The following blog post is one installment in a series related to board oversight of corporate culture. The National Association of Corporate Directors (NACD) announced in March that its 2017 Blue Ribbon Commission—a roster of distinguished corporate leaders and governance experts—would explore the role of the board in overseeing corporate culture. The commission will produce a report that will launch during NACD’s Global Board Leaders’ Summit Oct. 1–4.
Incentives can reward performance—and create tension and unintentional risks.
One element that helps define an organization’s culture is the set of incentives motivating employees to act. While incentives can effectively reward performance that benefits the enterprise, the compensation committee—and the board more generally—must factor in the tension and unintentional risks that incentives can create.
NACD, along with Farient Advisors, Katten Muchin Rosenman, PwC, and Sidley Austin, last fall cohosted the first-ever joint meeting between the NACD Compensation Committee Chair Advisory Council and the NACD Advisory Council on Risk Oversight. Committee chairs from Fortune 500 corporations joined governance stakeholders for an open dialogue on incentives and risk taking.
The discussion was held under a modified version of the Chatham House Rule, under which participants’ quotes are not attributed to those individuals or their organizations, excepting cohosts.
Six questions emerged that boards and compensation committees should consider:
Do we have an appropriate balance of metrics?
Are we calibrating goals and upside opportunity appropriately?
Are we considering the quality of performance?
How robust are the controls on data that is used as inputs to the compensation plan?
How are our board’s committees collaborating on developing and monitoring incentive plans?
Are we actively exercising discretion?
Below are details for three of those questions. More information is available for download in NACD’s complimentary brief, Incentives and Risk Taking.
Do we have an appropriate balance of metrics?
The Report of the NACD Blue Ribbon Commission on Performance Metrics states, “Corporate leaders must select metrics that encapsulate the company’s strategy, the balance of risk and reward, and the milestones along the way.” Management chooses appropriate metrics for the company. The board’s role is to decide if those metrics help create long-term value for shareholders—and also to ask management the right questions to ensure that risks associated with compensation plan incentives are being mitigated.
“Our responsibility is to understand the business and the industry,” said one director at the meeting. “The more we understand the business, the more [any] red flags will become apparent.” Meeting participants added that just as there is no silver bullet or single perfect metric to use when developing incentive plans, there is no one-size-fits-all approach to finding a satisfactory balance of metrics.
“There’s no perfect performance measure because every one of them can be gamed either deliberately or not deliberately,” said Dayna Harris, vice president at Farient Advisors. “In addition, it’s important to factor in trade-offs—for example, between metrics related to earnings and those related to revenue or returns—in order to get a combination that works.”
Thomas J. Kim, partner at Sidley Austin, said, “Performance metrics for compensation should be consistent with how management and the board think and talk about the business, both internally and externally. Qualitative metrics are generally more appropriate for, and tailored to, specific individuals, rather than for management as a whole.”
Are we calibrating goals and upside opportunity appropriately?
In addition to selecting performance measures, compensation committees must ensure the pay plan keeps the firm’s risk appetite in mind. The goal is to avoid unintended consequences that might compromise the enterprise’s reputation or its long-term viability. At one council delegate’s company, “the chief risk officer does a risk analysis of the executive compensation plans and shares it with the board. We can assess where it nets out on the risk spectrum. The analysis is repeated at the end of the year to look at incentive payouts and whether any business area took undue risks.”
Participants highlighted two areas for compensation committees and boards to consider:
Incentive thresholds. “Stretch goals are great and often important to strategy execution. But the board needs to ask whether high incentive thresholds may encourage bad behavior,” one participant said.
Slope-of-the-payout curve. Harris advised, “Make sure the upside [payout] opportunity is not excessive, especially for annual incentives. Three hundred to four hundred percent payout ranges can be dangerous.”
Are we considering the quality of performance?
Council delegates also emphasized that it is essential for compensation committees—and, indeed, for all board members—to ask probing questions about the way in which management achieves results, not just whether or not a particular performance target has been met: “How you get there makes all the difference: we have to look at the quality of earnings,” one delegate said. “If our incentive plan is heavily weighted toward rewarding revenue, did we end up with a bunch of low-margin or bad deals?”
One compensation committee chair reported, “To make sure that our results are sustainable, we’ve introduced strong metrics around employee satisfaction and engagement, along with customer satisfaction. These can count for as much as 25 percent of the CEO’s annual bonus.”
Questions about the quality of performance have risen to the top of many boards’ agendas in the wake of criticism over the consequences of aggressive incentive plans at companies such as Wells Fargo and Mylan. Reflecting on what has been publicly reported about these two situations, participants identified the following takeaways for directors:
Exercising skepticism is essential in times of good performance—when it is often most difficult to do. “It can be hard for directors to push back when they’re in the boardroom of a high-functioning organization and hearing lots of great stories from management,” observed one participant. Several delegates pointed out that executive sessions can be particularly useful in this regard.
Question over-performance as closely as underperformance. “If it looks too good to be true, it probably is,” a director said. “Wells Fargo’s cross-selling numbers were significantly above industry standard. As directors, we need to look very closely at outlier-level performance—it might be a red flag.”
Reputation risk can be material, even when financial losses are relatively small.
By incorporating into board discussions the above-listed questions, directors can strengthen responsible oversight of incentives. “It’s our responsibility as directors to understand the business and the industry in depth—trends, competitors, pricing models,” one director said. “That gives us a much deeper understanding about what is possible and what we’re asking management to do when we set goals and targets. It will also help us see potential risks and red flags much earlier.”
While the essentials of director pay remain steady, interesting changes are happening at the margins. Review the findings of the forthcoming Pearl Meyer/NACD 2016–2017 Director Compensation Report in this condensed article from the March/April edition of NACD Directorship magazine. Members may read the full article, including charts, here.
Continued slow growth in what boards pay their members suggests that “director compensation is evolutionary, not revolutionary,” said Jannice L. Koors, managing director at compensation consulting firm Pearl Meyer and head of the firm’s Chicago office. Director pay has, in other words, changed little over time.
Data from the Pearl Meyer/NACD 2016-2017 Director Compensation Report show that median director pay at public companies increased by 3 percent over the previous year. That brings median total compensation for individual directors to $191,440 for all firms, from micro-sized to the top 200 public companies. Median pay across all companies studied in the previous year’s report was $186,610.
While the report found no about-faces or surprises in overall median director compensation, a closer look at what is happening in the margins reveals continued evolution.
Pay Growth Aligns With the Stock Market
Directors have seen steady increases in pay in recent years as the stock market has continued to recover from the 2008 global financial crisis. The link between director pay and the stock market has strengthened as boards have offered directors less cash and more equity.
When Pearl Meyer published its inaugural director compensation report with the NACD in 1999, less than 25 percent of the largest 200 public companies in the United States included stock in their director compensation plans. That percentage had grown to 50 percent by 2002. In this year’s survey, 93 percent of the companies indicated they include some type of equity in their mix of director pay.
Changes in the Political and Regulatory Environments
The political and regulatory environments can stimulate strong performance among companies traded on the U.S. stock exchanges. Attempts to forecast what the next few years will look like for corporations prove difficult.
The director compensation report notes that President Trump’s administration and a Republican-controlled Congress could adopt protectionist policies that would likely refocus business activity on the United States and away from some international trading partners.
The president’s promises to help businesses by deregulating, however, have produced some level of optimism in corporate America. JPMorgan Chase & Co. in February published results of an online survey showing that more than 75 percent of middle-market business executives expect the policies of the Trump administration and the Republican-controlled Congress to positively affect their businesses because of expected tax reform and fewer regulations.
Koors noted that the current administration feeds the populist sentiment. That environment could call into question how year-over-year growth in director pay aligns with—or outpaces—employee pay increases. “There will continue to be a focus on income inequality and pay gaps,” said Koors. “Even if there’s not regulation around it, boards will continue to have to be sensitive to the broader stakeholder groups, not just the shareholders.”
Committee Pay and Workload
Seventy percent of companies surveyed for the report provide retainers or meeting fees to directors serving as members of a standing committee. However, pay differs depending on which committee the director serves.
Koors said that committees whose workload grew as a result of more regulation have tended to see increases in pay for members. When Enron’s corporate failure led Congress to pass the Sarbanes-Oxley Act of 2002, for example, the law’s regulations to protect shareholders from fraudulent accounting by corporate leaders meant greater oversight responsibilities for the audit committee.
This year’s director compensation report shows that, across all firms, audit committee members earn a median of $7,500 above their base pay for board service, while audit committee chairs drew $20,000.
Similarly, passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act took aim at executive compensation, and subsequent rules, such as say on pay, led to greater responsibilities for—and attention on—the compensation committee. Increased attention on high CEO pay and disclosures meant to improve pay transparency have also translated into more work for compensation committees, and more work should mean higher pay.
Median retainers and meeting fees for compensation committee members, above their standard director pay, totaled $5,000 across all firms, according to the report. Compensation committee chairs earned $15,000 for their service.
Koors added that heightened attention on issues such as increasing board diversity and improving succession planning could presage a workload increase for nominating and governance committees. Members of that committee received a median of $2,500 above their standard pay for board service across all firms, while chairs received $10,500, the report noted.
“Have we reached the point where every committee has an increased workload? Do we go back to pre–Sarbanes-Oxley [when all committee service resulted in the same level of extra pay]? We started to see a little of that in the data, but the most prevalent practice is still differentiation in pay,” Koors said.
Connecting Director Pay to Board Turnover
In addition to director compensation adapting to the political and regulatory environment, the report notes that director pay could be used as a mechanism to spur board turnover.
The 2016–2017 NACD Public Company Governance Surveyfinds that board turnover slowed last year, with just 67 percent of respondents indicating that their boards had added at least one new director in the past 12 months. That was down from the prior year.
Most boards deliver the biggest portion of pay to directors as equity. But many boards model their director compensation plans on those of executives, which seek to retain senior managers.
Many director compensation plans are similarly set up so that a director forfeits any unvested equity if he or she retires earlier than expected. Common practice is for directors’ equity grants to vest immediately or after one year, the director compensation report states, but companies with vesting periods longer than one year could inadvertently encourage directors to stay on a board for which their skills are no longer applicable in order to avoid forfeiting unvested equity.
“Make sure your director-award provisions allow the director to divest equity at the time of retirement,” Koors said. Doing so could help the company adapt to changing expectations around board turnover.
This spring, as usual, most pay-related resolutions in proxy statements will be from corporations seeking shareholder approval of pay packages for named executives. But not all the pay votes will implement this now-familiar “say on pay,” where shareholders look back at the past year’s compensation plan to give thumbs up or down. More shareholders will be proposing their own pay concepts for a vote this season—and many of these proposals will reflect shareholder’s growing interest in social issues.
Who Needs Dodd-Frank?
Click to enlarge.
Directors in 2017 may see a new kind of resolution meant to re-assert any Dodd-Frank pay rules that get stalled or repealed this year. As reported in detail in the January/February 2017 issue of NACD Directorship magazine, President Trump may use executive orders to delay or undo Dodd-Frank, and Congress may revive a number of bills to repeal Dodd-Frank, including the parts of the law focused on executive pay. As expected, the president on February 3 issued an executive order outlining core principles that should guide the rollback of Dodd-Frank era regulations. As a result of this potential pullback on pay rule-making, companies may see shareholder resolutions mandating what those rules would have imposed, e.g., mandates for stricter executive pay clawbacks or for pay-versus-performance and pay-ratio disclosures.
Not surprisingly, directors and shareholders have been talking face-to-face about pay in preparation for this season. The 2016–2017 NACD Public Company Governance Survey reveals some interesting trends. In 2016, 48 percent of respondents indicated that a representative of their board had held a meeting with institutional investors over the past 12 months, compared to 41 percent in 2015. The most common discussion topics at those meetings were executive pay and CEO performance metrics and goals. Another common topic was “specific shareholder proposals,” which no doubt included the range of causes noted in our recent post predicting a rise in socially-minded proxy resolutions.
For many companies, measurement of performance includes social goals. In 2016, 80 percent of respondents to the NACD survey indicated that they consider non-financial metrics when evaluating executive performance to determine executive compensation. The metrics they use include, in descending order from 37 percent to 8 percent, the following:
Maintaining good standing with regulators;
Sustainability-related measures, and;
Many of these performance metrics could be considered “social” aspects of pay.
Executive Pay Proposals at Apple, Walgreens Boots Alliance
The 2017 proxy at Walgreens Boots Alliance (WBA) reveals that Clean Yield Asset Management proposed that WBA issue a report linking sustainability metrics to executive pay. The proposal asks the board compensation committee to prepare a report “assessing the feasibility of integrating sustainability metrics into the performance measures of senior executives,” and defines sustainability as “how environmental and social considerations, and related financial impacts, are integrated into corporate strategy over the long term.” The company recommends a vote against this proposal, highlighting its achievements in the field of sustainability, and concluding that preparing this report would not be a productive use of company resources.
On another note, Apple’s 2017 proxy statement contains two shareholder resolutions on pay—one focusing on increasing the requirements for stock ownership, and one that takes a more social turn. In proposal 8, shareholder activist Jing Zhao brings into the current season an economic concern voiced by a significant number of shareholders across several companies in 2016, when the 250 largest companies saw 38 shareholder-sponsored proposals on pay. While the subjects of these proposals varied, most of the 2016 proposals alluded, in one way or the other, to compensation practice reform.
Zhao’s current resolution proposes the following: “Resolved: Shareholders recommend that Apple Inc. engage multiple outside independent experts or resources from the general public to reform its executive compensation principles and practices.”
In summary, Zhao’s proposal takes aim at the identical nature of the senior executive pay below the CEO, and questions the need of a compensation consultant given such conformity. But the supporting details reveal that the proposal is not really about how many advisors Apple engages. Rather, it is about income inequality. Zhao’s commentary goes on to address the larger picture of societal well-being. He quotes Thomas Piketty, arguing that income inequality “has contributed to the nation’s financial instability,” and tracing this inequality to “the emergence of extremely high remunerations at the summit of the wage hierarchy.” (Capital in the Twenty-First Century, Harvard University Press, 2014, pp. 297-298, reviewed here in NACD Directorship).
The response from Apple management addresses the proposal itself rather than the surrounding complaint. Apple’s executive officers “are expected to operate as a high-performing team; and we believe that generally awarding the same base salary, annual cash incentive, and long-term equity awards to each of our executive officers, other than the CEO, successfully supports this goal.”
The Sleeper Issue: Director Pay
The sleeper issue this year may be director pay. The 2015-2016 Director Compensation Report, authored by Pearl Meyer and published by NACD, showed only a modest rise in director pay, and predicted the same for 2017. Nonetheless, director pay is becoming a hot issue for shareholders.
Consider the new guidelines from the leading proxy advisory firm, Institutional Shareholder Services (ISS), which serves some 60 percent of the proxy advisory market. Proxy voting guidelines of ISS and Glass, Lewis & Co. contain updates to discourage perceived director overboarding—and compensation does not follow far behind. It is notable that ISS amended its proxy voting guidelines, effective February 1, 2017, to include director pay. The ISS voting changes also include changes to ISS policies on equity-based pay and other incentives, as well as amendments to cash and equity plans, such as mandatory shareholder approval for tax deductibility. But the most unexpected development was ISS’ support for “shareholder ratification of director pay programs and equity plans for non-employee directors.”
ISS says that if the equity plan is on the ballot under which non-employee director grants are made, ISS policy would assess the following qualitative factors:
The relative magnitude of director compensation as compared to similar companies;
The presence of problematic pay practices relating to director compensation;
Director stock ownership guidelines and holding requirements;
Equity award vesting schedule;
The mix of cash and equity-based compensation;
Meaningful limits on director compensation;
The availability of retirement benefits or perquisites, and;
The quality of disclosure surrounding director compensation.
These values are not new. NACD went on record supporting such concepts in our Report of the NACD Blue Ribbon Commission on Director Compensation, issued in 1995. Every year since then we have issued an annual survey on director compensation with Pearl Meyer (cited above), reinforcing these key points.
In explaining the rationale for its policy update, ISS notes that there have been several recent lawsuits regarding excessive non-employee director (NED) compensation. For a summary of these lawsuits, see the Pearl Meyer/NACD director compensation report cited above.
ISS notes activity behind the scenes re director pay. According to the proxy vote advisor, “some companies have put forth advisory proposals seeking shareholder ratification of their NED pay programs,” and further, “ISS evaluated several director pay proposals during the 2016 proxy season, and we expect to see more submitted to a shareholder vote.”
Say on Pay for Directors?
Given the new interest in director pay, might it become subject to “say on pay” in the U.S.? Such a mandate has already begun overseas. Since 2013, Switzerland has had an “Ordinance against Excessive Compensation with Respect to Listed Companies.” The law mandates annual shareholder votes on the total pay awarded in any form by the company to its directors and, in a separate vote, to its senior executives. The pay period can be retrospective (last year) or prospective (next year). So far, after an initial wildensprung of rebellion against some boards, approval ratings have been very high. The 2017 proxy season may continue this trend—or contain surprises. Given volatility in the global economy, and in shareholder sentiment, it is wise to avoid complacency.