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Mar

Lessons Learned in the Aftermath of the Banking Crisis

Categories: Blog, Blog Archives, Blog Current

Tags: CEO pay, Dodd-Frank, executive compensation consultants, wall street pay

This article originally appeared on Robin A. Ferracone’s “Executive Pay Watch” blog on Forbes.com.

Last week’s blog on proposed changes to Wall Street pay got me thinking: while it’s easy to see in retrospect what was going wrong in executive pay leading up to the financial crisis, why didn’t shareholders spot these problems sooner, before the crisis hit? Perhaps it’s just hard to be critical when times are good. When shareholders are satisfied, it’s easy to overlook the distinction between proper pay-for-performance and simply egregiously high pay. Unfortunately, it took a major crisis for us to open our eyes and demand reform. While it’s better late than never, what can we learn from the major banks during the financial crisis that might help us identify and eliminate risky compensation practices before they cause systemic damage?

To help spot what did and what didn’t work in the pivotal years leading up to the crash, I pulled the Farient Alignment Reports^TM on some major US banks. The Alignment Reports clearly show whether or not the CEO pay of each bank was: (1) reasonable compared to the relevant market, and (2) sensitive to company performance, as indicated by Total Shareholder Return (TSR) over time. It was no surprise to me that, for the most part, the better aligned companies were more successful in getting through the crisis than those with poor alignment.

To illustrate the point, I have drawn lessons learned from two companies (Bear Stearns and Lehman Brothers) that were misaligned from a pay and performance perspective, and two companies (JP Morgan and Morgan Stanley) that were relatively aligned.

Bear Stearns: Bear Sterns’ Alignment Report shows that in every single year from 2001 through 2007, the total Performance-Adjusted Compensation^TM of CEO James Cayne was unreasonably high, even compared to the lofty pay levels in investment banking. A study commissioned by the Council of Institutional Investors, entitled Wall Street Pay – Size, Structure, and Significance for Shareowners, found that the sheer magnitude of Wall Street pay, while seemingly aligned with shareholder interests through the heavy use of equity-based compensation, was actually misaligned with shareholder interests because the vast size of the pay acted as a kind of insurance for executives against failure. So, even though Bear Stearns’ chart shows good sensitivity between TSR performance and Performance-Adjusted Compensation, the fact that Cayne’s pay was unreasonably high cancelled any benefit of pay being sensitive to performance and failed to provide the disincentive needed to stave off excessive risk-taking.

Lesson learned: Pay sensitivity is not enough; the amount of pay must be reasonable relative to long-term industry norms for the performance delivered.

Lehman Brothers: While Lehman Brothers also had issues of unreasonable pay (as indicated by Dick Fuld’s pay being above the Alignment Zone in the years leading up to the crisis), a more alarming concern was that Lehman’s pay was overly sensitive to performance. Fuld had an enormous upside in pay for only moderate increases in performance relative to others in the industry. Moreover, the downside wasn’t as punitive as the upside was enriching. For example, Fuld’s restricted stock awards, while seemingly “performance-based,” vested one year after grant for achieving relatively low financial hurdles.

Lesson learned: High upside opportunity, with little to lose on the downside, is not a winning combination for shareholders.

JP Morgan: In stark contrast to Bear Stearns and Lehman, JP Morgan’s Alignment Report illustrates a very conservative approach to pay. In all years from 2005-2009, Jamie Dimon’s pay was actually slightly under the Alignment Zone, demonstrating a refreshing level of modesty in pay for one of the better-performing companies during the recession. Even in 2008 when JP Morgan was far ahead of its peers in terms of relative performance, aggregate incentive compensation for executives decreased by 72 percent from the prior year in response to the company’s absolute performance suffering in the recession. Despite a heavy use of discretion in determining bonuses, the Compensation Committee demonstrated an appropriate understanding of limiting the level and leverage of incentive pay, keeping any risk that may be induced by executive compensation plans in check.

Lesson learned: Successful companies manage risk as well as reward.

Morgan Stanley: In a way, I’ve saved the best until last. Morgan Stanley’s Alignment Report is a standout in the industry. From 2000-2009, pay was well-aligned with performance, and the leverage, or risk-orientation, of the program was balanced on both the upside and downside. In terms of reasonableness, the Performance-Adjusted Compensation for Morgan Stanley’s CEO, John Mack, is in the Alignment Zone, indicating a history of reasonable pay for the company’s size, industry, and performance delivered. It’s worth noting that is not a coincidence, as Morgan Stanley did a number of things differently from its banking peers. For example, while most banks used only absolute measures of performance in their incentive plans, Morgan Stanley used a combination of absolute and relative measures that compared the company’s performance to that of its peers. As a result, in using the relative stock price growth and other market measures, Morgan Stanley did not pay its CEO for the windfall gains that were realized during the boom years of 2005 to 2007. Also, Morgan Stanley was ahead of its peers by attaching long-term performance criteria to the vesting of stock options based on ROE, TSR, and Pre-tax Profit measures over three years.

Lesson learned: Set goals in a relative context and/or use relative measures in the pay program; unless there is a strong rationale otherwise, set target pay at median market levels, letting actual future performance drive actual pay to above or below market levels over time.

At this point, Dodd-Frank requires that banks report on their pay and performance alignment. My hope is that all banks will not only comply with the letter of the law, but also with the spirit of it as well, offering reasonable pay for performance, as well as pay that is appropriately sensitive, or leveraged, to performance. Doing so is bound to benefit the company, the industry, the economy and investors alike.

Special thanks to my Farient colleague Katherine Edwards who helped with the research for today’s blog.

Robin A. Ferracone is the Executive Chair of Farient Advisors LLC, an independent executive compensation and performance advisory firm that helps clients make performance-enhancing, defensible decisions that are in the best interests of their shareholders. Robin Ferracone is the author of a recently published book entitled Fair Pay, Fair Play: Aligning Executive Performance and Pay, which explores how companies can achieve better performance and pay alignment. Robin can be contacted at robin.ferracone@farient.com.

Mar

New Bank Regulations on Compensation – Well, At Least It’s a Start

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This article originally appeared on Robin A. Ferracone’s “Executive Pay Watch” blog on Forbes.com.

On March 2^nd, the SEC moved forward to adopt a proposal requiring at least 50 percent of annual incentive compensation for executive officers of large financial firms to be deferred for no less than three years. Stripped to its essence, this proposal is attempting to fix “short-termism” and address the widely popular view that actions motivated by short-term self-interest on the part of those in the financial services industry brought about the near-collapse of our financial system in 2008 and 2009. In other words, the ones in the financial world who benefitted, despite our deep financial woes, were the ones who also reaped the handsomest rewards. They did this by taking undue risks in the years leading up to the collapse, and then let the rest of us take the losses and clean up the mess. It is a modern day “take the money and run” scenario.

While I don’t subscribe to the idea that executive compensation was at the root of the problem, I do believe it played a role. In an extensive study commissioned by the Council of Institutional Investors, entitled “Wall Street Pay – Size, Structure, and Significance for Shareowners,” the authors found that while Wall Street pay was seemingly aligned with shareholder interests through the heavy use of equity-based compensation and long deferral periods, the sheer magnitude of the pay, coupled with excessive focus on short-term growth, was an even more powerful force that divorced the interests between executives and their shareowners.

In attempting to realign bankers’ bonuses with long-term performance, the FDIC became the first agency to implement the Dodd-Frank requirement prohibiting financial institutions from offering any compensation arrangements that could lead to material financial losses for the company. Under the FDIC proposal, now supported by the SEC, the deferred portion of annual incentive compensation can be paid no faster than on a pro-rata basis (e.g., one-third per year for three years), and the remaining deferred compensation is subject to recoupment if actual losses or other negative performance happens during the deferral period. Although this proposal must be adopted by all seven of the federal regulatory agencies with authority to implement the rules of the Dodd-Frank Act, this new rule could become effective this year.

So, will the new holdback requirement solve the problem? Given all that we have learned, the new rule is a start, but doesn’t go far enough in addressing the core issues. It’s a start because the incentive payouts now remain tied to company financial success during the minimum three-year deferral period. However, they don’t go far enough because the earn-out of these awards in the first place is still tied to short-term performance and the amount earned can still be excessive.

A more holistic solution would be for companies to implement the required holdbacks, but also to:

Ensure that a significant portion of compensation (i.e., over half) is earned over multi-year periods (vs. a year at a time)
Apply holdbacks to all awards, not just annual awards
Ensure that awards paid for any given performance, and in any given performance period, meet industry standards of reasonableness

As far as reasonableness is concerned, using the Farient Alignment Report^TM may be one place to start. The Alignment Report is a visual tool that shows whether a company’s CEO Performance-Adjusted Compensation^TM is both reasonable and appropriately sensitive to performance given the size, industry, and performance of the organization. The reason that using a tool like this is advisable is that it relies on 15 years of inflation-adjusted data, reflecting market norms established over long periods of time. If you think this long-term data base produces a piker’s wage, think again. For example, we ran our Alignment Report for Goldman Sachs, and it shows that Lloyd Blankfein’s compensation (and that of his predecessor) was reasonable for the company’s size, industry, and performance delivered for all but the 2005 to 2007 time period. The Alignment Report allows for good compensation for good performance, but also nails any issues.

In general, I am not a fan of government intervention in our free markets. However, a compensation arms race, like the one that has gone on in banking, serves no good purpose. I’d like to think that smart companies will not stop with the requirements of the new legislation, but will go on to implement more far-reaching measures that solve the problem of short-termism, support long-term success, and deliver compensation that is truly reasonable. And who knows . . . if enough companies act smartly, perhaps we can avoid an arms race, pay reasonably, pay only if performance is sustained, and stave off the need for yet another round of legislation.

Mar

The Realities of Say on Pay: Proxy Season 2011

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This article originally appeared on Robin A. Ferracone’s “Executive Pay Watch” blog on Forbes.com.

With Proxy Season 2011 in full swing and Say on Pay a reality, I am spending lots of time with investors and compensation committees. As our clients get clients ready for the 2011 and 2012 Say on Pay disclosures, I wonder how realistic it is to think that shareholders will have the resources to take a deep dive into the pay programs of the companies in which they have invested. I think it’s more likely that they will have to rely on the company or on shareholder advisory groups to make a convincing case one way or the other.

As of March 2, 2011, there have been 35 Fortune 1000 companies for which advisory vote results on compensation have been reported. For most of these companies (33 out of 35), the vast majority of their shareholders have voted affirmatively for their executive pay arrangements. Last year, four companies, Motorola, Occidental Petroleum, KeyCorp, and Abercrombie & Fitch, received “no votes” from investors on their executive pay programs, and this year, two companies, Jacobs Engineering (47%) and Beazer Homes (47%), joined their ranks.

In my experience, when investors say “no” to pay, they do so for three primary reasons. The first is that they view executive pay as being too high; the second related reason is that they do not see the company demanding sufficiently high performance in return for the high pay; and the third is that they do not think that the pay programs and decisions are transparent enough, which implies that they do not trust that the board will make decisions on executive pay that are in their best interests. The questions then for boards (and their compensation committees) are: (1) how can companies ensure that there is proper alignment between performance and pay; and (2) how can they demonstrate, in a clear, concise, and transparent way, that good performance and pay alignment exists? Moreover, if the relationship between performance and pay is weak, how can they identify and fix any alignment issues up-front, before these issues become apparent to investors as they cast their Say on Pay votes?

The first step in answering these questions is to analyze the relationship between the company’s performance and its total executive compensation levels over time. Although there are various ways to do this, many of our clients are using Farient’s Alignment Report™, which assesses a company’s performance-adjusted pay (i.e., total compensation adjusted for actual performance) relative to its actual performance, as measured by total shareholder return (TSR), over time, and does so in relationship to its peers or industry sector. We say that performance and pay are aligned when total compensation, after performance has been factored in, is both:

– Sensitive to company performance over time; and

– Reasonable relative to the market for executive talent and for the performance delivered

This alignment tool visually shows whether or not these two conditions have been met. If so, then the company has an easy way to communicate the integrity of the pay program to investors, leading to a “yes” vote on Say on Pay. If not, the company has an opportunity to diagnose and correct the features of the pay program, or pay actions, which may have caused misalignment in the past, but will be corrected for the future, heading off a “no” vote “at the pass.”

The intent of Say on Pay was to create ongoing communication between shareholders and boards of directors. By keeping the lines of communication open, Say on Pay doesn’t have to be extreme – a crisis at one end of the spectrum or a “non-event” at the other. Clear and proactive steps can be taken to ensure that Say on Pay becomes a useful communication platform between companies and their investors, and nothing more. These steps are: (1) get the facts – do an alignment analysis; (2) diagnose any alignment problems and take corrective action, if needed, for the future; and (3) take your case for alignment to investors. By taking these steps, companies can ensure, rather than merely hope for Say on Pay to be a “non-event.”

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Robin A. Ferracone is the executive chair of Farient Advisors, LLC, an independent executive compensation and performance advisory firm which helps clients make performance-enhancing, defensible decisions that are in the best interests of their shareholders. She is the author of Fair Pay, Fair Play: Aligning Executive Performance and Pay, , which explores how companies can achieve better performance and pay alignment. Robin can be contacted at robin.ferracone@farient.com.

Mar

Performance Share Plans – The Best of Both Worlds

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This article originally appeared on Robin A. Ferracone’s “Executive Pay Watch” blog on Forbes.com.

In a recent Compensation Committee meeting, one of the executives participating in the meeting asked whether or not I favor Total Shareholder Return (TSR) as a performance measure for performance share plans. This question was particularly apropos, as performance share plans are now prevalent among US companies, with approximately half of S&P 500 companies offering them, and with TSR as the most popular metric in these plans.

In addition, relative TSR is used by vast majority (80 percent) of FTSE 250 companies in the UK for their performance share plans, due largely to the fact that their version of Say on Pay was implemented back in 2006. So, the answer I gave the executive at the meeting flew in the face of conventional wisdom. I told him that relative TSR is not my first choice. Why? Because while TSR does a good job of measuring performance outcomes for shareholders, it does not do a good job of signaling to plan participants how to deliver those outcomes.

Now, don’t get me wrong. Anyone who has read my book, Fair Pay, Fair Play, can see that I am an ardent proponent of achieving alignment between executive pay and TSR. So, what could be better than forging a direct link to TSR itself in the incentive plan? The answer lies with financial measures, and in some cases strategic measures, that drive value.

Unlike TSR, good financial and strategic measures can communicate how to drive value, and therefore, can be infinitely more motivational than using value itself. The key in designing such a plan is to determine which financial (i.e., input) measures have the most significant influence on the stock price, i.e., the output measure.

Notwithstanding my preference for financial measures, relative TSR can be a reasonable default measure. After all, it does have some redeeming qualities. With relative TSR, companies can have confidence that the plan captures something that investors care about, and that the plan is likely to produce good pay and performance alignment. However, both relative TSR and relative financial measures can do an equally good job of stripping out the effect of external economic and industry factors, thus measuring management’s value added rather than economic conditions.

In either case, the key is to find the right relative benchmark. Unless the benchmark (i.e., using a peer group, industry, or index) is appropriately structured, the measure will do a better job of measuring the company’s volatility, rather than its performance.

For example, we worked with one high-tech company that was measuring TSR against a broad market index (i.e., the S&P 500). However, the tech cycles were much deeper than the general economic cycles, and as a result, the company was really measuring relative volatility, not performance.

In another example, we worked with a company that was measuring its performance against six peer companies. We showed them that if just one company got acquired, the awards would change considerably for no good reason. In this case, we moved the client from using a percentile ranking system to using a TSR range (e.g., +/ – 5 percent) around the median.

Another issue with relative plans is that the payouts may be high, even if the company performs poorly. This argues for having some type of failsafe mechanism in the plan.

In the end, I still prefer a performance share plan that is driven primarily by financial measures that drive value. This type of a plan offers motivational value to the executives as well as alignment to the shareholders. While no plan is perfect, it does seem to capture the best of both worlds.

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Feb

When a Picture is Worth a Thousand Words: Effective Use of an Executive Summary in the Compensation Discussion & Analysis

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Tags: CEO pay, Dodd-Frank, executive compensation, executive compensation consultants

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This article originally appeared on Robin A. Ferracone’s “Executive Pay Watch” blog on Forbes.com.

In last week’s blog, I talked about writing a Compensation, Discussion and Analysis (CD&A) for this year’s proxy that really speaks to your shareholders. With proxies getting longer, it is becoming increasingly important that CD&As provide stakeholders with a clear understanding of the logic, decisions, and transparency of a company’s executive pay programs.

With non-binding say on pay now mandatory for all public companies, your board will want to highlight that you are indeed doing “the right things right” around executive pay programs. But more disclosures mean more ink, and bigger challenges to organize the information. As we at Farient Advisors work with our clients to help them complete their 2011 CD&As, we are advising a number of clients to include an executive summary at the beginning of their CD&As to set the tone, create a blueprint for what is to come, and make the fine print easier to follow. This is especially important to do for investors, who must read and analyze thousands of documents across their portfolio companies to determine their votes.

To avoid adding bulk, we feel as though the summary should be succinct and should contain four important sections:

1. Summary of compensation philosophy and design: This section should be used to state your company’s compensation philosophy and objectives, and discuss how your program design achieves these goals. We are supporters of tables and charts because they provide simple and effective takeaways for readers. For example, Deere & Co presents a “Total Rewards Strategy” table that labels all of the components of compensation and describes their role in the overall compensation philosophy. This discussion is then followed by stacked bar graphs of target pay mix by component for each Named Executive Officer. The use of graphs allows Deere to concisely explain their compensation program on one page, and makes the relevant information easy to understand.

2. Pay and performance alignment: This section provides an opportunity for the company to describe how its performance plans translate performance into pay. A discussion of pay and performance will be required in next year’s proxy. However, it is a good idea to address pay and performance in this year’s proxy as well. The company should strive to demonstrate how its executive pay, adjusted for performance, has been higher when performance has been up, and lower when performance has been down. Here again, we prefer charts and tables to words. To directly address pay and performance, Farient’s Alignment Report shows how a company’s Performance-Adjusted Compensation ^TM fluctuates over time relative to Total Shareholder Return (TSR) and in comparison to other relevant companies. This tool has been tested with compensation committees, executives, and investors. All report that it is a good intuitive mechanism for helping them understand the company’s track record of aligning pay and performance over time.

3. CEO compensation: This section allows the company to describe the pay actions it took in the prior year for the CEO and why these actions were justified. This is yet another opportunity to show a chart. For example, Jack in the Box includes charts comparing CEO total compensation to EPS and total shareholder return over five years, offering a succinct view of how CEO pay is directly affected by the company’s performance.

4. Significant changes made to compensation policies or programs: If you changed your compensation system last year, or if you are changing your compensation system for the upcoming year, the executive summary is an excellent place for signaling these changes, including those in program design, performance metrics, executive contracts and policies, and processes for making compensation-related decisions. For example, Navistar International uses the executive summary almost exclusively for purposes of describing the changes made in 2010. The bullet-point formatting highlights the changes (in this case, the elimination of gross-ups, amendments to the executive severance agreements, and revisions to the annual incentive plan design). The list is short and to-the-point, and readers are reminded that full details are contained in the body of the CD&A.

Given the length of CD&As these days, executive summaries are becoming increasingly useful. Executive summaries make it easier for stakeholders to not only understand what the company is doing and why it is doing it, but also how the executive pay system supports the company’s business strategy and links to shareholder value. In addition, compelling visuals make a difference. In the case of CD&As, a picture is definitely worth a thousand words.

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Feb

Proxy Season Again? Creating a Compensation Discussion and Analysis That Really Speaks to Shareholders

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Tags: CEO pay, Dodd-Frank, executive compensation consultants, Proxy Season, Say on Pay

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This article originally appeared on Robin A. Ferracone’s “Executive Pay Watch” blog on Forbes.com.

It seems like it was just proxy season. If your company is on a calendar fiscal year, proxy season is here again. With all of the legislative changes around compensation, this is a great time to talk with your shareholders about the year in review. So, as your compensation committee, HR and legal departments, and outside advisors hunker down to write drafts of the Compensation Discussion & Analysis (CD&A), will it be business as usual — dusting off the prior year’s proxy, making a few edits and updating the numbers — or will it be time to start over?

Perhaps driven by Dodd-Frank and Say on Pay, we are seeing a new energy around companies telling their stories from a fresh perspective. From our experience at Farient Advisors, we know that writing proxies can be a time-consuming proposition, and really, who wants to start over? As part of our work with clients, we have read a great number of proxies, and have written our share of CD&As. Through this work, we have developed some points of view about how companies can most effectively communicate with their shareholders, and invite commendation rather than criticism around the logic, decisions, and transparency of executive pay. These observations include:

1. Set a meeting between the proxy writers, i.e., members of legal, HR, outside counsel, and independent consultants to articulate and organize the messages that they really want to get across to shareholders. Craft a compelling story

2. Depending upon the length of the CD&A, consider whether you should present an executive summary

3. Create a CD&A that is clear and concise. If you are changing your executive compensation programs, we find it most clear to signal up front that the programs will be changing, then describe last year’s programs and decisions in one section (preferably in the past tense), and then launch into this year’s changes in another section

4. Don’t make more of Say on Frequency than it is. We do not regard this as a significant issue. Our advice is to determine whether the company feels strongly about an annual, biennial, or triennial vote, test this thinking with the company’s largest investors, and then make a recommendation. While you may not convince shareholders to vote with you, whatever you recommend will not be held against you

5. Assess your performance and pay alignment, and determine whether or not you should report this year. If your company has a strong story to tell, where pay is reasonable for the performance delivered, and pay and performance move together appropriately over time, we suggest going ahead and reporting on pay and performance in 2011. If not, we suggest addressing your alignment issues during 2011, with an eye toward being able to make a compelling case when you will be required to report on pay and performance in 2012.[i]

This year’s proxy writing exercise will be interesting, as I’m sure next year’s will be as well as the SEC continues to interpret Dodd-Frank. While you may not be starting from scratch in writing your proxy, I doubt that a simple “find and replace” exercise will suffice. One thing I am confident in is that shareholders, and perhaps the SEC, will ask the hard questions . . . if you don’t answer them first.

[i] To help companies address performance and pay alignment with shareholders, Farient has created a proprietary Alignment Index™, which analyzes the relationship of your company’s performance and pay relative to companies in your peer group, industry, and/or the broader market. Using a combination of proprietary algorithms and an analysis of the S&P 1500 over 15 years, in three year increments, this visual and quantitative tool provides an opportunity for your company to demonstrate the integrity of its compensation programs and administration, or to help diagnose why your company’s performance and pay may not be aligned, thereby offering guidance on how to improve alignment.

Feb

When Familiarity Breeds Complacency: Factors to Consider When Selecting a Compensation Consultant

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Tags: CEO pay, Compensation Committees, Dodd-Frank, executive compensation, executive compensation consultants

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This article originally appeared on Robin A. Ferracone’s “Executive Pay Watch” blog on Forbes.com.

As the first quarter of 2011 is in full swing, and proxy season is around the corner, many compensation committees are considering whether they should take another look at who their compensation consulting advisor should be. And rightly so. In the wake of heightened concern about independence and conflict of interest, three of the top five executive compensation consulting firms to the top 1000 companies are still the integrated firms, which offer a variety of services primarily to management.

So, why do compensation committees stick with these companies when there is pressure to prove impartiality and independence of the board’s advisors? Some committees say that they trust their advisors, despite the corporate package that they come in. Others say that they rely on the reputation and name recognition of the integrated firm. So, what’s in a name? As it turns out, maybe too much.

This “safety in familiarity” approach, while perhaps comforting to Directors, appears at odds with the pressures facing Compensation Committees to identify and retain a compensation consultant who is both independent and whose capabilities extend beyond the collection and analysis of competitive pay data. In particular, the consultant’s knowledge and expertise ideally should encompass an in-depth understanding of performance measurement and goal-setting, the capacity to relate compensation to various performance outcomes, and the research base needed to identify potential misalignment between pay and performance before it becomes an issue.

In selecting a compensation consultant, Boards and Compensation Committees ideally should examine a wide variety of factors. Failure to do so may result in less than optimal results in terms of the quality of advice or the perception of external investors regarding the counsel received. Some things to consider include:

While Dodd-Frank does not require the outside advisors to the Compensation Committee to be independent of the company, it does require the company to disclose how the committee considers factors that affect the independence of the advisors. (The SEC is expected to provide greater clarity on the factors that they deem affect independence.) And of course, there is still the requirement to disclose services in excess of $120,000 that are provided to the company by the board advisors. I’ve heard some boards say that in hiring an integrated firm to do their executive compensation consulting, they will disqualify these firms from consulting to management. However, these firms are good at things like benefits consulting and one has to ask whether taking a major competitor out of the bidding for these other activities is doing more harm than good.
At this point, the emphasis on independence has resulted in a spate of spin-offs of the executive compensation consulting businesses from the large integrated firms. But what also has happened as a result of, and prior to, this “spin cycle” is that many of the best compensation consultants no longer work for the integrated firms. It is inevitable that compensation committees will need to acknowledge this trend and at some point, explore what the smaller firms have to offer.
Data on competitive pay practices has essentially become a commodity, with size and industry-specific data being accessible to most consultants, not to mention the fact that a tremendous amount of data can be gleaned from proxy reports. In the end, it is how the pay data is analyzed, interpreted, and used for decision-support, rather than access to the data itself, that has become a key issue in providing high quality, independent advice.
While specific industry knowledge can be an asset, it also can result in failure to sufficiently consider other approaches to incentive design and performance measurement that may better fit the strategy of the company. In fact, the comfort of conforming to industry practices can result in sub-optimal decisions in compensation design. As a case in point, one has to look no further than financial services to see the impact of destructive and imitative pay practices.
Due in part to increased investor scrutiny on the alignment between pay and performance, consulting on pay, and in particular, on executive compensation, the world around consulting has become more complex. As such, the traditional approach to compensation consulting around “how much pay” rather than “how to pay” is no longer sufficient. Instead, experience in the strategic aspects of compensation, including performance measurement, peer group selection, and methods of aligning pay and performance in incentive design, have become much more important in providing sound compensation advice.

With significant changes in the compensation consulting landscape, the time when Compensation Committees can take comfort in “name recognition” to select their pay consultant has passed. In fact, Compensation Committees will benefit by adopting a more open and inquisitive approach to selecting a consultant that factors in independence, expertise in performance measurement, and strategic capabilities. Such due diligence by no means precludes retaining a “name” firm, but rather, provides Committees the opportunity to better understand the resources that are available and to ensure that they have selected the best firm to meet their needs. The results may be surprising.

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Robin A. Ferracone is the Executive Chair of Farient Advisors, LLC, an independent executive compensation and performance advisory firm which helps clients make performance-enhancing, defensible decisions that are in the best interests of their shareholders. Robin Ferracone is the author of a recently published book entitled Fair Pay, Fair Play: Aligning Executive Performance and Pay, which explores how companies can achieve better performance and pay alignment. Robin can be contacted at robin.ferracone@farient.com.

Feb

New Year Resolutions for Compensation Committees – 2011

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Tags: CEO pay, Compensation Committees, Dodd-Frank Act, executive compensation, executive compensation consultants

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This article originally appeared on Robin A. Ferracone’s “Executive Pay Watch” blog on Forbes.com.

This week I want to welcome our first guest blogger, Simon Patterson, from Patterson Associates LLP headquartered in London. Simon and I were partners together at Strategic Compensation Associates (SCA) and have recently created a global alliance between my firm, Farient Advisors LLC and Patterson & Associates, to ensure that our clients are provided the most reliable executive compensation solutions wherever they do business. Simon originally wrote this piece in December, 2010, for the United Kingdom’s (U.K’s.) Executive Compensation Briefing.

Since today is February 1, 2011, New Year’s resolutions are either well underway or broken. I hope you enjoy Simon’s 10 resolutions around executive compensation as much as I did. Even with the U.K. colloquialisms, you might see some of your own resolutions in Simon’s top ten list below.

New Year Resolutions for Remuneration Committees – 2011

1. Make a difference

People do what you pay them to do. If a pay programme rewards the growth of assets, then you can expect the management to start making acquisitions. If you want executives to focus on profitability then don’t reward the growth of revenues. The Compensation Committee has an enormously important role in shaping the design of incentives to ensure shareholders get the performance they are looking for. So why not ask yourselves a simple question: “What are we paying [management] for?” If you can’t answer that question now, you must be able to very soon.

2. Say less, mean it

Have a look at the Directors’ Compensation Report in your Annual Report? Are you asleep yet? I thought so. Now, try to imagine you are an investment director who is making that all important decision – where to put place his or her fund. Will she go for the company which takes 14 pages to tell her that the management team are probably as confused as she is about how much they will make in three years, or will she choose the company which spells out how improving value is their top priority, how that can happen, and how the management team will then be rewarded.

3. Value-based decisions

It is worth remembering that the stock market works. Despite the noises off-stage, investors are remarkably canny at spotting the basics of value creation – cashflow today, with the prospect of more cashflow tomorrow. They also have the ability – through the mechanism of the market – of valuing companies in a surprisingly accurate way, very quickly. So bear this in mind when you are setting goals for the management team. If the sum total of management’s performance aspirations for the coming year – the budget – will not actually deliver what investors already expect, then only one thing can happen. They will re-value the company and value will be destroyed. This isn’t a disaster, but nor is ‘beating budget’ a maximum bonus payout.

4. Bonus – is it an entitlement?

It’s certainly a dirty word these days. Take a moment to consider what a bonus is for. A bonus is a sum of money, paid by the owners of the business, for extraordinary results over and above an individual or team’s “day job”. Apply that test to the list of bonus recipients in front of you and see if you can distinguish that element of the ‘bonus’ which is actually an entitlement – without which the retention of the employee(s) could be at risk – and that element which is clearly paid for through performance which had come as a pleasant surprise to the Board. The latter is a bonus. Now, what are you going to do about the first part, because it isn’t variable pay!

5. Remuneration Governance can be fun

Most companies approach the prospect of a dialogue with remuneration governance professionals as if they were about to waste precious time with an eccentric grandmother having afternoon tea. The sense is that all this wonderful analysis calibrating performance goals and benchmarking pay will somehow get lost, and the conversation will boil down to “I wouldn’t do that if I were you, dear”, or just “don’t”. Although it remains true that the process of engaging with shareholders on the topic of executive pay must be managed carefully – so there are no surprises – the content of the discussion can be very interesting. It has always surprised me how companies fail to appreciate how a good argument usually wins the day. Those who work in remuneration governance may be manning the ramparts on behalf of shareholders, but they want the programmes to work. They are far less interested in ‘benchmarking’ or ‘prevalence’ (i.e., what are the others up to) and more interested in a powerful argument about why executives should be paid differently.

6. Check your tail

It is likely, particularly if base pay has been frozen for a year or two, that you will be faced with a decision to increase salaries by at least a modest sum early this year. Before you sign off that “inflation plus x” figure, take a look at the full cost to the company in terms of pension contributions. It may surprise you. It will certainly leave you feeling less guilty that the increase is probably lower than the executives were looking for and, quite possibly, less than you feel they deserved.

7. Calibrating good performance

Take a moment and draw a large ‘L’ on a piece of paper. Now, along on the bottom write the details of what you think performance could look like next year, with “outstanding” towards the far end and terrible performance close to where the two lines meet. On the vertical line write in how much bonus could be paid if performance is terrible, how much if it is outstanding and the points in between – be honest. When you have marked with an “X” how much bonus is paid at each level of performance, and connected the “Xs” with a line, you have a reward curve. See what happens when you cap pay. Where did you cap it? How much bonus was paid when performance was terrible? More than you’d like, perhaps. This basic tool, which works on the back of an envelope, will move your discussions further, faster.

8. At your discretion

When executive pay is reasonably stable, there is an argument for benchmarking pay against a basket of similar organisations – selected because talent either leaves for those kinds of companies, or is recruited from their kind. But when the market is in turmoil, benchmarking is by no means a simple matter of studying market reports. Take a moment to consider how close your decision-making on pay actually resembles the market mechanism. How closely would you like your company’s remuneration governance to resemble that of soccer management in the United Kingdom? That is how the market actually operates. So don’t be squeamish about mentally preparing to fire your Executive Directors when considering his or her value to the organisation.

9. Defend yourself

You have a vital role. You are being asked to judge what the shareholders are looking for, what is happening in the market for talent, how the management really are performing, and how executive pay should move – given all of these various moving parts. If you have done your homework, no-one is in a better position to be able to make the decisions you are required to make, and therefore shareholders should listen to what you have to say. So, defend yourselves vigorously in the media, with shareholders and with the management team. The management will be heartened to know that your sleeves are rolled up, and you will earn a respectful hearing.

10. Read the papers!

The Remuneration Committee papers, that is.

Simon Patterson is founder of Patterson Associates LLP. Previously, he was a Partner at SCA Consulting and a Worldwide Partner with Mercer HR Consulting in London, where he led the executive compensation service line of Mercer’s Performance, Measurement and Rewards (PMR) Practice. He is actively engaged as advisor to the Remuneration Committee of several FTSE100 companies, and consults widely on the topic of executive compensation and performance measurement. Simon can be contacted at simon@pattersonassociates.co.uk.

Reprinted with permission from the Executive Compensation Briefing 2010, a publication of ClearView Financial Media, Ltd.

Jan

Executive Compensation: Before and After the IPO

Categories: Blog, Blog Archives, Blog Current

Tags: CEO pay, executive compensation, Initital public offering, IPO

Comments: No

This article originally appeared on Robin A. Ferracone’s “Executive Pay Watch” blog on Forbes.com.

It’s unmistakable that the IPO market is heating up. According to IPO Monitor, the number of IPOs increased in 2010, up threefold from 2009, and there’s no slowing in sight.

I recently attended a board meeting for a company that just IPOed. The Compensation Committee was having its first post-IPO meeting, and not surprisingly, had more questions than answers. These questions ranged from compensation strategy and design to the nuts and bolts of good governance processes.

Having assisted a number of companies through IPOs, I’ve learned some lessons about what challenges companies face when transitioning through IPOs and what are the most successful strategies in dealing with these challenges. Here’s my “top ten” list of what I’ve seen works best:

10. Cash compensation will become more important in the pay mix – Venture-backed IPO executives often will be paid less than the market in salary and bonus, since cash was scarce prior the IPO and equity was counted on to “carry the day.” As a result, companies, ideally before they get to the IPO, should conduct a competitive pay analysis and take steps to correct inequities. This competitive look also provides an excellent platform for discussing and establishing a pay positioning strategy post-IPO.

9. Go ahead – fix internal inequities before the IPO – Companies should assess where everyone is in the pecking order in terms of ownership and equity position before the IPO. It’s easier to at least partially even up internal inequities before the IPO happens because the valuations are lower and topping up executives is not as costly or visible as after the IPO.

8. Don’t expect to fix the “inequities in equity” after the IPO – It’s simple math. The “haves” are those who came into the company prior to the IPO, and the “have-nots” are the ones who came in afterwards. Most executives understand that those who were there prior to the IPO took more risk, and therefore, deserve to be rewarded for that risk, and the company can’t possibly afford to put all executives on equal footing in this regard.

7. Don’t think in terms of reloads post-IPO – Those who made it big on the IPO can’t expect to replicate that experience post-IPO. With one of my IPO clients, the CEO expected to be “topped up” after taking money off the table post-IPO. My view was that the “top up” was not warranted as it would have led to overcompensation. Compensation Committees should not fall into the trap of thinking that they need to “reload” executives as a result of equity liquidations following an IPO.

6. Plan for declining burn rates and overhang – A burn rate is the percentage of shares that a company uses annually for incentive grants. Overhang is the percentage of shares that are outstanding and available for incentives. In other words, overhang is a “sharing ratio” or percentage of the company that shareholders are sharing with employees. The fact of the matter is that both burn rates and overhang are higher for pre-IPO than post-IPO companies. Overhang comes down as employees exercise their options and take gains off the table following the IPO. So, IPO companies need to carefully budget their equity usage and manage to a declining burn rate and overhang over time.

5. Consider pay structures to be your friend – High growth IPO companies often eschew anything that is perceived to constrain creativity. But establishing a pay structure (i.e., setting salary ranges, target bonus opportunities as a percent of salary, and equity grant ranges) is one of the keys to scaling the business. If there is no structure, then everything is an ad hoc negotiation, which is sure to lead to pay inequities (and discontent).

4. Expect to redesign the short-term and long-term incentive plans – In my experience, venture-backed companies typically focus on bookings and revenue for bonus purposes, and private-equity-backed companies tend to focus on EBITDA (earnings before interest, taxes, depreciation, and amortization). In addition, publicly-traded stock post-IPO is a different sort of incentive vehicle than one pre-IPO, having virtually no liquidity. These issues almost always prompt a relook at the short- and long-term incentive plans as part of the IPO.

3. Aggressively manage talent – sooner rather than later – Some executives will take to the post-IPO environment like a duck takes to water. Others will remain on land. It’s extremely important to determine which executives will succeed in the public environment. As a result, a deliberate executive assessment process, and pay actions that are consistent with these assessments, are critically important before the IPO.

2. More growth requires increased differentiation – In the early days, almost everyone is a star, or they don’t survive in a start-up or high-change environment. As the company grows, it gets increasingly populated by value maintainers that surround the value creators. As a result, it becomes increasingly important to identify the value creators and pay them at a premium. This helps the organization allocate resources more efficiently, and also helps fill talent gaps more quickly.

1. Good governance is always in vogue – New IPO companies can get caught flat-footed if they are not prepared for the new governance environment. For example, some legal advisors still encourage IPO companies to put evergreen share authorizations into their equity plans. But shareholders strongly dislike evergreens, so why establish them in the first place? My view is that it is best to establish good governance processes, preferably before the IPO happens, so that no one has to break bad habits later on.

If your company is planning an IPO this year, congratulations. My experience is that the best time to ask questions (and get answers) is before the IPO happens, not after. Also, it is helpful to obtain the best professional compensation advice from those who are experts, not from investment bankers or legal advisors. The good news is that it’s easy to avoid mistakes before they happen. You just have to know what they are.

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Image via flickr.

Jan

Does Your Culture Value a Fair Deal?

Categories: Blog, Blog Archives, Blog Current

Tags: CEO pay, Dodd-Frank, executive compensation, executive compensation consultants, Pay and performance alignment

Comments: No

This article originally appeared on Robin A. Ferracone’s “Executive Pay Watch” blog on Forbes.com.

The continuing economic stagnation coupled with the deep recession of 2008, and 2009, have exposed the very real dangers of misaligned executive compensation programs, i.e., coupling high pay with low performance. Just the perception, let alone the reality, that pay packages of certain executives were high, despite great hardship among the masses, caused unmistakable animosity toward Corporate America.

In my experience, most companies were sensitive to this issue and demonstrated at least some restraint toward compensation whether motivated by the harsh economic realities in their own companies or by the unseemliness of personally prospering in difficult times. However, there also were those who appeared to be tone deaf to the issue, or had already taken a great deal of money just as the wheels were about to fall off of the wagon. Financial services companies were identified as the poster children for misalignment, but others were singled out as well.

Achieving performance and pay alignment, where pay goes up when performance goes up, and vice versa, is a mandate from most investors these days. In addition, increased disclosure around the relationship between performance and pay is a requirement by the Dodd-Frank Act – an imperative that already has gotten a head of steam, and is sure to kick in for the 2012 proxy season.

As companies contemplate how they will satisfy investor and SEC requirements, they will be well served if they put themselves to a three-pronged test: (1) Are our programs and goal-setting processes geared toward pay and performance alignment? (2) Do our decision-making processes and actions around executive compensation drive alignment? (3) Does our firm have a culture that actually values alignment? In other words, does our organization truly value a fair deal?

From the opposite perspective, what does it look like if a company suffers from a “culture of misalignment?” In these organizations, executives believe that their own standards are right and fair, and not the standards to which everyone else is held accountable. This belief permeates the entire organization and is difficult to change. Because it’s easy to ignore cultural issues when times are good, and shareholders and management are both benefiting from lofty stock prices, it often takes a burning platform, like a major financial crisis or a shareholder activist, to sound the alarm and motivate change.

As we welcome the New Year, it is always a good time to step back and candidly assess

our values. So, as you think about your company’s values, you may want to test whether your company has a culture of performance and pay alignment, or misalignment, by asking the following questions:

Do our people really want a fair deal? Do they want more pay for better performance? Or do they just want more pay?
Do our people attribute our company’s performance more to the team? Or more to the individuals on the team?
Do our people feel as though they need to play by the rules? Or do they feel as though they can make up their own rules, or not play by any rules at all?.

The answers to the above questions will tell you on which end of the cultural spectrum your organization resides.

At the end of the day, the ability of an organization to align performance and pay is in large part a function of its culture. A culture of alignment will make it more likely that a company’s performance and pay will be aligned. As performance and pay alignment takes center stage among investors and regulators alike, it’s a good time to take stock of whether your company’s culture tips toward alignment or misalignment. 2011 will be a good year to work on your company’s culture if its alignment needs tuning.

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