and early estimates show executive pay continued to climb in 2006. Based on the responses of 441 companies surveyed by The Conference Board, executive compensation rose by a median of 3.6% last year.
The strong economy contributed to the inflation of executives’ compensation in 2006. First, it caused more executives to cash in their options, says Compensation Resources’ Dorf. Second, it made it harder for boards to justify reining in compensation, according to some directors.
“You a have a robust equity market that’s lasted for the last couple of years. It’s hard to say executive compensation should be going down when stock prices are going up,” says Charles Yamarone, chair of the Continental Airlines board’s human resources committee and a director at El Paso Electric.
But according to Calpers’s McKinley, executive compensation that rises and falls in tandem with shareholder returns doesn’t qualify as pay for performance.
“It’s got to be with respect to their peers,” he says. “When you see a CEO who’s getting twice as much as the CEO of a competitor and the competitor is outperforming him, that’s when it doesn’t make sense.”
Comp committees had better make sure their companies’ executives’ supplemental retirement plans [SERPs] make sense, too. The new compensation rules require companies to include actuarial calculations of what executives will receive when they retire, as opposed to allowing them to leave it up to investors to estimate these amounts.
“Those numbers are staggering,” says The Corporate Library’s Higgins. “We’re talking about $90 million to $300 million.”
For these reasons, some have predicted the new rules will sound the death knell for excessive SERPs. The same goes for perquisites.
“People will say, ‘Pay me an extra $100,000 and I’ll take care of all these little silly things that companies are giving people that they’ve never had to disclose in detail,’” predicts Yamarone.
Nevertheless, there are reasonable explanations for executive compensation inflation, some directors maintain. High compensation is necessary to attract and retain talent, they say, especially in this market, where qualified executives are a rare commodity.
“Being a CEO is a very hard job,” says Pamela Lenehan, a director at Avid Technology and Spartech. “It entails a lot of stress, no job security. The good candidates want to be paid for all that.”