Executive pay has long been a key focus for shareholders, activists, directors, and the media—and there are no signs of that changing. Increased attention on income inequality, corporate social responsibility, and incentive plans that encourage risky behavior has further increased scrutiny of executive pay, making it a critical oversight area for boards of directors.
Compensation committee members should address the following questions to assist in exercising sufficient oversight:
What is the board’s required level of oversight on executive pay? Emerging best practices are pushing compensation committees to go beyond the technical requirements for approving and disclosing CEO pay set by the U.S. Securities and Exchange Committee and stock exchanges. It is now becoming a best practice also to include a broader view of human resources-related issues, including how a company allocates resources toward compensation and benefits, how incentive plan metrics interact with desired behaviors, and the board’s involvement in proactive succession planning.
How can compensation committees operate with the greatest efficiency? Compensation committee agendas tend to follow a similar pattern from year to year across companies, but certain practices can ensure meetings run more efficiently. For example, following an established cadence of pre-calls in advance of meetings between management and the committee chair, the committee chair and the advisors, and among other committee members can help them run smoothly. Many committees also reference the agenda at the end of each meeting to ensure that all parties’ expectations are aligned. Selecting and working effectively with outside advisors can further enhance efficiency and keep the committee as a whole up to speed on potential pitfalls and implications of pay and governance decisions.
How do compensation committees evaluate incentive plan designs and set performance goals? Incentive compensation is an important lever to encourage behavior and align management with shareholders. Recently, goal setting has received increased scrutiny from shareholders and proxy advisors who have raised concerns about significant payouts to management when performance did not yield a sufficient return for investors. Whether goals are set on an absolute basis or relative to peers, compensation committees often review models that stress-test payouts under various growth and return scenarios to avoid windfalls to executives. In defining acceptable target performance levels, compensation committees may consider multiple perspectives of the company’s expected future performance, such as past performance, peer performance, analyst expectations, internal budgeting and planning, financial modeling, and correlation between the company’s share price and the general market.
What are shareholders really looking for in compensation plans? Institutional investors and proxy advisory firms have views on compensation levels and design that are generally well documented. Committees should consider how compensation design features and pay decisions will be perceived by the company’s major shareholders and the proxy advisory firms. Typically their voting guidelines stem from the principal of pay for performance, but subtle changes to a compensation plan design can make it more acceptable to particular stakeholders. For example, investors have different views on acceptable levels of dilution from stock-based compensation. Knowing those levels may steer a company toward cash-based phantom shares for certain levels of employees to avoid triggering a dilution concern from a major shareholder. In addition, directors should be aware of trends in shareholder proposals, litigation risks, and how and when to engage directly with shareholders on issues related to compensation.
What keeps compensation committee members up at night? Succession planning, risk mitigation, environmental and social goals, gender pay equity, board diversity, director pay, and executive employment agreements are just some of the areas that have bubbled up to the compensation committee agenda recently. US tax reform is also affecting compensation plans and processes. Most notably, the elimination of the performance-based exception to Internal Revenue Code Section 162(m) means that compensation above $1 million paid to certain executives cannot be deducted by a public company, even if it met the former Internal Revenue Service definition of “performance-based.” The elimination of the performance-based pay exception gives companies more flexibility in how plans are designed (e.g., goals can be set later in the year and subjective judgement can be used to set and evaluate performance against goals). However, companies may not want to abandon the best practices dictated by the performance-based exception since shareholders and proxy advisors may object.
To help directors with their oversight responsibility, Mercer has partnered with NACD to publish the Director Essentials Guide to Board Oversight of Executive Pay. The goal of the publication is to provide directors with a clear and concise reference guide to basic principles that affect design and governance of executive compensation programs. Mercer and NACD are committed to helping directors stay ahead of the curve and aware of evolving trends. We hope you find the guide a useful reference and welcome your feedback in the comments section below.
Teresa Bayewitz is a principal in Mercer’s rewards consulting practice based out of New York City.
Performance management relates virtually to everything that is important to a company’s progress—execution of its strategy, the customer experience, investor expectations, executive compensation, and the board’s oversight itself. In spite of the importance of performance to a company’s success, there is very little literature on board oversight of performance management. Given the complexity of the global marketplace, the accelerating pace of disruptive change, and ever-increasing stakeholder expectations, how should the board oversee the performance management process so that it is effective in driving execution of the strategy and in its efforts to incent the desired behaviors across the organization?
In August 2017, Protiviti met with 18 active directors during a dinner roundtable at a National Association of Corporate Directors (NACD) event to discuss this topic. As the ultimate champion for effective corporate governance, the board engages management with an emphasis on four broad themes: strategy, policy, execution, and transparency. With effective performance management touching each of these themes, many organizations use some variation of a balanced scorecard that integrates financial and nonfinancial measures to communicate what’s important, focus and align processes and people with strategic objectives, and monitor progress in executing the strategy.
Our discussions with the directors identified six important concepts to consider when overseeing performance management.
Return on Expectation
Performance management must embrace the appropriate metrics, given the strategy management seeks to implement and the entity’s expected investments. Alignment with strategic priorities is a challenge. As one director noted, most organizations have yet to bridge the gap between efforts to attract and retain employees and efforts to engage and align them.
The directors agreed that managing the balance between short-term and long-term performance presents particular challenges when determining executive compensation. Executives must be rewarded for performance, and long-term shareholder interests must be preserved. The prevailing view was that performance management should be linked to the storyline articulated in investor communications. However, directors should not allow stock price performance to dominate the spotlight so much that it detracts management from focusing on business fundamentals and strategic drivers.
Performance management must focus on operational excellence in the structure, or business model, in place to execute the strategy. Alignment starts with defining performance expectations, as set forth by the strategy, and communicating those expectations across the organization. Performance measures should be used to track the execution of the strategy at the organizational, process, and employee levels so that accountability for results cascades down into the organization. Tracking for these measures allows for necessary midcourse adjustments to be made on a timely basis to achieve performance targets. Metrics must be linked the reward system in a manner that ensures people are incented in the right way, consistent with the strategy. The impact of incentive compensation on behavior and risk taking should be a board priority.
With this topic sparking considerable discussion, several directors noted that while most boards assess and understand the tone at the top, they neither assess nor understand the tone in the middle. One director suggested the use of organizational health and effectiveness surveys to gauge how employees perceive the current leadership culture and compare that perception to the culture they desire. Gaps in perception revealed by such surveys almost always provide informative insights into what’s really happening in the business and what people below senior management really think. They also reveal opportunities for leadership development and improving the tone at the top and in the middle. The consensus of the group was that boards should encourage and, if necessary, push management to consider culture-related measures that make sense for the company. As one director noted, “What gets measured matters.”
The customer base should be segmented, and metrics should focus on the needs of each targeted segment. Customer experience metrics should address the distinctive attributes of the value proposition underlying why customers choose the company’s product or service over other alternatives and provide insight into what a company needs to do once issues are identified. To that end, these metrics should reach beyond nonfinancial areas and address quality, responsiveness, and other critical aspects of the brand promise, both expressed and implied. Less than half of the directors in the roundtable indicated that their top executives reported on one or more customer experience metrics. Several directors noted that when it comes to the customer experience, and even culture across the company, it is incumbent upon board members to “do some homework.” As one director put it, “Try to do your own research and be a ‘secret shopper.’”
Innovation and Resilience
Metrics should inform the organization’s focus on innovation, changes in technology and the business environment, emerging disruption, and market opportunities. The directors at the discussion dedicated a portion of the evening to innovation as a source of new revenue-generating opportunities and a driver of a positive, thriving culture. Among the key points made, the directors agreed the board should encourage consideration of innovation in the performance management process with emphasis on establishing an “innovation pipeline” with reporting on progress through the pipeline.
Monitoring for “Perfect Narratives”
When it comes to performance management, there is a risk of gaming the system. It is human nature for management to instinctively want measurements to reflect positive results. As one director noted, “Flawed stories are better than perfect ones.” It’s a positive when the performance management process identifies one or more areas requiring attention and improvement. So-called perfect narratives, a term used by the director referenced above, tend to raise questions about the rigor under which performance is measured and monitored, as well as the authenticity of the results.
These points get to the bottom of an essential question: do the CEO and executive team really want to know the unvarnished truth about the culture? The customer experience? Innovation? The effectiveness of the business model?
When executive management commits to managing by fact and earnestly seeks genuine results, the board can stand behind them with confidence when results are communicated to shareholders.
Dig into deeper insights from Protiviti by visiting their Board Perspectives piece on board oversight of performance management.
Take a look at the business section of any publication today and it’s clear: discussions of corporate culture have leaped from the pages of academic commentary to the agendas of directors across the world. Between the coverage of misdeeds at Wells Fargo & Co. to reported gender bias and workplace toxicity in the technology sector, the issue of a company’s culture is front and center. Investors, boards, and management teams are seeing direct impacts to shareholder value, which is leading companies to pay attention to their culture without any regulatory mechanism in place encouraging them to do so. They are trying to understand the common current that runs through their organization and whether it creates an environment for value creation or an environment that hinders it.
How companies evolve beliefs and procedures around hiring, retaining, developing, and rewarding a workforce—and how they implement them practically—is what defines a corporate culture at its core.
Thinking about culture in this way does require expanding one’s perspective on the topic. Similarly, when it comes to aligning compensation with that culture, we have to think broadly. Constructing executive pay programs so they support the organization’s long-term business strategy has become a fairly steady drumbeat, but is that executive pay program also in line with company-wide recognition and rewards systems? Ideally, it should be. A productive compensation philosophy is one that is well-known and well-understood at all levels and meets the achievement and recognition needs (both financial and non-financial) of its workforce and management team.
There are two straightforward questions a board can ask to uncover the firm’s true philosophy when it comes to talent development, career progression, and compensation:
how do people move up within the organization; and
what can stall or derail a career?
The answers will point directly to the culture and have tremendous influence on the company’s success.
Operating under the assumption that a “good” culture is the goal, in a positive environment there is always a high level of transparency. Employees up and down the command chain understand the system, believe it is fair, and have a clear idea about how they can advance their careers. There is consistency at all levels in the kinds of behaviors that are compensated in some way and it is clear that actions which run counter to the company’s values are not rewarded.
Accountability is a key part of the system. Personal performance and team and/or business unit achievements are evaluated on the basis of well-established goals and metrics. And finally, a degree of flexibility offers room to evolve strategy or take into account changing business needs or circumstances.
Perhaps what’s most important for boards and management to know is that this scenario is not mythical or unattainable. There are companies well known for their vibrant, performance-based cultures and the long-term value creation that follows. What they share is a company-wide compensation philosophy that carefully tracks to their business and talent strategies. They implement programs that appropriately incentivize, but also more holistically develop talent, understanding that people are at the heart of the company’s success.
As readers of this blog can attest, the role of the board is going to evolve. Today, we are seeing a demonstrated need for greater stewardship over corporate culture. As this and other “soft” issues become increasingly important to investors and impactful to the bottom line, the compensation committee will continue to find itself in a unique and powerful position to effect change and build value for the organizations they serve.
David Swinford is president and CEO of Pearl Meyer.