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Four internal factors to consider when determining executive pay 

Four internal factors to consider when determining executive pay 

By Ken Tysiac 
September 11 2012

Executives at all kinds of companies – from banks to banana distributors – have had compensation packages receive disapproving votes from dissatisfied shareholders. Citigroup, Chiquita and WPP advertising and marketing agency, in what became known as the “Shareholder Spring” in the UK, made headlines when shareholders voted against raises and incentives for top executives.

Now business leaders around the world say shareholders should be more involved in setting executive pay, according to a survey of 3,000 businesses in 40 countries. Sixty-seven per cent of business leaders said shareholders should have greater involvement in establishing remuneration policy for senior executives at large public companies, according to the survey conducted in May and June by Experian as part of the quarterly Grant Thornton International Business Report.

Just 28% said shareholders should not have greater involvement in setting executive compensation at large public companies. Meanwhile, 66% of respondents said senior executives at large public companies are paid too much.

“The danger of overpayment is, it’s a waste of shareholder assets, it’s corrosive to the culture of the organisation itself, and it’s corrosive to the social fabric and the general culture,” said Charles Elson, director of the University of Delaware’s Weinberg Center for Corporate Governance. “It’s a bad idea all the way around.”

In the US, shareholders were given a voice in executive compensation by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, P.L. 111-203. The Dodd-Frank Act’s “Say-on-Pay” provision gave public company shareholders the right to register a nonbinding approval or disapproval of the compensation of executive officers beginning in 2011.

But pay of US CEOs continued to climb last year. A study conducted for The New York Times by compensation data firm Equilar showed that in 2011, the median pay raise among the 200 highest-paid CEOs in the United States was 5%. And a study by the not-for-profit, non-partisan Economic Policy Institute showed that US CEO compensation grew by more than 725% from 1978 to 2011, while worker compensation grew 5.7% during the same period.

Elson said shareholders’ new say on pay isn’t the best solution to the problem of skyrocketing executive pay. “The threat of non-approval is important, and I think you’ve seen a lot of changes in pay on that basis,” he said. “But the real cause of the problem … has to do with the process by which pay is set.”

Internal benchmarks

Elson said companies need to go back to using internal benchmarks to establish CEO pay. About 20 or 30 years ago, the development of the “superstar” CEO phenomenon led to outsized CEO pay, he said. Corporate boards began setting CEOs’ pay by comparing it to the pay of CEOs at peer companies.

When companies sought to set compensation in the 50th, 75th – or even the 90th – percentile among their peers, Elson said, CEO pay quickly spiralled upward. But he said that’s an unnecessary retention strategy. In a paper Elson co-authored, he cites numerous studies that he says provide evidence of underperformance by CEOs hired from outside the company.

“With the rise of business schools, talent or executive talent was viewed to be acquired and transferable company to company,” Elson said. “[In theory], a great person can run any company. Well, it turns out, it didn’t work out that way. When you bring in the superstar, generally their returns are average or below average, oddly enough, and most people don’t move [from company to company].”

Elson suggests that corporate pay should be set based on internal factors such as:

  • Achievement of internal goals. Executive pay can and has been linked to stock price, earnings, cash flow and even sustainability. Top Whirlpool executives’ compensation, for example, is heavily tied to performance metrics, according to an SEC proxy statement filed in March.

  • Internal pay structures. “Rather than having bonus pools, where usually the company has a pool and the CEO has a pool, the pool ought to be companywide,” Elson said. He believes the CEO wage structure should be an extension of the structure for other employees to promote consistency and equity.

  • Pay grade escalation between the CEO and his or her lieutenants that reflects the pay grade levels throughout the organisation. Elson’s paper cites DuPont as a company that for many years limited a CEO’s pay to 1.5 times that of the executive vice president.

  • A company’s performance compared with its peers. “Is Pepsi eating your lunch or not?” Elson said. If you’re the CEO of Coca-Cola, that might be reflected in your pay.

Business leaders participating in Grant Thornton’s survey overwhelmingly supported the idea of using achievement of internal goals to influence executive pay. Ninety per cent said executive remuneration at public companies should be closely linked to performance targets.

Pearl Meyer & Partners, an independent compensation consultancy, offers tips for responsible management of executive pay. Among them:

  • Understand your company’s pay-for-performance links: To gauge an executive’s potential pay increase, companies must first be able to properly measure companywide success. Total shareholder return takes into account more than just a company’s stock price. Other indicators, such as the metrics of long-term performance plans, should be evaluated.

  • Understand total executive compensation: Sometimes, stakeholders look only at what an executive is to be paid in the coming year. But an understanding of “what-if” scenarios is vital. For example, if an executive is terminated without cause, what is the severance agreement? This knowledge should cut down on “pay for failure” results. Incentive plans should be fully evaluated, as should the effect of other what-ifs, such as acquisitions or restructuring.

  • Balance short- and long-term incentives: Assess the relationship between these performance metrics and the creation of value for investors. If the incentives are not intertwined with value for stakeholders, then the executive likely will focus more on individual goals and less on what’s best for the investors. An interdependency of short- and long-term incentives helps balance the goals and can produce sustained returns for shareholders.

Ken Tysiac (ktysiac@aicpa.org) is a CGMA Magazine senior editor.

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