Workshop calls for executive comp improvements

But boards making progress and too many restrictions could be harmful, says consultant
By Sarah Dobson
|Canadian HR Reporter|Last Updated: 09/24/2013

The levels and structures of executive compensation were in the spotlight at a June workshop organized by the Rotman International Centre for Pension Management (ICPM) in collaboration with the Generation Foundation (funded by Generation Investment Management in New York).

The Toronto event looked at five action steps around sustainable capitalism, with recommendations outlined in the white paper Ten Strategies for Pension Funds to Better Serve their Beneficiaries.

In one session, attendees talked about how difficult it is to understand why and how generally rich, stock-based compensation arrangements motivate executives to create sustainable, long-term value in their corporations.

“The puzzling thing is that in many cases, the compensation is… not driven by executive performance but it’s driven by whether the markets are going up or down. So usually the comp is skewed in a way that they’ve got downside protection but unlimited upside,” said Keith Ambachtsheer, director of the Rotman ICPM at the University of Toronto and co-author of the paper.

That gets into the whole question of what long-term value is and whether it’s just stock price, he said.

“Have we really thought through how we should structure executive compensation and what, in fact, are the incentives that drive what we want these people to be thinking about and doing? If we want them to think about having a valuable company 10 years from now, what are the kinds of things that we want to use as markers along the way in order to see whether we’re making progress?”

But it’s bold to say there is no obvious connection between executive compensation and the level and structure of compensation, said Scott Munn, a partner at Hugessen Consulting in Calgary.

“There’s a large number of boards that work hard to try to align the pay for the executive with what they consider to be a reasonable peer group based on the size of the company and industry they’re in and its complexity and its overall level of performance,” he said.

“The new disclosure that we’ve seen in place the last two or three years has gone a long way towards eliminating the use of any judgment by any board that’s not aligned with performance.”

And through say on pay, majority voting and individual director voting, there are already mechanisms for shareholders to deliver messages to boards about their level of satisfaction and dissatisfaction, said Munn.

“That may not be enough for this group but it certainly is a strong starting point and we’ve seen the impact of it, where we’ve seen negative say-on-pay outcomes followed by changes to executive pay programs that have received strong support from shareholders.”

But there is a self-generating “club effect,” according to the workshop participants — who included about 80 board members, senior executives and investment professionals — where individual compensation is determined by the collective compensation levels and structures of a “CEO club.”

Often, compensation consultants compare a company’s executive pay to that of other companies of the same size, in the same industry. If, for example, the range is between $15 and $25 million, they might recommend $20 million, even if the board was hoping for $5 million, said Ambachtsheer.

“So, if you’re a board and you’re given that information and you like your CEO, what do you do?” he said. “That’s the club effect.”

Canada is a relatively small market so it’s often difficult to come up with five to 10 really close peers to a public issuer, said Munn.

“This is where a board needs to exercise its judgment and consider which companies go in that peer group and to what degree they should be following the practices of that peer group, given what may be the unique nature of the business involved,” he said.

“Where you see a challenge is where boards are quick to follow the results of survey data and to administer it without consideration for their own performance, their own size, for their own circumstances. Where you end up with useful use of this information and diminishment of the club effect is where a board is willing to take the data as an input to its decision — as opposed to the eventual outcome.”

A coherent, collective action initiative is needed, according to Ambachtsheer, and Rob Bauer, associate director of programs at Rotman ICPM, with the outcome being a coherent, internationally consistent regulatory regime with enforceable consequences for boards.

“(It’s about) what can we do together to require boards of directors to behave within certain boundaries in terms of how they deal with compensation,” said Ambachtsheer.

“And those boundaries ought to reflect principles around, for example, having an explicit structure of your comp scheme that ties compensation to long-term value creation, that that becomes a principle that a board accepts and that then, by definition, the board would be required to explain how their particular structure achieves that purpose.”

But that could just create a new club effect, according to Paul Gryglewicz, managing partner at Global Governance Advisors in Toronto.

“We cannot look at it as a homogenous solution. The better answer is that the public disclosure needs to be clear and there needs to be good evidence that there was a well-engaged process to design the executive pay that included input from both the board and management,” he said.

“There has to be a sense of reasonableness of the executive pay — both the design and pay level. It has to ensure and give the investors comfort in its disclosure that it clearly demonstrates that executive pay is aligned with business strategy and… businesses have the right to be as risky or as risk-averse as they like.”

When a company has performance-based vesting within its long-term compensation, it aligns pay better with performance, said Gryglewicz. But there has to be a collaborative effort to actually implement performance-based pay, as happened in the banking industry coming out of the financial crisis.

“In a governance world, unfortunately, there’s a bit of a ‘first-mover’ disadvantage,” he said. “You have created for yourself a risk of losing your talent prematurely or unnecessarily because they can go to one of their competitors and receive the same dollar value without the additional restrictions around achieving additional performance.”

But it’s hard to say how many CEOs would be a first mover and forego stock-based compensation, said Munn.

“We have to accept we operate within a market and labour has a price and that any board needs to think carefully about adopting that first-mover disadvantage by foregoing stock-based compensation, which then gets you back to the argument on how can we best align stock-based compensation to corporate performance, so that there are rewards to the executive when a company performs well. And how do we then characterize performance: Is it absolute growth in stock price or is it relative growth of stock price, and over what period of time?”

Regulation such as disclosure has had very positive effects, as has the influence of shareholders, he said.

“Where it becomes very problematic is trying to regulate how a board would look at pay for performance. You significantly constrain a board’s ability to apply reasonable judgment, which might actually cause more harm than good.”

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