Judgment by directors acting on shareholders’ behalf is a cornerstone of U.S. corporate governance. So why is it so controversial when CEO pay is based on judgment?
This post focuses on a more structured approach to making and explaining discretionary pay decisions. It’s not a post about the say-on-pay shareholder advisory vote, which is now required for publicly traded firms, but we use it as an illustration because it has brought the issue to the fore in many boardrooms. A more transparent process, with clear expectations and discussions, can focus performance messages and de-mystify the pay decision for all employees in addition to informing shareholders publicly about CEO pay.
Many of our financial services clients use discretionary approaches to deliver pay and performance messages. The virtue of this model is that it allows for a multi-faceted evaluation of corporate and individual performance. A strict formula does not necessarily create a holistic view of results delivered, no matter how complex or long-term the system.
Say-on-pay has increased the external focus on understanding the relationship between senior executive (primarily CEO) pay and performance. The compensation discussion and analysis section of the proxy form is intended to provide shareholders with insight into the material elements of the pay decisions. Shareholders often rely on proxy advisors, whose recommendations can be highly critical when their simple analyses indicate a pay and performance “disconnect.” If the proxy does not provide enough insight, shareholders must come to their own conclusions about pay and performance.
A compensation committee may interpret this as a demand for a rigid formula by an outsider that “doesn’t get it.” Critiquing proxy advisors is a path well-worn. We’re taking a different tack, with greater potential benefit. Criticism of discretionary pay should prompt a committee to investigate the process and communications to ensure that shareholders and those getting paid have a clear understanding of performance and dollars earned.
Committees should start with three questions:
1. Do executives (and shareholders) know what results we value?
These vary. Financials and shareholder return over time are always important, but how results are achieved also must be reflected in the assessment. These can be environmental (e.g., good performance in a down cycle), or internally-focused (e.g., exceeding numbers in a business at the expense of companywide performance). These are often more nuanced and can be more critical to future success than just “making plan.” Of course, pay has to be affordable, but there’s value in investing in pay to encourage non-financial activity that creates future success. If you're not clear about what results are important and how to achieve them, how can executives (shareholders) understand pay decisions?
2. Do executives (and shareholders) understand performance assessments?
This approach is formal, not formulaic, and has key questions of its own:
- Are there individual performance discussions up front and throughout the year about key accountabilities?
- Does the compensation committee hear from the CEO and executives about results and individual performance?
- Are questions asked to fully understand successes and areas of development?
- Are goals measurable and tied directly to financial, operational and strategic priorities?
There should be no pre-established weightings, allowing decisions to focus on what was really important, compensate executives accordingly and provide a clear rationale for pay decisions. If you aren't talking about expectations and progress, how can you be clear about performance on the most important items?
3. Do executives (shareholders) get a clear explanation of the pay decision?
A chief financial officer once told me that 90 percent of his time delivering pay decisions is spent with the lower performers, who tend to argue about their performance assessment and lobby for more money. A high-performing executive at the same bank told me, “Pay discussions last two minutes. They tell me my number and I say ‘thanks’.” This is a model working in reverse. The year-end discussion should be a proactive, rich overview of expectations, performance and next challenges. Arguably the most time should be spent with future leaders versus poor performers, and the conversation should be driven by the person delivering rather than receiving the message. If you don't use the pay discussion wisely, how will your top performers be energized to continue to succeed?
Fully discretionary pay is very powerful, but to quote from Uncle Ben in the Spider-Man comics, “with great power comes great responsibility.” Proxy advisor criticism in say-on-pay recommendations may seem like an obtrusion by uninformed third parties. We think there’s an alternative viewpoint. Before you dismiss or rail against your critics, ask three questions to ensure you’re getting everything you can from how you make and communicate pay decisions.