Why ‘Safe’ CEO Pay Formulas Can Lead to Generic Results

Should all CEOs be paid in the same manner? Given that people and companies are different, surely the answer is “probably not.” However, in a world in which proxy advisory services use formulas to assess executive pay, it can be hard for companies to avoid adopting generic compensation programs.

And even though it seems like we are coming off of a few years of frothy compensation-related shareholder litigation, the breathing room to assess executive compensation in a calm environment will be limited in light of some tough issues on the horizon.

Enter the proposed rules under the Dodd-Frank Wall Street Reform and Consumer Protection Act that would require public companies to disclose the pay ratio of a company’s CEO to the median compensation of the company’s employees.

When implemented, this new rule will bring its own set of challenges. That said, now is the perfect time to reflect on how boards can be effective when it comes to compensating senior executives, and communicating that to shareholders.

So, how do you effectively reward and motivate directors and officers to allow them to make a real impact on their companies?

The WomenCorporateDirectors (WCD) Thought Leadership Council’s recent report outlines five key considerations that boards can use to stop relying on “safe,” which is to say “generic” pay practices, and design a compensation program that supports long-term business strategies.

In its report, "Going Beyond Best Practices: The Role of the Board in Effectively Motivating and Rewarding Executives," WCD looks at:

1.    Using judgment when aligning pay and performance.Compensation committees should retain the power of discretion when making decisions about pay, especially when the compensation program has not anticipated certain business events or the pay is unintentionally inappropriate.

2.    Targeting pay to the person.The report notes that compensation guidelines should be just that – guidelines, and not rules. Directors and officers should be paid according to their individual skills, experience and performance relative to the market.

3.    Remembering that it’s worth paying for retention.CEO turnover is at an all-time high, per the report. So, a solid, stable management team is important, as unwanted turnover is costly for the organization – something that’s a shareholder’s concern as much as executive pay is.

4.    Understanding that value is created over time.Performance and incentives should match the landscape of the business. For example, some retail companies use a 6-month incentive structure to align with the seasonality of the business. This same structure would be nonsensical in other industries.

5.    Limiting excessive severance packages. Compensation committees must balance expectations of executives and shareholders when creating severance packages. Of course, the best time to change policy could be when hiring the CEO.

The WCD report takes a thoughtful and encouraging approach to creating compensation programs, and builds a case for ensuring they align with shareholder value through case-by-case decisions on what will support the long-term growth of the business.

And, it comes at a time when proxy advisory services like ISS seem to be driving boards towards a formulaic approach for CEO compensation. It does shareholders no good when directors abstain from using their best judgment when it comes to paying executives.

You can get the full report by WCD (full disclosure: I’m a member of the San Francisco chapter of WCD) here. A video by the WCD that highlights key considerations of the compensation topic follows:

The views expressed in this blog are solely those of the author. This blog should not be taken as insurance or legal advice for your particular situation. Questions? Comments? Concerns? Email: phuskins@woodruffsawyer.com.