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?
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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.
As proxy advisors and shareholders continue to focus on improving the relationship between compensation and shareholder returns, and new pay for performance rules are finalized by the U.S. Securities and Exchange Commission, it is likely that more companies will consider adapting incentives based on Total Shareholder Return (TSR) principles. Ultimately, companies need to balance shareholder value creation with executive motivation and retention when deciding whether a TSR-based incentive plan is appropriate and aligns with the company’s compensation philosophy.
If TSR is utilized in a performance-based award package, companies need to consider the following three factors: whether TSR should be measured on an absolute or relative basis, the appropriate TSR performance hurdle, and whether there will be a cap on payouts based on absolute TSR performance.
1. Absolute versus Relative TSR. Absolute TSR requires the company to set stock price targets that must be achieved to earn a payout. Establishing an absolute stock price level at the beginning of a performance period can be challenging, as a declining stock market could make goal achievement difficult to achieve, while a “buoyant” stock market could make the absolute goal relatively easy to achieve. The challenge with relative TSR is that it requires the company to select a peer group or index that is appropriate for relative TSR performance comparisons. Identifying an appropriate comparator can be particularly challenging for companies in unique markets or industries with just a few competitors.
A well-designed TSR plan might provide that when a company achieves both low absolute TSR and relative TSR, little to no payouts would be allowed (Figure 1, box C); similarly, when absolute TSR and relative TSR performance are high, payouts would be sizable (Figure 1, box B).
In cases of high absolute TSR with low relative performance (Figure 1, box A), some type of reduction in payouts might be appropriate, as the company underperformed the stock market. Similarly, in cases of low absolute TSR and high relative TSR performance (Figure 1, box D), management could be rewarded for out-performing a down stock market.
Competitive practice, however, does not often combine these two concepts. Most plans are based on relative TSR, with no adjustment for absolute performance. The few companies that set absolute stock price (or TSR) goals do not consider relative performance. A few large companies have introduced payout caps when absolute performance is negative, a concept which is discussed below.
2.TSR Performance Hurdle. If absolute TSR is utilized, a company will need to decide a minimum stock price level that must be achieved to trigger a payout (e.g., the current stock price is $15, and a trigger price of $30 is established before a payout can be earned). Determining an absolute stock price, or TSR hurdle, should stretch the executive’s efforts, but should not be demotivating. That said, the performance of the overall stock market or the stock performance of the company’s industry sector can make the $30 target in the example either impossible or easy to achieve, which may not create the intended incentive.
For relative TSR, the company must decide the minimum level of relative performance compared to a peer group or market index that begins to provide a payout. This approach allows companies to avoid the need to set a specific stock price. However, it is important to remember that a relative TSR goal may not provide the intended motivation, as the goal is not as clear cut as the absolute stock price target (and, presumably, the underlying earnings or cash flow that must be achieved to support the target stock price).
A typical relative TSR performance curve for a US-based company is illustrated in Figure 2. The threshold level is often the most debated payout level on the performance curve, although competitive market practice suggests the 25th percentile is the most common threshold performance level. By way of contrast, a UK-based company would typically start payouts at 50thpercentile relative performance.
3. TSR Caps. In order to reward both relative and absolute performance, some companies with relative TSR plans have placed a cap on payouts when absolute TSR is negative. These caps often limit payouts to 100% of target despite the company’s ability to outperform in a down market, as shareholders lost value during the performance period.The obvious issue with this approach is the lack of symmetry. Specifically, if the share price increases significantly, but relative TSR is below the threshold level, no payouts will occur. Thus, shareholders will realize a significant increase in stock value and management does not receive a payout (contrast this result with stock options, where management would realize a significant amount of “intrinsic value”). The lack of symmetry and the general belief that out-performance in a down stock market should be rewarded has likely led companies to refrain from imposing caps on payouts.This may change as shareholders and the proxy advisory firms continue to apply pressure on companies to better align pay and performance. In addition, the SEC proposed rules required under Dodd Frank in July 2015 that when finalized will require disclosure of the relationship of pay and TSR (both relative and absolute). This disclosure could impact the design of incentive plans including TSR-based plans to further align realized compensation with shareholder returns (including the use of TSR caps).
Michael Kesner is principal and Jennifer Kwech is senior manager of Deloitte Consulting LLP’s Compensation Strategies Practice.
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