The Right Way to Determine Executive Pay

The Right Way to Determine Executive Pay. By Richard R Floersch
Compensation is about more than just recruitment and retention.
WSJ, Mar 05, 2009

It's that time again -- proxy season -- when compensation committees, independent advisers and HR executives are making final decisions about executive compensation in public companies for 2009 and beyond. Meanwhile, public anger about big paychecks is at a fever pitch.

In this climate, those responsible for setting the parameters in the private sector need to start asking the right questions and taking actions, even if the results aren't popular among executives. If they don't, Congress will likely seek to change the way compensation is provided.

This would be unfortunate, because aside from disclosure, past attempts to regulate the amount and form of executive compensation have backfired. The $1 million limitation on deductibility of senior executive compensation, which became law in 1993, resulted in many companies increasing CEO salaries to $1 million. Earlier limitations on exit packages had the same effect -- the ceiling became a floor.

Often lost in public debate is a critical point: Compensation is, or should be, an integral part of a business strategy, devised to incentivize executives to accomplish that strategy.

Pay isn't just about recruitment and retention. It's also a form of communication about a company's culture and values, which can impact a company's relationship with its employees, its brand reputation, and ultimately its share value. The boards and executives at leading companies have created a culture of leadership that reinforces a true pay-for-results orientation -- pay goes up with positive results and down when the company does poorly.

Perhaps the best way all companies can demonstrate this orientation is to ask the following questions:

Does your company have incentive measures that address both company performance and its sustainability? A focus on revenue growth means little if the results will have negative long-term effects or result in massive write-downs.

Are the potential payouts under your annual incentive capped at a reasonable level to minimize "swinging for the fences" at the expense of long-term company viability? Does your compensation committee have discretion to adjust payouts that, while reflective of actual performance, do not appear fair in the broader context? Finally, does your compensation committee place a higher priority on doing what's right for the company in the long term ahead of merely copying what competitors and other companies are doing?

Other questions: Are your company's stock ownership and/or retention policies sufficiently rigorous to require executives to own substantial company stock over their careers, and hold it for long periods of time to align pay with shareholder interests? Does your company have a meaningful clawback (recoupment) policy? More than 64% of the Fortune 100 companies have clawback policies. If a company doesn't perform as well as originally believed, then why pay executives as if it did?

The good news is that setting aside the unique Wall Street pay model, which was focused on short-term results and annual bonuses, many large companies already have executive compensation structures that are predominantly focused on compensation for long-term performance. According to Equilar Inc., a leading compensation data and analysis firm, roughly 70% of total compensation for S&P 500 CEOs was in the form of long-term incentives, typically earned over three years or more and predominantly tied to shareholder return.

The debate over executive pay will no doubt persist. Policy makers should abjure knee-jerk reforms and carefully consider the actual impact of proposed changes on pay. And boards and corporate leaders need to earn policy makers' trust by demonstrating that we understand that pay communicates a broader message, and are willing to be part of the solution.

Mr. Floersch is executive vice president of McDonald's Corp. and chairman of the Center on Executive Compensation, which represents the senior HR executives at some of the largest U.S. corporations.