Five Executive Pay Challenges and Responses

An inaugural report from the newly launched Thought Leadership Council (TLC) of Women Corporate Directors (WCD), a global membership organization, explores common missteps by corporate boards and compensation committees regarding executive pay strategy.

The report, Going Beyond Best Practices: The Role of the Board in Effectively Motivating and Rewarding Executives, was produced by TLC in association with pay consultancy Pearl Meyer and Partners.

Boards face numerous challenges and distractions when setting compensation strategy, the report argues—from the outsized influence of external groups (such as proxy advisory firms, large investors and the government) to the weighting of short-term stock gains over long-term strategy. It highlights five challenges facing boards and compensation committees, and recommends appropriate responses.

1. Reluctance to use their discretion. One of the most controversial issues for boards is the decision of whether to use the power of their discretion to overrule a compensation formula. Boards fear that this will create an issue with proxy advisory firms and shareholders.

Response: Use situational judgment. “Discretion can be the linchpin that connects the compensation program to the business and management team, leading to better alignment of pay and performance,” says the report. But these situations require that directors “show commitment and courage by standing behind tough, well-reasoned decisions until results are clear.”

2.Being handcuffed by data. The decision to set pay solely through the use of competitive market data ignores important considerations such as individual performance (especially during unusual company circumstances) and the variances in actual job duties from company to company even for nominally the same title.

Response: Target the position, pay the person. “Data should serve as only one factor in making decisions,” says the report. Other variables and individual circumstances must go into the mix.

3.Skepticism over the need for retention pay. Shareholders and other stakeholders tend to be skeptical of pay for retention, especially when the economy isn’t doing well.

Response:Retention is worth paying for. “Unwanted turnover in the senior ranks has a cost to the organization,” the report notes. This includes hard costs such as executive search fees and replacement costs for “trickle-down turnover” in reporting positions, and soft costs such as the organizational distraction that happens during a top-level change. Retention of a strong management team is as legitimate an objective for compensation design as performance.

4.Short-termism. Companies often experience short-term investors clamoring for quarterly returns, while investors claim the short tenure of executives leads to a focus on maximizing immediate results. But incentive programs that have a particularly long time horizon (e.g., 10-year stock options) may not truly incentivize, either.

Response: value creation is a marathon, not a sprint. Boards must tailor their incentive time frames to make sure they are rewarding against their business plans. While a company in start-up mode may want to weight executive compensation toward long-term equity to focus executives on a sale or initial public offering, a company in turnaround mode may want to emphasize the achievement of shorter-term goals that are necessary to corporate survival.

5.Opposing pressures on the issue of severance. Severance provisions have been greatly reduced and are more shareholder-friendly than ever, but the expectations of executives are still high, and market norms are hard to ignore. At the same time, high severance payments routinely generate negative press and shareholder anger.

Response:Stop paying for failure. “It is naive to believe that severance contracts will disappear completely,” says the report. However, it outlines possible strategies for reining in potential payouts under the most extreme circumstances, such as providing an offset for signing bonuses in the case of short-lived executives.

High Stakes for Boards

“The pressures compensation committees face are significant, often unpredictable, and very real,” explains the report. Unhappiness on the part of shareholder activists and institutional investors may “lead to negative votes from a governance group—even when portfolio managers are pleased with a company’s strategy and performance.”

“In this environment, what is required more than anything else for boards is courage,” comments Alison Winter, a director at Nordstrom and a co-founder of WCD, who is quoted in the report. “Directors need the courage to stand behind tough, well-reasoned decisions around pay, and not reflexively bend to outside pressures.”