C-level executives may encounter roadblocks to higher compensation this year as new federal regulations take effect that tie executive compensation disclosures to a company's overall success over a fixed five-year timetable.
Those roadblocks primarily stem from the U.S. Securities and Exchange Commission's (SEC's) pay-versus-performance disclosure requirements, which are effective for the 2023 proxy season. The new rules could change how U.S. companies handle C-level executive compensation.
The SEC's new rules, published in August, require companies to disclose in a clear manner the relationship between executive compensation and financial performance (i.e., how incentive pay and other benefits were calculated).
Then in October, the SEC unveiled its long-anticipated rules on the recovery of erroneously awarded incentive-based compensation (commonly referred to as a clawback).
"These are the rules that will affect executive compensation and require HR departments and board compensation committees to take action," said Susan Divers, director of thought leadership at LRN Corp. She said that in issuing these rules, the SEC is clearly targeting executive compensation that was erroneously paid to company executives for clawback.
"The rules require a listed company to recover from its executive officers any incentive-based compensation received as a result of erroneous financial results during a three-year look-back period whenever the listed company is required to prepare an 'accounting restatement,'" Divers said.
HR's Action Plan for Compliance
HR directors can prepare for the new SEC rules by leading compensation-related conversations through the lens of maintaining integrity and living out the company's values.
"Pay equity and C-executive pay regulation is about … ensuring that all employees benefit from a company's successes," said Josh Saterman, CEO of Saterman Connect, an executive coaching firm in New York City.
To meet that balance of performance and ethical standards at the C-level, HR executives must start with a clear action plan.
"Human resources executives should already be well on their way in preparing test calculations and drafting recommended guidance on the required disclosure and where to incorporate in next year's proxy statement," said Ian Keas, managing partner at Zayla Partners, an executive compensation firm in Denver. "HR should be working with the various functions across the company to ensure preparations are made in a timely manner for disclosures."
HR execs should take these five action steps to help their companies become fully compliant with the pay-versus-performance rules:
1. Identify the "compensation actually paid" (CAP) number. HR should take the lead in coordinating efforts—especially with compensation consultants, valuation experts and legal counsel—to set an action plan for determining the CAP number, which will be disclosed on the new pay-versus-performance table.
2. Learn and educate about fair value calculations for equity and pension. HR should also lead companywide education efforts on the divisions within compensation actually paid.
"Human resources should prepare recommendations on whether voluntary pay/performance disclosures would be helpful in the storytelling of the compensation discussion and analysis, which is a required part of a company's annual proxy statement," Keas noted.
3. Prioritize the selection of financial performance metrics. HR leaders must also identify the appropriate peer group for use in establishing the performance and valuation prime (PVP) table, which lays out a company's overall performance record over a 10-year period.
"Many companies are leaning towards a qualifying index of companies rather than their self-selected compensation or performance peer groups," Keas said.
In laying out a "blueprint for pay-for-performance," HR should also prepare early drafts of the PVP table to test different relationships between conversations about performance, teaching support roles and potential company-selected measures, as well as assess if any voluntary additional measures would be helpful," Keas advised.
4. Identify and compile additional performance measures. Draft a list of other performance measures for the tabular list of the "most important" ones that must be included in the disclosure. Do this by gathering input from various departments and outside advisors.
5. Keep your board informed. Boards of directors have been hyper-engaged on recent SEC actions, especially on clawbacks.
"Company boards are expecting to be informed at year-end board meetings on how their management teams plan to comply in the coming proxy season," Keas noted.
Getting a Grip on Pay-Versus-Performance
Complying with these rules won't be easy, as companies tend to be distracted by other issues in a highly competitive business environment.
"Performance-versus-pay disclosures will get decent media coverage, especially in year one," Keas said. "But the issue could easily turn into an afterthought."
To keep the issue front and center on a sustained basis, company leaders need to stay focused on how they design and govern their executive compensation programs.
"Although there will be more details to consider once the exchanges implement the rules, the new requirements are clear enough that boards, board committees, outside advisors and management should start their review prior to the exchanges' proposals of new listing standards," Divers said.
For HR leaders, the trick is to focus on the pay-versus-performance issues that truly affect executive compensation and require HR departments and board compensation committees to take action.
"Prioritized topics should include the technical requirements for implementing the new clawback requirements and the impact on any existing clawback policies or compensation agreements," Divers said. "HR should also focus on the impact on financial reporting and restatement determinations, pay program designs such as metrics used to grant incentive-based compensation, and governance around executive compensation more broadly."
Brian O'Connell is a freelance writer based in Bucks County, Pa. A former Wall Street trader, he is the author of the books CNBC Creating Wealth (John Wiley & Sons, 2001) and The Career Survival Guide (McGraw-Hill, 2004).