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The Importance of CEO Compensation Plan Design

By Brent Longnecker and Josh Henke, Longnecker & Associates

Pay for performance has taken on new meaning for many shareholders and boards of directors. When attacks on Wall Street banks ensued after large bonuses were paid post-bailout, quite a few shareholders felt cheated because taxpayer monies were directed toward senior executives’ pocketbooks rather than their own. The banks’ poor form also led to a resurgence of a true pay-for-performance mentality in corporate boardrooms. Never before have boards purposed to demonstrate credible oversight with respect to pay. In addition, the Securities and Exchange Commission (SEC) is placing more emphasis on risk oversight and the actions compensation plans motivate executives to take.

Given the increased attention to pay for performance, it is important for companies to understand that the key to successful compensation plans is not the amount of compensation. Rather, it is intent and design. Simply put: CEO pay should be designed to drive a company’s business strategy and create shareholder value.

Compensation Plan Players
A public company’s leadership structure — corporate executives, the board of directors (specifically, the compensation committee) and outside advisors (executive compensation consultants) — provides proper checks and balances on compensation through oversight. (See Figure 1.) Key roles and responsibilities of these three players are as follows:

Corporate executives: To set company and individual performance targets, provide the compensation committee with recommendations on compensation levels for executives, incorporate the HR team into the compensation planning process

Board of directors: To supply corporate governance oversight and business experience, be shareholder representatives to the company, providing inside independence from management

Outside advisers: To present independent third party compensation expertise, provide opinions on reasonableness through an independent analysis and process.

ceo_planning_process21Figure 1: Public Company Leadership Structure for Compensation Planning

Creating a silo of or excluding any of the three parties may produce an unbalanced process. Note, too, that external influences such as the SEC and its proxy requirements and shareholders who have “say on pay” provide opinions on reasonableness but shouldn’t take the place of sound business judgment in the boardroom.

In conjunction with HR leadership, management should work together to marry company performance forecasts, long-term objectives, budgets and remuneration recommendations for the compensation committee’s consideration. Compensation committees are responsible for setting CEO pay that is fair to shareholders and employees, ensuring appropriate performance hurdles are in place and providing payouts that are clearly aligned with actual performance. Executive compensation consultants, meanwhile, provide an independent, third-party perspective based on market data and experience, presenting recommendations independent of management’s and the committee’s suggestions.

Incentive Plan Components
One of the key considerations for any incentive plan is line of sight: the direct effect an employee can have on company performance based upon his/her own actions and decisions. CEOs have the single greatest line of sight within an organization and thus the most exposure. With public reaction to the millions paid on Wall Street in cash bonuses, a second look is required for the reasonableness (i.e., the appropriateness and/or fairness) and optics (i.e. the perceived pros/cons by an outsider) of such large cash incentives. Companies should always ask whether a compensation plan is reasonable and has positive optics. For example, the use of A corporate aircraft for business use may be financially reasonable for some companies, but may have bad optics to shareholders if company performance has been poor.

Note that the SEC will contend that large annual incentives may motivate top executives to forego long-term company goals and objectives for short-term payouts. While cash incentives are not to blame, the plans themselves need to be reviewed.

A reliable annual incentive plan for a CEO:

• Drives annual performance without sacrificing long-term goals and objectives

• Provides proper stretch performance (company and individual) with requisite thresholds, targets and payouts.

Most importantly, annual incentives are only a portion of the CEO’s total mix of pay (the blend of base salary, annual incentives and long-term incentives). Mix of pay varies from company to company based on the stated compensation philosophy and company culture.

The most important vehicle necessary to tie CEO compensation to the interests of shareholders is long-term incentives. Companies often get into trouble when the annualized bonus opportunity is greater than that of the long-term incentive. For CEOs, the long-term incentive opportunity should always outweigh the short-term compensation opportunity.

In a post-FAS 123R environment of expensing stock options, companies now balance the vehicles used with the associated retention, motivation and expense of each vehicle. While restricted stock remains the most useful retention vehicle, performance shares are gaining prevalence in this pay-for-performance environment. As a best practice, the use of a single long-term incentive vehicle should be limited to companies that have a specific reason for doing so. Diversifying a CEO’s equity portfolio between two or three types of long-term incentive vehicles will allow boards and HR departments to maximize retention in a market downturn and motivate in an economic recovery.

Risk Oversight and Balance
When it comes to risk oversight in public companies, one step the SEC is taking is requiring additional proxy disclosures. Specifically, the SEC wants to determine whether compensation plans motivate executives to trade short-term gain for the loss of shareholder wealth. A true pay-for-performance compensation plan offers paid compensation for defined and visible results.

As much as the SEC and shareholders would like to see full pay for performance for CEOs, a fully variable compensation plan with no guaranteed compensation could lead companies back to the short-term, risky actions taken by Wall Street executives. On the other hand, a 100-percent guaranteed compensation plan, such as base salary and perquisites, will not provide the motivation required by companies and shareholders. It is counterintuitive to require less corporate risk while still requiring increased corporate pay for performance. The answer is placing a stronger emphasis on the process in which compensation plans are designed rather than the results of the plans. Examples that could be perceived as having additional risk in a CEO’s compensation package include: highly leveraged short-term cash plans, a CEO’s compensation package heavily weighted toward annual incentives or very low long-term incentives, no requirement to hold a portion of equity through stock ownership requirement, etc. A balanced pay-for-performance compensation plan for a CEO requires attention and analysis on an annual basis to ensure companies are not over- or underpaying the CEO.

The amount CEOs are compensated will always be at the forefront of the pay-for-performance debate. However, it is the compensation design process that requires more consideration and disclosure. While there always will be skeptics to any approach to CEO compensation, there is no debating that good process, sound business judgment and independent third-party counsel provide the best foundation for CEO compensation plan design.

Contents © 2010. Reprinted with permission from WorldatWork. Content is licensed for use by purchaser only. No part of this article may be reproduced, excerpted or redistributed in any form without express written permission from WorldatWork.

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