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HR Plays the 'Critical Role'

It's up to HR executives to manage the executive-comp process as well as the comp committee itself, according to experts. Recent trends in CEO compensation and proxy analysis were also topics of discussion, as was the impact of private-equity firms on comp packages.

Friday, May 23, 2008
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HR leaders play "the critical role" in executive compensation as they balance the competing ideas and strategies of a company's board and its management.  

So said Patrick McGurn, of RiskMetrics Group, formerly Institutional Shareholder Services, after a session he co-presented with David Chun, CEO of Equilar, entitled "Emerging Executive Compensation Trends" during the Total Rewards 2008 WorldatWork Conference being held May 20 to 23 at the Philadelphia Convention Center.  

HR needs to step between the "dueling consultants" hired by both the board's comp committee and the CEO, he said, to make sure executive compensation is appropriate for both the performance of the corporate leaders and the interests of the shareholders.  

And HR must struggle to work with comp committees that seek independence from management, deeming the company's consultants as "tainted," and opt to operate in a "vacuum" when determining pay packages, he said.  

While such a situation comes about because too many HR leaders rework comp packages to suit the CEO's desires, the end result of such board independence can result in a failure to create pay packages that meet the company's philosophy and strategic needs, he said.  

"That's just problematic," McGurn said. "I think this is the area for HR professionals to get more time with the board and comp committee directly.  

"I think increasingly you will see HR professionals play that role," he said.  

As for emerging trends, he sees the potential conflicts of interest on the part of compensation consultants to be the "big issue going forward."  

In addition, he sees the focus on comp "shifting, by and large, from just looking at the CEO and management team [to] monitoring the board's role in overseeing that process."  

And regardless of who wins the presidency, legislation affecting executive compensation is almost sure to be approved, possibly within the first 100 days.  

There has been "unprecedented" interest in executive comp, McGurn said, including the "Congressional show trials," which drew some of the extremely highly paid CEOs and comp committee chairmen to Washington for hearings.  

Restricting executive comp is a populist issue, he said. "There's not an ounce of difference among the candidates."   

The content of that legislation, of course, is a mystery, but it could include some "say on pay" provisions, a cap on compensation, broader clawback provisions (requiring corporate leaders to repay compensation based on  less-than-stellar performance), and zero tolerance "or something close to it" for conflicts of interest by comp consultants, he said.  

But even now, some changes have been noted in company practices, said Chun, who offered some analysis of proxies filed in the prior year.  

He said there has been a shift toward pay for performance, with the CEOs of S&P 500 companies receiving an average hike of 1.3 percent in 2007, versus 6 percent in 2006.  

Total bonuses were down 5 percent, the number of stock options issued were flat, and stock awards were up about 11 percent, he said.  

Last year, he said, was the first year the number of CEOs receiving stock awards exceeded the number of CEOs receiving stock options. That reflects a shift, Chun said, from rewarding CEOs with tenure-based equity to performance-based equity.  

It is a trend that may not continue, however, as he sees the number of option grants starting to increase in the current year, he said.  

Greater transparency has been widespread, McGurn said.  

"We have seen most every board and company come forward with disclosures that provided much more ...  information on how their [pay-for-performance plans] worked," McGurn said.  

Chun said 68.3 percent of companies disclosed actual performance targets last year, which was the "biggest surprise" to him. The prior year, it was 44.4 percent.  

But even when performance targets need to be confidential, McGurn said, companies should make sure the proxies include some "valid rationale" for not disclosing the information  

In addition, he said, companies should keep such information simple. Pay-for-performance dislcosure should include metrics, target and payout, he said.  

Institutional investors and the SEC will look much deeper at convoluted presentations than simple, clear reasons for performance plans.  

"The issue of why the plans are structured the way they are" will drive the questions, he said.  

His organization, which advises institutional shareholders on proxy votes and provides corporate governance consulting, also looks for companies attempting to "game" performance metrics by choosing peer companies that are not good for comparison, such as a company whose market cap or revenue doesn't fit for a peer group.

He also advised companies to look at long-term executive contracts as "the root of most evil" in executive comp. Short-term contracts should be offered for new executives, he said, but there's no need for long-term agreements.  

Other areas HR leaders should be wary of are "gross-ups," where executive are reimbursed for tax payments ("This is Leona Helmsley land," McGurn said. "Only the little people pay taxes."); personal use of company aircraft ("It's going to become a flashpoint issue and one that will attract significant negative attention for the company."); and relocation-expense guarantees for executives who have made poor real estate decisions ("These disclosures will start to show up in major numbers next year.").  

Chun said that, while overall perquisite trends fell 1.3 percent for CEOs at Fortune 100 companies, the median value of aircraft-related perqs increased by 12.1 percent.  

He also said the median value of tax gross-ups offered to Fortune 100 CEOs fell nearly 41 percent from 2005 to 2006, while the prevalence of tax gross-up disclosures increased from 40 percent in 2005 to 53.8 percent in 2006. 

Comp Committee Relations   

Compensation committees look to HR to manage the process of creating comp packages, according to the presenters of a session entitled "What the Compensation Committee Wants."

Kathryn DCamp, the former senior vice president of HR at Cisco Systems, who now heads a comp committee for one public company and sits on comp committees for two other companies, and Robin A. Ferracone, a compensation consultant, who is CEO of RAF Capital and executive chair of Farient Advisors, said it's important for HR leaders to understand what -- and why -- comp committees want what they do.  

"They really want confidence to do the right thing but to stay out of the spotlight," Ferracone said.  

Comp committees want "unbiased information, untainted information" from HR and they want "good process" and "good debates," she said.

If the current committee process is lacking, DCamp said, that provides a good opportunity for HR leaders to step up and make an impact to set the agenda and add insights, such as offering a review of the competitive landscape or providing tutorials to help members, who are less financially inclined, get up to speed.  

HR should not be acting as an advocate for the CEO, they said. HR -- and all the other stakeholders: the CEOs, comp committee chair, consultants and other executive staff -- should be acting as advocates for the shareholders.

Comp committee members also don't want an HR leader "carrying water" for the CEO, said Ferracone. "That's not the right lens these days. It's to get the shareholders what they want [not the CEO]."

And they want HR to provide them with honest information, said DCamp. That means presenting pay-for-performance plans that have proper goals attached to them -- not ones so easy the executive merely has to show up for work -- and using peer companies for comparative purposes that are appropriate.

In addition, they said, HR should not act as a "gatekeeper," meaning it should not try to prevent information from coming to the committee, such as a consultant's recommendations that don't agree with management's.

And they don't want HR "coming in to sell something. ... You don't get the decision. They get the decision," DCamp said.

But, at the same time, Ferracone said, "Think about adding value through your own view of what's right."   

HR leaders should be proactive and "think ahead of them and come to them with materials instead of having them calling around for details," she said. HR should "think several moves ahead," like a chess player. "The last question you want is 'Why didn't you think of that?' or 'What were you thinking?' "  

The "elephant in the room" of comp committee meetings, DCamp said, is that there is "natural tension" between the board and management.  

It's up to HR to supervise the tension and make the comp committee feel more comfortable, the presenters said.  

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"Managing relationships" is an important part of the job, Ferracone said, and it's better to deal openly with the conflict "instead of ignoring it or pretending it is not there."

CEO Comp Trends

In a session entitled "CEO Pay: The Latest Numbers, Trends and Performance Linkages," two Hay Group executives reported on the findings of the 2007 CEO Compensation Study.

Referring to the Wall Street Journal/Hay Group study, consultant David Wise pointed out that a major milestone in the history of CEO pay was reached in 2007, when performance-based plans overtook, for the first time, stock options as the most popular form of long-term incentive compensation.

"This is something shareholders have been calling for more and more in recent years -- and we've seen companies respond in the big way," Wise said.

For total compensation, Wise said, the study found that the average CEO took home close to $10 million in 2007. "Most of that -- $6 million of the $10 million -- was dominated by the long-term incentive piece," he said.

"When you think about how CEOs become wealthy here in the U.S.," Wise told the audience, "it isn't because of their base or their bonus, but because of the long-term piece. That's where all the upside is."

Despite a poor fourth quarter for businesses, Wise reported that the study showed a median increase in net income of 7.9 percent and a 9 percent total shareholder return in 2007 for CEOs. Base pay increased roughly 4 percent.

Performance plans made up 47 percent of the CEO's total long-term incentive value in 2007, up from 41 percent in 2006, the study found. Stock options, meanwhile, declined to 37 percent in 2007, from 42 percent in 2006.

Of the nine industries studied, three still relied "most heavily" on stock options: consumer services, financial and healthcare.

"Because we have this shift to more performance-share plans, the focus going forward is really going to be on performance measurement," explained Irving Becker, national practice leader for executive compensation at Hay Group.

"The comp committees are really challenged with this issue," Becker said. "In the past, they had to worry about the annual bonus and the budget process, but now they have to feel comfortable looking three years out."

Similarly, he added, "HR executives are going to need to become much more comfortable with these metrics."

What lies ahead? Becker said the study's findings suggest that a framework is now being laid for more pay for performance in the future.

As for "internal equity," he predicted that companies would be taking a much closer look at their practices.

"It's not as simple as saying the CEO should be paid two times that of direct reports. Every industry is different. I would expect new proposals around this issue in the next couple of years."

Private Equity and Comp

If you're an executive looking for a big upside, a private-equity-owned company might be the place to go.

So suggested John D. England, a managing principal at Towers Perrin, during a session entitled "How Private Equity and Hedge Funds Are Changing Executive Compensation."

England noted that it's probably not a coincidence that Robert Nardelli, who made headlines because of his rich pay package while at the helm of Home Depot, took a rare "vacation" after leaving the home-improvement retailer and went to work for automaker Chrysler, which is owned by Cerberus Capital Management, a private-equity firm.

"The opportunity for wealth creation is far greater in a private-equity-owned company than in a public company," he observed.

In his presentation, England detailed some of the major differences between private-equity-owned companies and their public counterparts.

In companies owned by private-equity firms, England said, the focus is on the back-end rather than what happens after an initial public offering is done. "The culture is very focused on making sure the deal is successful in a three- to five-year time frame," he said. "Longer-term thinking is simply not front and center."

The upside of reaching one's goals can be significant, England said, with 8 percent to 12 percent of the equity available to management. But failing to reach one's goals can be costly, including earning no bonuses at all. "If there's no upside, [the thinking is], 'Well that's too bad,' " he said.

England pointed out that private-equity firms tend to limit incentive pay to a small, select group of executives. If CEOs want to reward a larger group of employees whom they considered critical to the business, he said, they should expect pushback from the private-equity firm.

To measure performance, England added, these firms like to focus on EBITDA (earnings before interest, taxes, depreciation and amortization) and cash flow, not earnings per share or revenue. "They care about issues that impact value," he said.

 

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