Executive compensation is rapidly changing due to the increasing media spotlight and shareholders’ heightened scrutiny. Accordingly, the roles of stakeholders in the executive compensation process are evolving. To make an effective contribution to a successful executive compensation program, HR professionals have to understand how the executive compensation environment is changing and what lies ahead.
Executive compensation stakeholders
Before describing HR’s role in executive compensation, it’s important to identify the stakeholders in the executive compensation process. They include, along with HR, the board, the chief executive officer and the compensation consultant.
In a publicly traded company, the board is usually represented by a compensation committee. The board and the compensation committee are responsible for protecting the best interests of the shareholders. The board and the committee are responsible for reviewing and approving the performance and compensation of the CEO and other senior executives. The executive compensation program they recommend must be effective in motivating and retaining key leadership talent and should support the elusive goal of aligning shareholder and executive wealth creation interests.
The CEO is responsible for choosing, nurturing, motivating and assessing an executive team. Executive compensation in all its forms (base salary, annual bonus, long-term incentives, benefits and perks) is an important tool a CEO can use to motivate an executive team. Therefore a CEO wants to have input on the design of an executive compensation program. There is a delicate balance here in that the CEO’s input into an executive compensation program design can also affect the CEO’s own compensation.
The compensation consultant:
Compensation committees and executives look to the consultant to bring new ideas on executive compensation practices that have worked in other companies, as well as an objective view of executive compensation levels at other organizations.
Executive compensation trends
Aftershocks from recent corporate scandals in the United States continue to shape executive compensation both in the U.S. and in Canada. In particular, there are two broad undercurrents that are having a significant influence on executive compensation.
There is an increasing consensus on board governance principles and how boards should manage executive pay. One of the key recommendations of The Canadian Coalition for Good Governance, a Toronto-based group that promotes the interests of shareholders, is for boards and committees to be independent of management and to develop and preserve an independent point of view, with their judgment not impaired by the influence, and potential self interest, of the CEO and other executives.
Now more than ever, investors look to the boards and their compensation committees to demonstrate a high level of understanding of, and involvement in, executive compensation. Compensation committees are looking to independent advisors or consultants, who do not report to and are not influenced by management, for assistance.
Long-term incentive program diversification:
Corporate scandals have also contributed to the view that executive compensation is out of balance. The perception is that compensation levels are either too high or, at best, ineffectively aligned with the interests of shareholders.
Aside from a basic desire to hold boards accountable for assessing and rewarding executives for performance, there has been a building consensus that long-term incentive programs, such as stock options, do not necessarily align shareholder and executive interests.
The concern is that stock-option incentive programs may encourage executives to manage their businesses to produce short-term gains in stock price, rather than sustainable, long-term growth in the value of the company. Consequently, there is a clear trend towards increasing diversification in the long-term incentive programs that now underpin executive compensation.
A look at the long-term incentive programs of companies in the S&P/TSX 60 shows that 34 per cent of the companies listed have two types of long-term incentive plans, 32 per cent have three long-term incentive plans, 17 per cent have four plans and eight per cent have more than four types of long-term incentive plans in their overall executive compensation programs.
Only eight per cent of listed companies have only one type of long-term incentive program. Whereas a few years ago long-term incentives would have exclusively taken the form of stock-option or share-appreciation vehicles, now companies are adopting a portfolio approach to long-term incentive plans. This includes whole share programs (restricted stock, restricted share units and deferred share units) to encourage real share ownership with the potential for closer alignment of shareholder and executive interests. This trend towards a portfolio approach in long-term incentive programs for executives will likely extend beyond the S&P/TSX 60 to other mid-cap and small-cap companies listed on the S&P/TSX composite index.
Where HR comes in
So, where does HR fit into the picture? What is HR’s role in executive compensation? Vice-presidents of HR must walk a tight-rope as they interact with their CEOs (to whom many directly report), compensation committees and consultants or advisors.
HR can and should act to support the compensation committee. Although the compensation committee must be independent and maintain an independent point of view, the practical reality is the time and resources of the board are limited. Compensation committees rely on HR to co-ordinate the consultant’s activities and to monitor his day-to-day activities.
HR is also responsible for providing specific data inputs to the compensation committee and the consultant, who needs numerical data on current and historical compensation levels and financial performance. However, even more important is the input that HR can provide relating to the:
•business issues the company faces;
•the organizational culture; and
•the “human” side of executive compensation, such as the needs of individual executives to continue to be effectively engaged in the business.
Although HR should not control the executive compensation process, it is critical that HR provide the inputs described above. Failure to do so can result in an executive compensation program design that may be inappropriate or ineffective.
HR also has an important role in communicating the executive compensation program recommended by the compensation committee to the executive team. With the trend towards a diversified long-term incentive, the job of communicating how an executive compensation program works is now more complicated. HR needs to have a good technical understanding of the taxation and accounting implications, plus the risk and incentive implications of the vehicles that are featured in long-term incentive plan portfolios.
Finally, executive compensation does not exist in a vacuum. An executive compensation program is influenced by, and is an influencer of, a business’s broader compensation programs. Since both executive and broad-based compensation programs must be responsive and compatible with the business context of the company, HR must be adept at recognizing and reinforcing the linkages. The philosophy behind an executive compensation program firmly based on pay for performance can be communicated by HR to the employee base as a whole and extended across the board to other compensation programs designed by HR.
Larry Moate and David Gore are senior consultants at Watson Wyatt’s Human Capital Group. They can be reached at (416) 862-0393.