Executive compensation and performance-based pay continue to be a hot topics in board rooms and in the press. Corporate directors should be wary of compensation plans that can distort the pay for performance equation. Two pending SEC rule changes may impact how public companies implement executive compensation in the future: the Pay for Performance disclosure, and the CEO pay ratio. Where CEO pay and company performance are misaligned, proxy reporting will raise a red flag for shareholders and investor groups. Large pay packages that result in problematic CEO pay ratios (the ratio of CEO pay to employee median pay) have been key topics in the press as companies anticipate the implementation of the SEC’s new pay ratios rules.
As the deadline nears for implementing these new pay disclosure rules, public boards and executives should focus on the effectiveness of all elements of executive pay. Since a large part of CEO compensation is long-term incentives, typically stock-based or plan-based compensation, these plans should be closely evaluated. While public companies will be concerned with the new pay rules, private companies will also be interested since pay for performance is a best practice. Consequently, long-term incentive pay will be a focus in the near term.
Historically, long-term incentives were granted to retain executive talent; executive retention is greatly enhanced when adding a vesting feature and a forfeiture clause for executives who leaves before vesting. Retention in the form of long-term incentives generally were implemented using stock grants, primarily in the form of restricted stock and RSUs with vesting after three or five year’s continuous service. Stock options could also be used to help with retention; however they often lose their effectiveness when the stock price drops and options fall underwater. While these types of grants are effective retention tools, they lack the focus that is generated with performance-based incentives.
We believe that a meaningful way to measure the effectiveness of long-term incentive compensation is to evaluate whether the incentives reward senior executives for meeting and sustaining the strategic goals of the company. While service vested stock grants have an element of performance, too often vesting of large stock grants occur during a time when the company’s performance is declining. This misalignment of pay and performance can send a bad message to shareholders and regulators. A better message to send occurs when a large block of stock vests when the company achieves a key success or during a period of excellent performance. For this reason, we believe that long-term incentive pay should be primarily tied to company performance that is linked to long-term, sustained improvement in shareholder value.
Naturally, these incentives should be linked to the executive team’s success against the main goals outlined in the company’s strategic plan. This can be a complicated task. Executive teams are leery of setting performance expectations too far into the future due to the uncertainty of the business environment. The need to set goals that are measurable and meaningful is a significant factor in a plan’s success. A few key goals can be far more meaningful than a long list of performance objectives that may be difficult to track and fraught with confusion about final outcomes. Ultimately long-term incentive plans should (1) be simple enough to communicate to multiple constituencies, (2) reflect the expectations of the board over a long time period and (3) align with sustained and improved total shareholder value.
However, long-term incentives tied to key performance objectives often compete against the desire to meet annual incentive plan goals. Focus on short-term earnings performance and near-term outcomes to satisfy investor groups can be a detriment to achieving a long-term strategy. For public companies, too much emphasis is placed on quarterly results at the expense of meeting longer term objectives. Private companies have less pressure, but the tension between short-term performance and longer term strategic objectives still exists. Successfully implementing performance-based long term incentive plans is one way to counter the pressure of shorter term thinking.
For example, most financial institutions are experiencing pressure to boost their earnings because of declining revenues due to low interest rates. Could this lead bank executives to seek higher interest rate loans with greater risks or higher market concentration in order to generate higher rates and more fees? Could this pressure to boost earnings cause executives to drift away from the long-term strategy of the bank? Of course it could; this is reasonable outcome when pressure on short-term earnings overshadows the long term strategy of a bank; this focus could be a problem for future success. Our suggestion to counter this short-term behavior is to establish long-term incentives linked to an emphasis on loan portfolios that are more consistent with the bank’s strategic direction.
So what are some of the key issues to address if you want to implement a performance-based long-term incentive plan? As a first step, do you have an up-to-date and effective strategic plan? If not, start here. Next, you need to decide whether stock or cash is the best way to provide executive incentives. Also, determining the best time frame for vesting is another important step. We think a minimum of three to five years makes sense. However, you may want to tie the vesting to a major business initiative or a future liquidity event; these events don’t always occur on a fixed schedule. Using multiple grants (annual or biennial) can add another favorable dimension to the plan design. Having rolling vesting dates can help sustain the plan’s long-term momentum. These plan design features and many other plan design decisions must be made when implementing a new plan or moving the emphasis away from service vesting toward performance vesting.
In summary, performance-based long-term incentive plans are a recognized best practice among industry experts and corporate governance groups like ISS and Glass Lewis. With the SEC implementing new rules that will spotlight pay for performance and CEO pay, this may be an excellent time to evaluate your current executive compensation plans to make sure that executive pay is closely aligned with company performance. Finally, directors and executives should examine both the annual bonus plan and the long-term incentive plan to validate that these plans are fulfilling the long-term strategic needs of the company.
Citi is finally getting CEO pay plans right! After losing their shareholder “say-on-pay” vote at the 2012 Annual Meeting of Shareholders, new Chairman Michael E. O’Neill, who just took over as Chairman last April, interviewed a large number of important shareholders. He was told that paying their CEO a $6 Million Incentive based on a two-year (2011 and 2012) cumulative pre-tax profit of $12 Billion, may sound like a good deal for the shareholders, but it was fraught with problems.
Incentive Pay Must Be Carefully Designed
To begin, the Company had 2010 pre-tax profit of approximately $12 Billion. So, the hurdle for earning the $6 Million was half of the actual earnings in 2010. Yes, the economy has made earnings difficult to produce, and yes, Citi is trying to overcome internal problems, but shareholders were unwilling to allow a hurdle rate that low. There were other problems with the design of the Plan.
Cumulative two-year pre-tax earnings ignores the fact that the bank could grow assets at a decreasing return on each dollar and meet the earnings hurdle while increasing their capital requirements significantly. Using volume of profit as a management performance measurement always has this inherent problem. In fact, increasing volume of profit can and often does result in lower returns on equity in banking. For that reason, shareholders can lose as management earns more, and a lose-win plan is never good.
Finally, building on the last point, there is no clear link between shareholder returns and management pay in the Plan Citi was using. A common objective of executive compensation plans is to align the interests of management with those of the shareholders. The old Citigroup, Inc. Plan did the opposite to some degree. The Board of Citigroup consists of intelligent and successful people, but they got some bad advice along the way. After Chairman O’Neill spoke with shareholders, he tasked the Board’s Compensation Committee to redesign the CEO’s Compensation Plan to address the shareholders’ concerns. He was not about to get a negative “say-on-pay” vote after his first year as Chairman.
Now, in my many years of studying and designing executive compensation plans, I have yet to see the perfect plan. It just does not exist. Business is too complex to allow for such a thing, and the need to keep the plan as simple as possible is an important constraint. Yet, the new Citigroup, Inc. Management Compensation Plan addresses shareholder concerns with an elegantly simple design.
Executives will be granted units worth a certain amount in three years if certain performance is achieved. Citigroup stock must perform in the top three-quarters of a carefully selected peer group of stocks of similar companies, and Citigroup’s Return on Average Assets over the three years must beat a hurdle equal to the previous year’s actual or there will be no units rewarded. Furthermore, if the Return on Average Assets over the three years is better than the previous year by a significant percentage, then a target number of additional units will be awarded.
This design is superior to the old design because it clearly:
aligns management’s interests with those of the shareholders and
it is tied to relative performance compared with peers as well as the Company’s strategic goals.
There are some potential draw backs to such a plan, but the new plan is so much better than the old plan, I will not spend words on the risks in this particular blog. Perhaps in the future, we can look at some of the potential flaws. In the meantime, I say congratulations to Mr. O’Neill. I may go buy some Citigroup stock!
A recent headline from WorldatWork indicates the gap between CEO and CFO pay is growing farther apart. The study conducted by BDO USA, LLP indicates that CFOs average 40% of CEO pay at 600 public companies included in the study. One reason offered for the increased disparity is due to CEO pay being more commonly tied to the increase in the company’s equity, which for most public companies, increased substantially in 2010 and 2011.
While CEO’s have historically been paid at levels higher than the rest of the executive team, this recent trend of an increased gap could lead to problems. Shareholders may assume that the change in the CEO – CFO pay comparison could be a reflection of how the Compensation Committee values the relative roles of risk-taker vs. risk-controller. Let’s hope not. That led to some serious problems in the past. It is more likely that the bigger recent gap is due to the 2010 and 2011 run up in stock prices and the CEO’s larger percentage of compensation tied to stock price gains. Should the mix be so different for the two positions? A return to a more equitable internal pay structure will help avoid potential perceptions among shareholders that CFOs are not valued as much as they have been in the past.
With slowly improving economic indicators, organizations are reviewing current compensation practices. In addition to the scrutiny on executive compensation as a result of Dodd-Frank, this renewed focus on executive pay will require organizations to focus on their philosophy and implement equitable compensation plans. Compensation Committees may want to look at how relative compensation has changed over time and consider ways of optimizing compensation mix to stabilize the fluctuation in the comparisons.
In our Firm’s work with client executive teams, we have historically measured the internal pay equity of senior executives measured as a percentage of the CEO’s pay. We have significant, historically viable data showing the relative pay for all executives on the senior team as related to that of the CEO. Two critically important objectives of any company’s compensation philosophy should be to target external competitiveness and be internally equitable.
If you would like a review of your company’s current compensation practices measured against market, industry and custom peer groups, please give us a call (919-644-6962) or visit us at http://matthewsyoung.com.
The short answer is that Salary Surveys provide the necessary market data to build competitive pay structures for your organization. While there are many objectives to a properly formulated compensation strategy, the two most commonly referenced are:
Ensuring our plans are internally equitable, and
Ensuring our plans are externally competitive.
Meeting both of these criteria enables your organization to attract, retain and motivate the right numbers of the right kinds of employees. Good Salary Survey data (i.e. from competitive sources like your State Bankers’ Association’s Salary Survey) provides you with the information needed to ensure your bank’s compensation plan is competitive.
Comparing roles to Salary Survey market data is important, but it’s not the only step to creating a competitive compensation program. First, before you can tailor a compensation strategy to your organization, you should have an understanding of your organization’s compensation philosophy and strategy (How do we want to pay?).
Second, you should clearly define the key roles within your organization including current and accurate Job Descriptions for each position. Accurate job description detail facilitates the comparison of market data to how you’re currently paying your people (Pay Practices vs. Market).
Taking this information into consideration, you can build one or more salary structures, as appropriate, with grades and control points (Grade Minimum, Midpoints and Maximums) customized to our unique organization’s needs. By combining your salary structure(s) with performance management ratings, you can pay for performance delivered as well as accurately anticipate, budget and plan for total compensation costs.
Because building an effective compensation strategy is a nuanced process with varied approaches that depend on your organization’s unique priorities, Matthews, Young Consulting is offering a new Learning Lunch Compensation Webinar Series this fall to help you turn salary data into insight and ensure your organization attracts and retains the staff necessary to achieve your goals. The topics and dates are listed below:
September 7th – Using Survey Data to Value Jobs
September 13th – Building Effective Job Descriptions
September 21st – The Compensation Audit: Do your pay practices match market and your intent?
October 5th – Using Job Values to Build Salary Structures
October 19th – Principles of Merit Pay
November 2nd – Merit Pay Budgeting
All webinars will start at Noon and last for about an hour.
We’re currently discussing the topics on Twitter; send us your questions and suggestions @MatthewsYoung!
Members of the GBA, NCBA, SCBA, TBA or VBA can receive a complimentary invitation by emailing me at W.LaFontaine@MatthewsYoung.com. If you are not a member of the State Bankers Associations listed above but would like to attend the webinars, the fee is $300 per session and you can register at http://matthewsyoung.com/WebinarRegister3.htm. We look forward to working with you to craft a current, competitive and most importantly effective compensation strategy!
We have been contacted over the past 6 months by a number of large employers across the southeast, who have recently experienced a compensation audit by the U.S. Department of Labor. Key parts of these audits have been requests for documentation on the Company’s compensation policies and information to support how the Company’s practices match policy. Key areas reviewed included overall compensation policy, base compensation, distribution of salary adjustments, incentive plan structures, and FLSA compliance (interestingly these audits do not seem to have targeted ERISA or other key DOL areas).
As with any audit, preparation is always a “best practice”. If you have questions about what being compliant means, if we can assist you with an audit of your current pay practices, and/or if you need help developing policies and processes that match Company intent and are legally compliant, please contact us at 919-644-6962, or complete a contact request at http://matthewsyoung.com/contact.htm.