Designing Executive Compensation Plans

April 3, 2017
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Scope—This article discusses considerations related to designing compensation plans for executives. It discusses the primary design elements, practical issues and compliance with federal laws.

Overview

Incentivizing executives to meet business objectives is a critical factor in designing executive compensation plans. Organizations can choose from several well-established methods to pay for the performance of executives, often with significant tax advantages to the executive and the employer.

It has become increasingly more important to ensure that the public and elected officials can readily grasp the reasonableness of executive compensation plans—especially in public corporations. Over the past decade, executive compensation plans have come under significant regulatory and political attack.

Seemingly lavish executive compensation garners high-voltage attention in print, TV and Internet media. The public often does not understand that executive compensation is a matter of meeting, and beating, global competition to attract the best and brightest executive talent. See CEOs Vastly Overpaid, Most Americans Say.

At the same time, executive compensation plans have abused both public funds and the interests of private shareholders. Directors of corporations, C-suite executives, division managers and HR professionals struggle with how to design the right type of executive compensation plans to meet corporate goals and still appear reasonable to a public that does not understand the complexities and market challenges of the job.

Given this legal, social and political environment, a straightforward and well-balanced assessment of key design issues is critical for HR professionals. See Corporate Directors Focusing on Executive Compensation and Viewpoint: Making Executive Pay Work.

A sound executive compensation program depends on good governance and well-established compensation philosophies, policies and practices that are closely aligned with the organization's overall goals and objectives.

Expanding the executive compensation package beyond a base salary and an annual cash incentive plan involves a number of accounting, tax, regulatory, cost and documentation issues. When considering the range of alternatives, employers should seek the advice and counsel of knowledgeable legal, technical and consulting professionals.

HR's Role

Within the realm of human resource management, the field of compensation and benefits has emerged as an area of specialization. As with other professions, specialization has proved to be a pathway to financial success for HR professionals. See HR Compensation: It Pays to Specialize.

The role of HR with regard to designing and managing an executive compensation program is varied. The most basic role an HR professional plays is being in a position to inform management of the benefits, costs and array of options in launching or improving an executive compensation program. This responsibility also includes assessing the adequacy of the technology being used in the incentive compensation program.

HR professionals are key in determining what in-house and outside expertise is necessary and sufficient to handle an executive compensation program. Almost every organization needs some degree of outside expertise for the design and management of an effective executive compensation program.

Communications

Communication is one of the most important and common roles of HR professionals with respect to executive compensation programs, and it is a key component for success. Communications take place with other compensation professionals, the executives at issue, the board of directors, and possibly the media and governmental agencies.

The failure of many executive compensation programs can be linked to failures in the communication process, such as the following:

  • Failure to obtain employee input in programs that will actually incentivize executive performance.
  • Failure to clearly define performance goals up front.
  • Failure to state performance goals that are within the scope of influence of the target employee.
  • Changing performance standards midstream.
  • Judging employee performance according to standards that were not stated in written documentation.
  • Providing job descriptions that do not reflect the goals set forth in the executive compensation plan.

Effective communication can also avert employee perceptions of unfair executive pay. Having a clearly communicated compensation philosophy that addresses the company's executive compensation strategy can be beneficial.

The U.S. Securities and Exchange Commission (SEC) issued a rule requiring U.S.-based publicly traded companies to disclose how median employee pay compares with CEO compensation. Employers must reveal this information for their first fiscal year beginning on or after Jan. 1, 2017. After that, they must identify the median worker wage once every three years—or more frequently if their workforce or pay arrangements significantly change. See How to Counter Employee Perceptions of Income Inequality and 'My Pay Isn't Fair,' Nearly Half the Workforce Thinks.

Metrics

As with any effort to improve organizational performance, metrics are key. Organizations spend a lot of time on executive compensation plans, so they should make sure they are getting their money's worth. The metrics should establish a baseline of where the organization is before the changes are applied and measure the results with the same methodology at the end of a specific time period. See The Compensation Scorecard: What Gets Measured Gets Done and CEOs and Directors Disagree on Performance Metrics.

Technology

Enterprise incentive management (EIM) and incentive compensation management (ICM) technology are categories of software and services for automating variable-pay processes, which can be powerful behavior modification tools and further HR's role as a valued business partner. This technology analyzes, tracks and pays bonuses, commissions and other types of variable compensation. It collates data from various systems to provide management with a comprehensive picture of payout versus performance, and it does so more efficiently than unwieldy manual entry systems. Automation makes it possible to rapidly generate and analyze compensation reports more efficiently than manually digging through numerous files to find and compile figures.  

Plan Design

Designing an effective executive compensation plan requires organizations to balance shareholder alignment, performance-based pay, recruitment and retention, and the assessment of cost versus perceived value. A long-term compensation plan with performance-based incentive vehicles can help achieve that balance.

Executives are privy to a wide range of compensation arrangements. Executive compensation arrangements may include several employees, or they may consist of individual agreements between the organization and one executive. According to the Center on Executive Compensation, "Executive pay arrangements typically consist of six distinct compensation components: salary, annual incentives, long-term incentives, benefits, perquisites and severance/change-in-control agreements."1 See High-Performing Companies Pay Executives Differently.

The following are some of the latest trends in executive compensation:

  • A higher percentage of executive pay is now linked to performance, based on measures such as income, profit and cash flow.
  • Pay incentives are more focused on long-term results. 2013 marked the first time long-term incentives became the single heaviest component in CEO pay packages, according to Hay Group.2 Long-term incentives like stock options now make up about 61 percent of total direct compensation.
  • Companies have cut back on perquisites for executives, especially the types most likely to raise shareholder ire—such as cushy severance packages, tax gross-ups on golden parachutes, spousal travel, cars and security. Personal jets remain the most popular perk, though, and haven't lost ground, Hay Group says.3

See Job-Changing Executives Saw Big Pay Increases Last Year and CEO-to-Worker Pay Disparity Increases.

Recently, politicians and the media have made a case that prevailing executive compensation practices drive employees to take short-term risks with little consideration for long-term effects on the organization and the overall economy. Regulatory proposals have suggested that employers offer more pay through restricted stock or other forms of long-term incentives designed not to reward short-term performance. Researchers from Washington University in St. Louis reviewed data from filings of more than 700 large publicly traded firms in the U.S. and found that a large number of firms manipulate data to meet short-term targets. While the research did not find evidence of fraud or illegal activity, it does question whether these firms are acting in the best interest of shareholders in the long term.4

Total compensation strategy

Each element of an executive compensation plan contains various degrees of accounting, tax and regulatory considerations. Organizations need to develop a strategy for how they will use each of these elements. The total compensation strategy should address all the elements of the executive compensation plan.

See:

When determining the appropriate compensation strategy, employers should consider the following organizational factors:

  • Business philosophy, mission and vision.
  • Business plan or strategy.
  • Life cycle, organizational structure and business processes.
  • Workforce composition and demographics.
  • Tax and accounting regulations.
  • Industry and competition.

An organization's business philosophy encompasses its basic values and beliefs and defines the environment in which a total compensation strategy is to be administered. Mission and vision statements normally set the employer's culture and philosophy as well as its total compensation strategy. Similarly, the organization's business plan outlines the executives' key performance measures and total compensation plan.

The total compensation strategy should also address benefits such as health care, retirement, life and disability insurance, and capital accumulation plans. These types of benefits, unlike vacation, holiday and paid-time-off plans, are directly affected by changes in business conditions, which in turn affect the organization's total compensation strategy.

Compensation rates and trends among comparable organizations are important factors in determining the direct and indirect pay that organizations may provide an executive.

See Five Executive Pay Challenges and Responses.

Direct compensation

After reviewing and determining the factors associated with the total compensation strategy, employers typically identify target amounts for each element of the executive compensation plan and express them as a percentage of base salary.

For many jobs in an organization, base pay rates are heavily influenced by compensation trends in the local or regional labor market. For executive-level jobs, the direct pay criteria are predominantly the type of industry and the size of the organization as measured by sales revenue or assets. See Executive Pay: How Much Is Too Much? and SHRM Compensation Data Center.

Annual incentives and bonuses

Annual incentives and bonuses are common ways to provide incentive compensation to corporate executives. Bonuses may be paid as a fixed amount or as a percentage of sales or profits. Generally organizations base annual bonuses on a predetermined percentage of profits.

Within the specialty of compensation, incentive compensation has grown in importance as organizations continue to refine their methods of paying for performance. Executive compensation has increasingly come under the pay-for-performance methodology. Performance-based cash bonuses are used by organizations as a source of motivation for executives to reach both organizational and individual goals. See Top Executives Earn Performance Bonuses Despite 'Tepid Growth' and Mid-Market Executive Pay Shows Momentum.

Bonus percentages can vary widely depending on the industry, on an organization's view of the at-risk element of direct pay, on a job's level in the organizational structure, on numerous combinations of the priorities and objectives of the overall organization or a specific unit or department, and on an individual's job performance.

Long-term incentives

Long-term incentive plans are another distinctive element of many executive pay packages. These plans typically have performance measurement periods of three years or more and are provided to select top managers whose decisions and actions have a direct impact on the performance and success of the entire organization. See CEO Pay Mix Is Changing, Emphasizing Long-Term Incentives.

The most common form of long-term incentive arrangement among organizations with publicly traded stock is the nonqualified stock option. With this type of incentive, participants are granted a right or option to purchase stock from the company at a specific price—usually the fair market value of the stock when the option is granted.

The option to purchase shares continues over an extended period that is measured in years. Presumably, sustained good performance by the organization will lead to a higher market price for the shares when they are sold at a future time. The executive can realize a monetary gain by exercising the option to purchase shares at a lower price and concurrently or at a later date sell the shares at a higher market value. Of course, if the market price of the stock falls below the price paid by the executive at the time the option is granted, the opportunity for compensation under the plan is nullified. If a stock option will not return a profit for reasons beyond control of the executive (for example, a natural disaster, terrorism or a scandal involving a different executive), then the incentive value is lost and the executive may lose motivation to perform in his or her area of responsibility; in fact, the executive may be motivated to seek more favorable compensation elsewhere. See Do Stock Options Work as an Employee Incentive? and Apply Long-Term Incentive Plans at Private Firms.

Stock plans

Incentive stock options and restricted stock grants are two other forms of longer-term incentive plans employers use to give executives an opportunity for significant additional compensation. 

Each plan has different eligibility, grant size or company and personal tax implications. The plans may be used alone or in combination with nonqualified stock options.

Organizations that do not have publicly traded stock may provide executives with longer-term compensation plans by using other types of organizational performance measures. These can include phantom stock arrangements, wherein the value of a hypothetical stock unit that may be granted is linked to the book value of the organization at various points in time, or the appreciation in the value of a hypothetical unit is determined with a precise formula.

See:

Perquisites/benefits plans

Executive compensation packages frequently include a number of indirect pay or noncash privileges called perquisites or perks. Employers have long used special perks and fringe benefits to attract, reward and improve the productivity of executives. These perks are generally noncash fringe benefits that provide an immediate financial reward and are given in addition to wages, commissions or incentives.

Perks include employer-provided vehicles, paid meals and lodging, use of eating and athletic facilities, paid entertainment expenses, participation in educational reimbursement plans, free parking, vacations, country club memberships, cellphones and laptops, and much more.

Many organizations also offer executives supplemental health and welfare benefits. Some of these may be automatic and fully paid (or reimbursed) or provided by the employer. Some organizations may even make a range of choices available to the executive, either within an existing pretax payment plan provided to all employees or as a voluntary out-of-pocket, after-tax expense to be paid by the executive.

Among these types of executive benefits are the following:

  • Supplemental life insurance.
  • Split-dollar life insurance.
  • Supplemental disability insurance.
  • Long-term care insurance.
  • Job-related liability insurance.
  • Supplemental medical insurance or reimbursement.
  • Extra or special vacation day allowances or sabbatical leave of absence.

Although the use of perks has been a longstanding practice, many organizations have started cutting back on perks and fringe benefits they provide to executives as a result of increased scrutiny and government regulations.

See Some Executive Rewards Decline; Other Perks Hold Steady and Fewer Companies Offer CEOs Perks and Incentives.

Additionally, the value of all fringe benefits must be included in an employee's wages for income tax and employment tax purposes, unless they are specifically excluded or exempt from taxation. See Executive Compensation—Fringe Benefits Audit Techniques Guide.

Four categories of noncash fringe benefits can be excluded from an executive's gross income for tax compliance purposes:

  • No-additional-cost services. These are free services provided to all employees in which the employer incurs no substantial additional cost in providing the service, and the service is normally offered to the employer's customers in the line of business.
  • Qualified employee discounts. These are discounts provided to all employees on the selling price of certain property or services in the ordinary course of the employer's business. In the case of merchandise, the discount cannot exceed the gross profit percentage of the price at which the property is offered to customers. For services, the discount may not exceed 20 percent of the price at which the service is offered to customers.
  • De minimis fringe benefits. These include property or services provided to all employees that are so minimal that accounting for them would be unreasonable or administratively impractical. See De Minimis Fringe Benefits.
  • Working condition fringe benefits. These consist of the fair market value of any property or service provided to an employee to the extent that if the employee paid for that property or service, the payment could be claimed as a business deduction. The fair market value of a working condition fringe benefit is excluded from the employee's gross income if the employee could have deducted the expense as a business expense if he or she purchased the item directly.

See Employers Tax Guide to Fringe Benefits.

Retirement plans

Plans that do not meet the guidelines required to receive favorable tax treatment are known as nonqualified plans. These plans are exempt from the restrictions placed on qualified plans and are typically used to provide additional benefits to key or highly paid employees, such as executives and officers. Nonqualified plans are not "qualified" under the Internal Revenue Code or the Employee Retirement Income Security Act (ERISA), the way 401(k) plans are, for instance, because nonqualified deferred compensation (NQDC) plans are offered only to certain highly compensated employees. That means they are exempt from most ERISA and reporting requirements; there are no caps on contributions and no minimum distribution rules. However, to ensure exemption from ERISA mandates, employers should offer the plan to no more than the top 10 percent of earners. See Nonqualified Deferred Compensation Audit Techniques Guide.

Deferred compensation

Due to the limitations imposed on qualified plans, such as 401(k) plans, under the Internal Revenue Code and Employee Retirement Income Security Act (ERISA), executives are often not given the opportunity to fully participate in an employer's tax-deferred savings plans. Nonqualified plans give an organization the flexibility to design an arrangement to compensate a select group of managers and highly compensated individuals. These nonqualified plans give executives the opportunity to defer taxation of compensation and investment earnings until retirement or some future date.

NQDC plans are one of the most popular nonqualified compensation options. These plans allow executives to defer part or all of their compensation until a time in the future, thus significantly reducing their tax liability in some cases. However, for the plan to retain a tax-deferred status, it must meet the following criteria:

  • The employee is not in constructive receipt of the amount promised, which means the employee has no right to receive or turn down the benefit.
  • The employee does not receive an economic benefit from the compensation; for example, the employee cannot use the promised benefit as security for a loan.
  • A substantial risk of forfeiture must exist; that is, the executive's ownership is contingent on meeting certain conditions and goals, and ownership is forfeited if those goals or conditions are not met.

The plan usually credits interest to the deferrals, which allows executives to maximize tax-deferred growth and take their total earnings over an extended period of time. Executives can choose to defer a significant amount of their salary or bonus and write their own pre- and post-retirement options. As executives' needs change, so can the amount of deferrals and future payout arrangements.

Supplemental executive retirement plans

One example of a nonqualified benefits plan is a supplemental executive retirement plan (SERP). A SERP may be offered to meet a number of different goals, including making up benefits lost in other retirement plans. Unlike a deferred compensation plan, a SERP is generally paid solely by the employer to offset the disparity in retirement benefits between key executives and other employees. The SERP provides retirement benefits that may not be provided through the employer's regular retirement plan because the level of benefits would cause the plan to violate nondiscrimination rules or would exceed specified caps on maximum benefits or compensation that can be provided. See SERPs Sweeten Tax-Exempt's Executive Pay.

A SERP can take into account all executive income, including bonuses and other incentives that exceed the compensation dollar limit for qualified retirement plans. For organizations with defined benefit pension plans, this is an attractive solution to retention.

Rabbi trusts

Protecting the plan assets ensures that executives receive the benefit promised in case of a change of control due to mergers or acquisitions of the company. The most popular trust vehicle in use today is the rabbi trust, which is a trust established by an employer to provide a source of funds that can satisfy the employer's obligation to executives under one or more nonqualified plans. The rabbi trust is used to provide the executive with assurance that the employer will pay the promise when due. However, the assets of the trust are always subject to some risk of loss because they are subject to the claims of the employer's creditors in the event of the employer's bankruptcy or insolvency.

Golden parachutes

Golden parachutes are executive compensation arrangements under which a corporation agrees to pay amounts—often in excess of the executive's usual compensation—if the corporation undergoes a change in ownership or control. Golden parachutes are often used by employers as a defensive measure to prevent hostile takeovers under the assumption that the guarantee of additional financial benefits to executives will increase the cost of the acquisition and, thereby, discourage prospective purchasers. See 'Golden Parachute' Payments Up by 32% Over Two Years at Large Firms.

A parachute payment is any payment, in the nature of compensation, to a disqualified individual (i.e., shareholders, officers or highly compensated individuals, including corporate directors) that is contingent on a change in ownership or effective control of a corporation, or in the ownership of a substantial portion of its assets. In addition, the aggregate present value of payments in the nature of compensation must equal or exceed three times the individual's base compensation amount.

Payments that are not contingent on a change in control may still be treated as parachute payments. Payments in the nature of compensation that are made to or for the benefit of a disqualified individual, pursuant to an agreement that violates generally enforced securities laws or regulations, are subject to regulation as securities violation parachute payments.

A parachute payment can come in the form of cash or property, including the spread on the exercise of a stock option, pension proceeds, insurance or annuity proceeds and payments made pursuant to a covenant not to compete.

The golden parachute rules were expanded in 2008 to apply in the event of a severance from employment by a covered executive of an employer that participated in the U.S. Department of the Treasury's Troubled Asset Relief Program (TARP). Because of the potential for abuse that is implicit in such arrangements, excess parachute payments that exceed three times an executive's compensation are subject to tax penalties. Amounts equal to the excess of any parachute payment made over the portion of the base compensation amount allocated to the payment are considered excess parachute payments.

Excess parachute payments may not be deducted by the employer. The disqualified individual is also subject to a nondeductible excise tax (in addition to applicable state and federal income taxes and Social Security taxes) of 20 percent of the amount of the excess parachute payment. The amount of an excess parachute payment may be reduced if there is evidence that the payment was reasonable compensation for services rendered by the disqualified individual prior to a change in ownership or control.

The Internal Revenue Service (IRS) has provided a safe harbor method for valuing compensatory stock options. The following payments are exempt from treatment as parachute payments and, thus, may be deducted by the employer and do not subject the recipient to the 20 percent excise tax:

  • Payments with respect to a small domestic business corporation.
  • Payments with respect to a corporation in which, immediately before the change in ownership or control, no stock is readily tradable on an established securities market or otherwise; and payments that have been approved by more than 75 percent of the corporation's shareholders.
  • Payments to or from a qualified plan, including a tax-sheltered annuity, simplified employee pension (SEP) plan or savings incentive match plan for employees (SIMPLE).
  • Payments made by a tax-exempt organization undergoing a change in ownership or control.
  • Payments of reasonable compensation for services to be rendered on or after the change in ownership or control (including payments made pursuant to a covenant not to compete).

See IRS: Golden Parachute Payments Guide.

Compensation agreements

The various elements of direct and indirect compensation included in the pay package of an executive are often expressly outlined in a formal employment agreement that spans multiple years. See Agreement: Executive Employment Agreement.

These agreements may also include special severance pay arrangements that become effective when an involuntary termination occurs or simply when there is a change of control due to a merger or acquisition.

Some employers also establish formal plans for deferring current compensation to a point in time when an executive's marginal tax rate may be lower. In addition, it is not uncommon for executive pay packages to include one or more (nonqualified) deferred compensation plans specifically designed to provide retirement income that, in effect, makes up for benefits payments that would have been available from any qualified (ERISA) plan or plans provided to all employees, were it not for a number of regulatory limitations on contribution, covered compensation and maximum benefit amounts. In some organizations, for example, other deferred plans are instituted simply to provide supplemental retirement income for a select group of highly paid personnel as an incentive to encourage prospective midcareer executives to join an organization.

Golden handcuffs

Although definitions vary, the general idea of golden handcuffs is to cause financial hardship to senior managers and executives if they leave the organization before the organization wants them to leave. A golden handcuff is a benefit, payment or incentive linked to the recipient staying for a specified period of time.

There are many ways financially to bind an employee to an organization, such as requiring the employee to reimburse the company for a hiring bonus or for education or relocation expenses if the employee leaves for a new job within a one- to three-year period. Golden handcuffs may do little to retain very wealthy executives who can easily shrug off the financial hit.

To bring home the consequences of leaving early on highly compensated executives, employers can use various kinds of NQDC plans. Typically these are set up as 401(k) mirror accounts. To executives, it seems just like a 401(k) account, allowing them to put aside some of their own salary, with a match, to be paid out either at retirement or at some point in the future. This approach gives highly compensated executives flexibility to invest money for retirement without immediate tax consequences. Another similar tactic is to provide a supplemental employee retirement plan that acts like a pension—as long as the employee makes it to retirement with the organization. The major disadvantage of retirement-based handcuffs is that they may be far less effective with younger executives.

Stock options with a vesting period are another common retention tool. Typical vesting periods range from one to three years and often include some kind of rolling schedule. As executives become fully vested and can exercise options, they pick up other options with a new, later vesting period.

Employers may also offer split-dollar insurance plans. Some executives have large estates that will be subject to hefty estate taxes when they die. To address this concern, some organizations pay for life insurance policies, the proceeds of which will be paid to family trusts, free of estate taxes, after the executive dies. An executive who leaves the company before death or retirement loses that insurance. When considering split-dollar insurance, it is imperative to review the details carefully, keeping in mind that premiums may not be deductible by either the employee or the employer.

Compliance Issues

Compliance with the many legislative and regulatory requirements surrounding executive compensation and NQDC plans is critical to avoid sanctions, fines and potential disqualification of the plans themselves.

Over the past several years, Congress and other governmental agencies have made significant changes to the rules governing executive compensation and NQDC plans.

Employers that maintain NQDC plans for executives must be aware of these rules, which require that many of these plans be amended periodically. Additionally, employers must address new tax reporting rules, disclosure statements and proxy statements.

SEC rules

At the federal level, the SEC defines what executive pay items must be disclosed to shareholders or filed with the SEC. The SEC also has oversight responsibility for financial accounting, which is currently more directly controlled by the Financial Accounting Standards Board (FASB), a privately funded organization that promulgates rules on financial accounting to be followed by organizations and independent financial auditors.

The SEC requires in-depth disclosure of executive compensation, pursuant to rules that are designed to accomplish the following:

  • Provide shareholders with a clear and concise report of all the compensation paid to an organization's principal executive officer, principal financial officer, highest-paid executive officers and directors.
  • Clarify and explain the reasoning underlying fundamental compensation decisions.

The U.S. Securities Act, the Securities Exchange Act and the Investment Company Act require certain companies to file public disclosures with the SEC.

See:

In a section called Compensation Discussion and Analysis, the SEC requires detailed disclosure of three categories of executive compensation:

  • Compensation with respect to the past fiscal year, as reported in a Summary Compensation Table that reflects current and deferred compensation and compensation composed of current earnings or awards provided under the plan.
  • Holdings of equity-related interests that pertain to compensation or are potential sources of future gain.
  • Retirement and other post-employment compensation, including retirement and deferred compensation plans, other retirement benefits, and post-employment benefits.

An employer must disclose compensation policies for nonexecutive officers if the policies create risks that are reasonably likely to have a material adverse effect on the company.

In disclosing executive compensation, organizations (other than small business issuers) are initially required to provide a narrative overview of the compensation program maintained for named executive officers. The Compensation Discussion and Analysis must address all material elements of the organization's compensation arrangements, including the following:

  • The objectives of the company's compensation program and what the program is designed to reward.
  • Each element of compensation.
  • How the employer chooses to pay each element of compensation.
  • How the employer determines the amount for each element.
  • How the element of compensation and the organization's decisions regarding that element fit into its overall compensation strategies and affect decisions regarding other elements of compensation.

The SEC adopted a final rule mandated by Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act that requires a public company to disclose the ratio of the compensation of its CEO to the median compensation of its employees. The rule provides shareholders with information they can use to evaluate a CEO's compensation and requires disclosure of the pay ratio in registration statements, proxy and information statements, and annual reports that call for executive compensation disclosure. Companies are required to provide disclosure of their pay ratios for their first fiscal year beginning on or after Jan. 1, 2017. The rule does not apply to smaller reporting companies, emerging growth companies, foreign private issuers, multijurisdictional disclosure system (MJDS) filers or registered investment companies. The rule does provide transition periods for new companies, companies engaging in business combinations or acquisitions and companies that cease to be smaller reporting companies or emerging growth companies. See SEC Pay-Ratio Rule Spotlights CEO Compensation and Trump Orders Dodd-Frank Review; SEC Requests Comments on CEO Pay Ratio.

In 2015, the SEC proposed the Exchange Act Rule 10D-1 that would direct national securities exchanges and national securities associations to establish listing standards requiring issuers to have policies for the recovery of erroneously awarded compensation, which are commonly referred to as "clawbacks." See In 'Clawback' Policies, Triggering Actions Vary.

Troubled Asset Relief Program (TARP)

The U.S. government created TARP to buy distressed assets from financial institutions in response to the 2008 financial crisis. The program was created through the Emergency Economic Stabilization Act of 2008 and is managed by the Office of Financial Stability at the U.S. Treasury. TARP was initially designed to buy distressed mortgage-backed securities from financial institutions, but it evolved to encompass corporate debt and inject equity into banks. Institutions that participated in this program were subject to more oversight from the government and limits on executive compensation. In Dec. 2014, Treasury announced the sale of its remaining shares in the last exceptional assistance recipient under TARP essentially ending the program. See TARP: Executive Compensation.

Sarbanes-Oxley Act

The Sarbanes-Oxley Act, also known as SOX, came into force in July 2002 and introduced major changes to the regulation of corporate governance and financial practice. SOX contains sweeping provisions relating to corporate governance and accounting reforms, executive compensation and employee benefits. See Excess Benefits: A Potential Pitfall for Nonprofit Insiders and Sarbanes Oxley 10 Years Later.

SOX contains the following provisions:

  • Public companies may not make personal loans to their directors and executive officers.
  • Insiders cannot trade in company stock during certain blackout periods.
  • Plan administrators of individual account plans like 401(k)s must give a 30-day advance notice of any blackout period.
  • CEOs and CFOs must repay certain compensation if earnings are restated.
  • Penalties are increased for ERISA violations.

Employee Retirement Insurance Security Act

A fundamental question employers must ask themselves is whether their executive compensation plans are covered by ERISA. If so, certain disclosure and reporting procedures are mandated, and administrators of the plan may be deemed "fiduciaries" subject to individual liability.

A nonelective retirement plan maintained in conjunction with a qualified retirement plan may provide for benefits under the qualified plan's formula, to the extent they cannot be provided by the qualified plan because of the limitations of §415 of the Internal Revenue Code. This plan is called an "excess benefit plan," and it is exempt from ERISA coverage. Therefore, it is a contract subject to state contract law. Any other nonelective, unfunded retirement plan that covers a select group of highly compensated employees is known as a top-hat plan and is subject to ERISA.

If an excess benefits plan is amended to provide benefits that are restricted because of the compensation limitation of §401(a)(17) of the Internal Revenue Code, the plan will become a top-hat plan because it is no longer limited to excess benefits.

Other executive compensation arrangements may be subject to ERISA enforcement if they are found to provide welfare benefits of the type covered by ERISA. Regardless of whether the arrangement provides for welfare or retirement benefits, the initial inquiry often focuses on whether the arrangement is a "plan." Given the broad scope of ERISA's definition of a plan, benefits provisions contained in employment agreements or memoranda are likely to be enforceable under ERISA.

Internal Revenue Code

Section 409A of the Internal Revenue Code defines coverage for NQDC plans. For deferral decisions to be in compliance, the election to defer must have been made in the year before the year in which services were performed, within 30 days after first becoming eligible or within six months before the end of a performance-based compensation plan of at least 12 months. See IRS Begins Section 409A Compliance Initiative.

Distributions may be made only for the following reasons:

  • Separation from service.
  • Disability.
  • Death.
  • Date specified on election date.
  • Change in company ownership.
  • Unforeseen emergency causing financial hardship (with amount limited to the amount of the emergency need).
  • Termination of the plan.

When an executive receives the deferred amount, it is taxed as ordinary income. An exception is if the deferral is shares of stock and the executive made an election in accordance with Internal Revenue Code §83b within 30 days of being informed of the award. In this situation, the executive would be taxed at the time of deferral at the current value of the stock and long-term capital gains tax on the increase in stock value when received. However, the executive forfeits the paid tax if he or she is unable to collect the deferral. Furthermore, employers are not required to allow executives to make an §83b election or even to defer income.

Global Issues

Incentive compensation programs are likely to produce a significant pay gap between persons in the program and persons outside the program, particularly in global organizations in which competition for the most qualified, internationally capable executives is fierce.

See:

Endnotes

1Center on Executive Compensation. (n.d.) Basics of executive compensation. Retrieved from http://www.execcomp.org/Basics/Basic/What-Is-Executive-Compensation

2 Lytle, T. (2013, Sept.). Agenda: Compensation linking executive pay to performance. HR Magazine. Retrieved from https://www.shrm.org/hr-today/news/hr-magazine/pages/0913-say-on-pay.aspx

3 Ibid. 

4 Washington University of St. Louis. (2016, March 23). Research reveals the dark side of CEO incentive-based pay. The Source. Retrieved from https://source.wustl.edu/2016/03/research-reveals-dark-side-ceo-incentive-based-pay/; Bennett, B., C. Bettis, R. Gopalan, and T. Milbourn. (2015, April 6). Compensation goals and firm performance. Retrieved from http://apps.olin.wustl.edu/faculty/milbourn/Performance%20Metrics.pdf


 

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News, trends and analysis, as well as breaking news alerts, to help HR professionals do their jobs better each business day.