Unprecedented scrutiny elevates role beyond mere oversight to future-oriented
Compensation committees are facing a level of scrutiny they have never seen before. Investors, analysts, government, the media and rating agencies are all putting the committee’s every move under a microscope.
With the adoption of executive compensation disclosure rules, and more active shareholder groups demanding a say on pay, compensation committees need to work harder to meet the requirements of all these stakeholders.
In response, many boards are seeking to transform and elevate the role and performance of the compensation committee, moving it from a mere oversight function to a more future-oriented role that anticipates the long-term needs of an organization and its shareholders.
Transparency is so fundamental that simply meeting reporting requirements may not be enough. With so much light being cast on executive pay, committees must also be prepared for new accountabilities and a strategic orientation.
A compensation committee needs to have clearly defined terms of reference — or a charter — that outlines the authority of the committee, the parameters for decisions and the process for recommendations to be brought forth to the board of directors for approval.
It should be composed of independent directors who are accountable to establish, review and recommend approval of CEO and executive performance measures, compensation design and payments. It should also approve the CEO’s recommendations for executive performance results and compensation payments.
The committee oversees and approves all policies under which compensation is paid or awarded to the CEO and other executive officers. In addition, the committee needs to:
• monitor management resources, structure and executive development and succession planning
• review incentive compensation, including long-term incentive and equity-based plans, to ensure incentive pay does not encourage unnecessary risk-taking
• annually review and discuss the relationship between risk-management policies and practices, corporate strategy and executive compensation.
The committee should also have the authority to retain compensation consultants, outside counsel and other advisors as appropriate. In the interests of transparency and independence, the committee should have a policy stating any compensation consultant used by the committee to advise on executive compensation will not be the same consultant used to advise the company on any HR matter.
Transforming compensation strategy
In addition to being able to absorb a significant amount of compensation design principles, along with tax and accounting considerations, the committee has to be able to distinguish between appropriate and inappropriate compensation practices for the business. Best practices are not a one-size-fits-all solution.
To ensure alignment with corporate strategy and the needs of the business, the compensation committee needs to devote considerable time — at least annually — to an in-depth discussion and review of compensation strategy and structure, with an eye to future business challenges and direction.
To anticipate potential issues, committees should review and consider the long-term impact of compensation plans, including the potential for total payouts in a variety of circumstances.
It is increasingly important to analyze future business performance scenarios for deferred compensation, pensions and equity holdings.
The compensation committee also plays a significant role in assisting the board in developing and evaluating potential candidates for executive succession, including the position of CEO.
A thorough review of the succession plan, executive career paths and changes to compensation assists the board in attracting and retaining a strong management team with the necessary skills and level of performance to advance strategic priorities of the business.
As part of the strategic compensation review, it is important to have a stakeholder communications strategy. Part of the strategy must contain a well-defined process to communicate sufficiently with shareholders to create greater understanding of the rationale underlying executive compensation decisions and to respond to any concerns.
Fostering relationships while maintaining independence
Conflict comes with the territory when dealing with executive pay — anyone who has dealt with compensation, or read any of the recent headlines on outrage over corporate largesse, is aware of this.
A clear compensation philosophy, clear pay practices and policies, and a communications strategy will help to avoid some of the issues and potential disagreements, both internally and externally.
Boards have a strong interest in the work of the compensation committee and need increased communication and detailed information regarding compensation practices and results.
It is also important the committee fosters good relations with HR, management and the CEO and effectively manages conflict while maintaining independence. The chair of the compensation committee must have a strong competency in relationship management to manage the expectations of such a diverse constituency.
Although it is widely understood committees should have their own performance evaluated regularly, there are still many boards that haven’t included committee evaluation as part of measuring overall board performance.
With the ever-growing responsibilities of the compensation committee, there is an absolute need to review the effectiveness of its performance and the compensation strategy. It is often recommended a third party review the performance of the committee to ensure independence of results.
The complexity of compensation strategy and programs increases with the size of organizations. The time commitment demanded by the regulatory and shareholder activist environment is significant and may require additional compensation for directors of the compensation committee.
To reinforce ongoing effectiveness, formal director education programs are important for new members of all committees of the board.
With the complexity of issues and compensation arrangements, it’s important to have education programs for new members of the compensation committee so they can get up to speed as quickly as possible and become full participants in ongoing decision-making.
A high-performing compensation committee that incorporates appropriate best practices will continue to evolve with the challenges of the business and regulatory environments. It will be an incredibly important resource for the board of directors and management.