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Public outcry has fostered congressional calls for reform. Where to start?
As the economy tanks and rank-and-file workers lose income, security and jobs, executive pay has again become the focal point of public anger. The pay gap between the most affluent executives and the average worker yawns wide. Last year, Standard & Poor’s (S&P) 500 chief executive officers averaged $10.5 million a year, 344 times the annual pay of typical U.S. workers. By contrast, the ratio is 22 in Britain, 20 in Canada, and 11 in Japan. Now, U.S. stakeholders are zeroing in from all sides: Shareholders are pressing for "say on pay," the president signed the American Recovery and Reinvestment Act of 2009, and regulators are setting disclosure requirements and pay limits for executives whose companies feed at the taxpayers’ trough.
It’s hard for people making $12 to $18 an hour to understand why these executives are making such outrageous numbers, says Stephanie McNeil, SPHR, human resources director for the town of Franklin, Mass.
"The publicity has made our people more skeptical," observes Steve Browne, executive director of HR at LaRosa’s Inc. in Cincinnati, a 1,400-employee pizza franchiser. "We play by rules that everyone agrees are fair. Every role has a certain value with pay based objectively on performance. When our workers see others who don’t operate that way, they find it confusing and upsetting."
HR managers are struggling to handle divisiveness and anger generated by executive pay excesses. But in the rush to judgment, don’t overlook the complex issues of risk, responsibility, effective incentives and the burden of leadership factored into executive compensation.
In 1991, grumbling about CEO pay led to reforms requiring more reporting and limits on deductibility. Now, that government intervention looks tepid: In late January, when media revealed that bankers had awarded themselves nearly $18.4 billion in bonuses as the economy was deteriorating and the government was spending billions to bail out financial institutions, President Barack Obama called their actions "shameful."
Yet the outrage has been ignited primarily by excesses on Wall Street. In 2007, for instance, Goldman Sachs Chief Executive Officer Lloyd Blanfein took home nearly $54 million in salary, perks, bonuses and other stock awards. J.P. Morgan Chase CEO James Dimon collected $30 million in cash, stock and options. When former CEO John Thain joined Merrill Lynch in late 2007, he received a $15 million signing bonus and a multiyear pay package valued from about $50 million to $120 million.
Beyond the financial industry, executive compensation consultant Bob Cartwright, SPHR, president of Intelligent Compensation LLC in Pflugerville, Texas, sees sound compensation planning by many responsible boards.
Professor of Human Relations Jay Lorsch, chairman of the Harvard Business School Global Corporate Governance Initiative in Cambridge, Mass., notes, "If a company is doing well, the amount the CEO and other executives earn is relatively small, probably 1 or 2 percent" of the annual returns to shareholders.
High-profile scandals are not representative, echoes pay consultant Gerry Miller, managing partner of DolmatConnell & Partners in Waltham, Mass. Thousands of U.S. boards and CEOs "try to do the right thing. You don’t hear about them; instead you hear about ridiculous abuses of shareholder trust."
Indeed, HR professionals across the country report that their executive comp policies encourage leaders to deliver their intended performance outcomes. In a January survey of 237 randomly selected Society for Human Resource Management (SHRM) members, 72 percent agreed or strongly agreed that their comp packages are motivating executives to excel.
Policies on pay packages are set by committees of corporate boards and then approved by the boards acting independent of company officers. That’s why boards hire consultants to advise them. Generally, the top HR person serves as a contact and resource for these committees.
Breaking Out Executive Pay
To understand the basics of executive comp, picture five buckets:
Salaries. Annual, fixed compensation without strings. Under IRS Reg. 162(m), payments to an executive that are not performance-based are tax deductible as a business expense up to $1 million. More can still be deducted if the company can demonstrate that the compensation—cash or equity—is geared to performance.
Bonuses. Variable pay based on annual performance. Usually in cash, bonuses can also be stock options or shares. Discretionary bonuses, such as money awarded to prevent an executive from jumping to a competitor, would not qualify as tax deductible.
LTI. Long-term incentives cannot be cashed in for a stipulated period. They aim to ensure that the executive will remain with the company and continue to focus on long-term sustainability. They include stock options, which are valuable only if the stock goes up over time; restricted shares, which must be held for three years or more; and restricted performance units.
Perks. Fringes may include insurance policies, financial planning and legal services, memberships, and travel allowances. They generally account for 2 percent to 3 percent of the typical pay package.
Severance. Golden parachutes open when executives exit involuntarily for reasons other than cause, usually following change in control through merger or acquisition. The provisions, negotiated in contracts or expressed as policy, apply to executives serving "at will." Typically, a CEO’s parachute might be three times annual salary and bonus; a departing vice president of human resources might get two times that, says Jim Heim, managing partner at Pearl Meyer & Partners in Southborough, Mass.
Committee members are striving to ride out the media fire-storms as CEO indiscretions generate headlines. They’re addressing perquisites that seem to have no direct business purpose and golden parachutes that greatly enrich departing leaders.
Comp committees are "protecting the core incentives: salaries, bonuses and long-term incentives [LTI], and cutting perks and severance," says Andrew Goldstein, North American co-leader of Executive Compensation Consulting at Watson Wyatt in Chicago. "The core categories are what really drive performance. For a CEO package that could go up to millions, [the public and legislators] focus on emotional things. It’s the club membership or the car that upsets them."
Who’s at the Top? Size Matters
Executive compensation policies may apply only to the CEO and all direct reports in the C-suite, or they may encompass as many as 80 executives. Actual salaries are difficult to determine because U.S. Securities and Exchange Commission (SEC) regulations only require publicly traded companies to report data on the CEO, chief financial officer and the three other highest earners. Typically, the CFO or senior vice president of human resources earns half or a third of the CEO’s rewards. For example, in 2007, large publicly traded companies such as Abbott Laboratories, Cigna, Delta Airlines Inc. and McGraw-Hill Cos. listed HR executives among their top five earners. Median annual total compensation for the top 50 highest-paid human resources managers was greater than $2 million.
Aside from Wall Street companies, where mega bonuses reach deep into organizations, most instances of excesses occur among CEOs, Goldstein says. "Have you heard anyone complain about the compensation package for the CFO or VP of HR?"
When the Numbers Are In …
Outside of finance, the highest-paid executives tend to head companies generating billions in revenue. In 2007, the 30 highest-paid CEOs received total annual compensation packages of $40 million to $322 million.
Yet when researchers with Corporate Library, an independent corporate governance group, looked at CEO pay for 2,701 U.S. companies in 2007, adding smaller companies to the mix, the median salary was $590,000 and total compensation was $2.5 million—certainly not chump change, but arguably more in line with the responsibilities corporate leaders assume.
As data filters into the SEC this spring, it should become clear that most CEOs have been scathed by the recession, too. "Executives in 2008 and 2009 will have lost tons of accumulated wealth," Goldstein predicts. "The largest part of most executive pay packages gets linked to performance via financial metrics such as increasing the company’s stock price. But last year, S&P 500 stocks averaged a 40 percent decline. Many were off by 50 percent to 75 percent, says Russell Miller, managing director of the Executive Compensation Advisors Team at Korn/Ferry International in New York. As a result, executives are likely to qualify for fewer stock options and other forms of equity. If they did receive options, they’re probably "underwater"—the share price is less than the price at which the option can be exercised.
Critics point to annual or quarterly "short-term" incentives as contributing to the reckless behavior that led to the collapse in banking and real estate. Yet most executives have the bulk of their compensation linked to performance criteria and awarded as LTI, usually across three years. In addition, many companies already require CEOs and other top executives to own and retain shares of company stock to ensure they will always have "skin in the game." Even at investment banks where employees earn huge annual bonuses, comp committees prorate payments across three years to retain talent.
A 2008 study of 417 companies with annual revenue of at least $5 billion conducted by the Hay Group with The Wall Street Journal reveals that compensation committees have been favoring LTI above all other categories of ongoing compensation. The typical allocation is salary, 18 percent; bonus, 24 percent; and LTI, 58 percent.
Most arrangements for bonuses and LTI include a threshold executives must reach to earn performance-based compensation. Meeting a target usually entitles executives to 100 percent of the bonus or LTI. Finally, there’s a maximum earned by exceeding the target.
When stock prices or company earnings are taken into account, formulas that allow executives to qualify for bonuses sometimes look like sweetheart deals. They satisfy the Internal Revenue Service’s (IRS) performance-based test, but the accomplishments to pass the threshold might not be challenging. This explains why executives can be eligible for bonuses when companies have not been successful.
Such incentive pay remains problematic for Wall Street companies benefiting from the federal Troubled Asset Relief Program (TARP). Critics argue that tax money should not be used, and they express disbelief at the almost $20 billion disbursed to executives while the institutions they head are teetering. Hence, the American Recovery and Reinvestment Act of 2009 (ARRA) applies retroactively to executives in companies that accept bailouts. It directs U.S. Treasury officials to review compensation paid to the top five senior executive officers and the next 20 most highly compensated executives to determine whether prior payments were inconsistent with the ARRA or public interest. If so, the secretary is directed to seek reimbursement.
What Happens Now?
Facing deteriorating economic conditions, 15 percent of respondents in SHRM’s January survey said their companies were planning to revise executive pay in the next 12 months. Twenty-nine percent had already done so in the past 12 months. Other studies show similar measures. Here are some changes that experts anticipate:
Salaries flat—or worse. Russell Miller says, "This year, you’ll see a 2.5 percent to 3 percent [increase], with scattered zero increases." In Pearl Meyer & Partners’ 2008 survey, respondents were more pessimistic. Thirty-six percent of companies were considering salary freezes.
Smaller LTI and bonuses. The bulk of 2009 cuts will be in LTI—ranging from 10 percent to 30 percent, Goldstein says. How come? In the past, a CEO could have received $2 million in LTI grants—through stock options, performance shares and restricted stock. Now, board members have seen stock prices halved, so the same award requires twice as much stock. That dilutes the number of company shares. As a result, comp committees will limit the number of shares they pay out. Of course, they could pay LTI in cash, but they’re not sufficiently cash rich, he says.
Half the companies responding to a December 2008 Watson Wyatt survey said they would cut bonus pools 20 percent to more than 50 percent this year; 11 percent do not plan to pay bonuses.
Overall, executives will still have performance incentives, but the thresholds will be lower to make it easier to qualify. Targets and maximums are expected to remain as before. "The threshold in the past would be 85 percent to 90 percent of the goal," says Irv Becker, national practice leader for Executive Compensation at the Hay Group in Philadelphia. "This year, companies are considering lowering the thresholds by 10 percent or 20 percent."
Plans that withhold LTI for four to five years are gaining support, says Bruce Ellig, SPHR, author of The Complete Guide to Executive Compensation (McGraw-Hill, 2007).
Evolving performance criteria. Because of economic instability, comp committees wait as long as they can before setting goals for bonuses and LTI. They’re broadening financial metrics—moving beyond increases of share values, looking to earnings, cash flow or receivables control. They’re looking inward, setting performance and pay targets based on company rather than market-driven criteria. They’re comparing their performance against peer companies that reflect their industry’s conditions, according to survey data from DolmatConnell, Hay, Mercer and Watson Wyatt. Some observers remain suspicious of such comparisons. "Make independent decisions for your company based on what is right for your company in its particular situation rather than following peer-group norms," advises Gerry Miller.
Sustainability measures. Many organizations are adding measures of long-term sustainability to performance criteria. These may be listed as "personal goals" in the proxy statement. They cover aspects of performance important for a company to maintain over time—customer satisfaction, the ability to build infrastructure, retention, development of talent and succession planning, says Vicki Elliott, worldwide partner and leader of Mercer’s global financial services industry network in New York.
"The CEO can get the financial numbers by stripping out the R&D or outsourcing stuff to make return on capital numbers look better," warns Doug Carlberg, president and CEO of M2Global Technology Ltd., a worldwide supplier of microwave components in San Antonio, Texas. Carlberg and his executive team are paid in accordance with a weighted dashboard that combines financial results with incentives for gaining market share, reducing costs per product, cutting cycle times and improving customer satisfaction.
LTI portfolio adjustments. Some companies will continue to break LTI into portfolios of stock options; time-based restricted stock that can’t be cashed out for a number of years or until retirement; or stock "performance units," a form of equity granted for achieving agreed-upon goals that must withstand the test of time to receive the award. The mix a committee chooses depends on its priorities. For retention, look to time-based restricted stock; for performance, look to options, says Jim Heim, managing partner at Pearl Meyer & Partners in Southborough, Mass.
The most common portfolio contains 50 percent options and 50 percent performance-based stock coupled to pay-out dates across three years. "If the stock price doesn’t increase, the options are worthless," Becker says. "If you don’t meet your goals, you get zero."
Perks toned down—and cut. Many executives will say goodbye to health clubs, golf and jets. In its December 2008 survey, Watson Wyatt found that 21 percent of the 264 companies polled have reduced or eliminated perks or expect to. Another 10 percent were considering doing so. Under ARRA, TARP recipients’ boards must have in place a policy regarding excessive expenditures including entertainment, facility renovations, transportation, or retreats and meetings for staff training or rewards.
Regulators Explore Conflicts of Interest
Critics suggest that conflicts of interest may contribute to skyrocketing pay for chief executive officers. For example, in December 2007, the U.S. House of Representatives Committee on Oversight and Government Reform issued a report concluding that there may be conflicts of interest pushing CEO salaries higher when consulting firms provide executive compensation advice and other services to the same company.
According to the report, in 2006, at least 113 of the Fortune 250 companies received executive pay advice from consultants providing other services to the company. On average, companies paid these consultants $2.3 million for other services and less than $220,000 for executive compensation advice. The median CEO salary of the Fortune 250 companies that hired compensation consultants was 67 percent higher than the median CEO salary of companies that did not use conflicted consultants.
Representatives of large consulting firms with portfolios beyond executive compensation such as Hewitt, Mercer, Towers Perrin, Watson Wyatt and others dispute the conclusion. They insist that they have sufficient safeguards. Andrew Goldstein of Watson Wyatt in Chicago says academic studies prove executive pay is not higher when consulting firms provide executive comp consulting and other HR services.
Others voice doubt. "There are studies that find there’s no conflict, but intuitively it doesn’t make sense," says Professor Steve Balsam of Temple University, author of Executive Compensation: An Introduction to Practice and Theory (WorldatWork, 2007). "If the CEO hires you to provide recommendations, you’ll want to make that CEO happy."
"Everyone knows what’s going on," says Gerry Miller at DolmatConnell & Partners, an executive compensation consultant. "There’s no way you can be totally objective when your executive comp business is generating $150,000 and your company is getting a million from the same client for your benefits practice."
Clawbacks gain popularity. So far, almost 65 percent of publicly traded companies have voluntarily adopted clawbacks that allow them to recover money previously paid to executives under certain circumstances. Ethical or financial misconduct trigger them, but some companies, such as UBS, go further, recouping payments when deals go sour down the road. So far, few companies actually exercise clawbacks.
Clawbacks have achieved notoriety through the Sarbanes-Oxley Act (SOX) of 1992. SOX applies only to CEOs and CFOs and is limited to fraud and inaccurate financial reporting on official company documents. Under the ARRA, top executives in companies receiving government support are subject to clawbacks. Companies can clawback bonuses, retention awards or incentives paid to five senior executive officers or the next 20 most highly compensated employees based on statements of earnings, revenues, gains or other criteria later found to be materially inaccurate.
Sensible severance reforms. According to a 2007 study by Alvarez & Marsal Taxand LLC, 82 percent of the CEOs from the 200 top publicly traded U.S. companies were entitled to cash severance upon termination. The average value of the benefits a CEO received if there was a "change in control" was $38.4 million. The average for lower ranking C-suite officers was $13.2 million.
"Severance packages are coming down," predicts Goldstein. "There will be self-imposed or legislative limits on pay for failure" to perform.
Congress is leading the way. The ARRA rules prohibit TARP recipients from offering golden parachutes. And, companies are reforming policies. In a 2008 survey by Pearl Meyer & Partners, 32 percent of board directors said they were considering changing severance agreements. Forty-one percent of the respondents to SHRM’s January survey whose companies made changes in executive comp policies said golden parachutes were eliminated.
Proponents say golden parachutes protect an executive from losing his or her job for no good reason. A newly named CEO, for example, takes a risk in the first few years. But as time goes by, the situation tends to stabilize. As a result, some boards are considering offering severance in tiers—protecting the executive for the first two or three years with a healthy payout, then reducing the entitlement.
Changing ownership requirements. The rule has been to require CEOs to own stock equal to three to five times base salary; for other C-suite executives, it’s one to two times. When stock prices declined, executives were obligated to buy shares to keep the ratio in balance. Instead, comp committees are looking for long-term ways to keep executives tied in that do not require them to buy and sell stock as the market fluctuates. "You’ll be seeing less focus on the value of the shares," Heim says.
Proxies brought into compliance. When the SEC required greater disclosure requirements for the compensation discussion and analysis (CD&A) sections that are included in proxy statements, it sought to require companies to justify payments in language that the average person could comprehend. So far, compliance has been uneven. In a 2008 study, Pearl Meyer & Partners found that CD&A sections were getting longer, but not clearer.
"The SEC is not happy," Ellig says. Most CD&A sections are too complicated. In addition, some companies have held back performance criteria and goals for fear of providing intelligence to competitors. Ellig says HR executives should draft them with the advice of an attorney.
Checking for moral hazards. A moral hazard arises when an executive team receives rewards for the positive outcomes of good investments, but remains insulated from the negative consequences of bad ones. Critics blame this approach in part for Wall Street’s financial crisis.
In the ARRA, Congress has taken the lead in seeking to mitigate moral hazards. It prohibits companies that take TARP funds from providing incentives that encourage senior executive officers to take unnecessary and excessive risks.
Compensation committees are required to review incentive arrangements with company risk officers prior to approval. It is likely that this mandate will be extended in future government programs and other companies may independently see advantages of internal risk analyses as a precondition for approval of incentive pay policies, Becker predicts.
This year, compensation committees will be mindful of the need to differentiate between prudent risk and "riverboat gambling." "They’re talking about attaching strings, deferring bonus payouts for three or more years, even until retirement," says Alexander Cwirko-Godycki, research manager for executive compensation at Equilar Inc. in Redwood Shores, Calif.
Retention and Recruitment Worries
As bonuses and equity values fell and stock options sank under water, retention handcuffs linked to compensation disappeared. Directors and CEOs worry about their top talent being picked off by competitors. So far, it’s not happening, and critics contend that illusory threats of executive mobility gin up pay. "Talk to senior HR people and ask them how much voluntary turnover they’ve experienced recently," Goldstein says. "The answer is: very little."
Some 1,484 CEOs left their jobs in 2008, the most CEO turnover recorded by outplacement firm Challenger, Gray & Christmas since it began surveying in 1999. Of those, only 127, less than 9 percent, moved on to positions at other companies.
Watch Congress Warily
Under the Obama administration, Congress quickly tightened retroactive regulations on executives whose companies participate in bailouts. The ARRA amends the Emergency Economic Stabilization Act, the source of TARP compensation standards.
It’s possible such standards might be extended to federal contractors—but not so far. The Office of Management and Budget set the maximum contractual cost reimbursement for executive compensation at $612,196 in March 2008. Congress, the SEC or IRS could weigh in with regulations aimed at everyone else. For now, it looks like clawbacks, severance restrictions and deductibility may be considered for U.S. companies not taking bailouts.
The ARRA requires TARP recipients to grant shareholders non-binding say on pay. President Obama and SEC head Mary Schapiro support requiring all public companies to offer shareholders an advisory vote. Proposed legislation modeled on the United Kingdom’s say on pay law would encourage transparency and dialogue between shareholders and directors. Apart from government involvement, according to The Wall Street Journal, 16 U.S. companies currently grant or plan to grant say on pay. Among them: Aflac, Ingersoll Rand, Intel and Motorola.
Just how far the feds will go has HR practitioners concerned: "Everyone shouldn’t be painted with the same brush," insists Ramona Frazier, chief human resources officer of Inomedic Inc., a health care services company in Hampton, Va. Those who "abused their positions should be penalized. But if a company doesn’t take money from the government, it should be able to pay executives whatever it decides."
As criteria for merit awards extend beyond financial measures, HR systems and processes that identify top performers will be crucial. "You can’t afford to pay large rewards across the board. You have to be more discerning; more attention to performance management and selectivity of high performers is required," advises Elliott.
Heim agrees. "There’s a lot of pressure on HR to spot the ‘A’ players."
For HR executives who want to gain the ear of the CEO, Ellig, a 1996 chair of SHRM, sees no area in the HR portfolio more important than executive compensation.
The author is a contributing editor of HR Magazine,
a lawyer and a professor of management studies at Marist College in Poughkeepsie, N.Y.
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