All Eyes on Executive Compensation

In the wake of the recession and multi-billion dollar government bail-outs, executive compensation is now the single biggest governance issue confronting public companies.  At the center of this discourse is the Chief Financial Officer (CFO), a position that is on the frontline when it comes to determining compensation levels and executive bonus packages.

Fueled in large part by the massive bonuses and salaries that were paid out by organizations that received funding under the Troubled Asset Relief Program (TARP), executive compensation is under more scrutiny than ever before.  That remains true even for those firms that have repaid TARP monies.

“It is a hot button issue with Congress, regulators, the media and, unfortunately, even among the general public.  It’s an issue that people are focused on and, in some cases, upset about.  That’s reason enough to keep CFOs awake at night,” said Sandy Godwin, partner, Mercer, a global provider of human resource and related financial advice, products and services. 

Indeed, many expect that scrutiny on executive compensation will only increase.  That, combined with SEC disclosure requirements, is why compensation is now among the top three items on a CFO’s radar screen.

“We’re at a point now where even a full economic recovery won’t dampen the focus on this issue,” said David Wise, senior consultant in the executive compensation practice at Hay Group, a global management consulting firm.  “The single biggest change that will keep executive pay in the forefront is the growing knowledge base and power of institutional shareholders to impact the decisions companies are making.”

He adds that shareholder access to information is only growing, noting that the SEC has just finalized another round of enhanced disclosure rules that give shareholders more and better information about executive pay programs than ever before.  Access to board members is also growing through initiatives like ‘say on pay,’ which gives shareholders an advisory vote on executive pay programs, and which will be a reality for all public companies in the near future.

Mitigating the Risk
 

But it’s not just public scrutiny of compensation that is keeping CFOs awake.  For many, compensation is the single largest expense each year.  As such, any misstep, such as overpaying, incentives that motivate “bad” behaviors, etc., can cause problems beyond financial.

“What’s more, the quality of the executive compensation program has now become an acid test on a company’s governance practices, and a poorly-designed executive pay program now has the potential to turn shareholders away from ownership of a company’s shares,” said Wise.  “A very difficult issue for compensation committees to deal with in this environment is how to balance the needs for incenting executive performance in a way that aligns shareholder interests with the needs to create ownership and retention incentives for executives.”

For example, he notes that keeping the right executive team in place is sometimes the best outcome for an executive pay program.  However, retention-oriented programs fair no better than incentive performance programs in the eyes of the shareholder.

According to Mercer’s Godwin, the most acute risk in financial services is the perceived disconnect between the timing of payment and performance outcomes.  For example, much of the public outrage and subsequent regulatory scrutiny in 2009 was the result of large annual bonuses awarded for transactions that occurred that same year, but for which profitability will not be apparent until several years from now.  In other cases, bonuses were paid for transactions that were ultimately unprofitable or, in some cases, catastrophic.

Godwin notes that while many companies are now focused on doing a better job of timing payments with performance outcomes, the risk of paying too much for too little still remains.  However, this basic issue can be addressed in basic plan design.

“Any company that was in TARP has reviewed incentive plans and, in most cases, made some changes with the idea of mitigating the risks associated with the plans,” he said.  “You can’t eliminate all risk, but even companies that didn’t get government assistance are trying to respond as best they can.”

In a well-balanced environment, executive pay programs will have the “right” level of focus on a variety of factors, including shareholder alignment, profitability, key strategic or operational performance measures, etc., as well as on ownership and retention for their best talent.

Companies should also look at establishing “multiple-measure incentive plans,” rather than on plans which base incentives on a single goal, such as profits.

“It is more difficult to succeed on several measures than just one and is less likely that the individual can manipulate or skew the outcome of any one and be rewarded,” said Godwin.

Compensation Restoration:  Fact or Fiction
 

In response to the recession, a number of companies found that executive pay cuts and overall pay freezes were a sound way to reduce spending.  However, a recent report by Equilar, an executive-compensation research firm, asserts that a number of firms that cut executive salaries in 2008 or 2009 are in the process of reinstating them.

However, the practice is still not wide-spread enough to be considered a true trend.  Rather, it is a situational decision based on a company’s viability.

“You should expect to see it as the economy improves.  But because the economy is not great and we still have 10% unemployment, businesses are not thriving,” said Godwin.  “They’re getting better, but not thriving.  So [compensation] depends on the individual circumstances.”

Hay Group’s Wise concurs: “As the economy recovers, we do expect some of the companies to restore pay that may have been taken away last year.  Companies made cuts for different reasons—some cut cash compensation due to affordability concerns, while others cut equity compensation due to significantly lower share values and constraints on share availability.”

In both cases, a recovering economy should result in a reversal over time.

Financial Industry Spotlight
 

For companies receiving TARP and other federal assistance, increased scrutiny was to be expected.  With all actions requiring disclosure, and that disclosure being examined by a growing number of people, these companies have become a primary target of compensation observation.

At the center of the firestorm of public scrutiny were financial services firms, where the financial impact of a poorly designed incentive plan carried the highest risk.  That is because these are the types of businesses where a single trader or small group of traders can make decisions that in a worst-case scenario could bring down the entire organization and impact millions of people.

Bank holding companies in particular were singled out for hefty criticism because of the overwhelming percentage of revenues paid out in the form of compensation.  On top of this, post-bailout, these companies still found the funds to pay out huge bonuses.

“In the wake of the TARP bailout, taxpayers and Main Street constituents became enraged that the banks still paid out bonuses that, on a per-person basis, were larger than the average Main Streeter takes home over the course of several years,” said Wise.  “Bonuses, a hefty portion of which is considered deferred salary in the banks, are under substantial scrutiny, and we are now seeing these organizations adopt significant changes to their compensation practices.

“What’s more, many of the executive pay restrictions imposed by those banks participating in TARP may be models of executive pay restrictions that may one day apply to all public companies.  As a result, all eyes are on Wall Street for good reason,” he added.

But it’s not just financial services organizations that are under fire.  Companies like General Motors, which also received federal assistance, and public companies that are subjected to disclosure regulations are also being scrutinized more closely than ever before in terms of executive compensation packages.

Despite what may appear to some to be wide-spread compensation shenanigans, Godwin emphasizes that pay decisions at most public companies are made by compensation committees that are very concerned with protecting the best interests of the shareholders and the company.

“Members of those committees are and have been very concerned about making good decisions.  They have been very cautious about how much they pay.  When making decisions to the extent they have a choice between one alternative and another, they are tending to err on what they perceive as the conservative side,” he said.  “People agonize over these decisions.  They tend to be conservative, which I would hope would be reassuring to the critics.  They’re being very careful and that’s not always understood by some people.  There is no rubber stamping of compensation in board rooms these days.”

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