January 20, 2022 Executive Compensation Executive & Director Pay Design Articles

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Executive & Director Pay Design

Five Questions Compensation Committees Should Ask When Setting Executive Pay

While the mandate of many Compensation Committees has expanded to Human Capital Management, the key responsibility of setting compensation remains. 

In this era of the great resignation and a fluid and competitive talent market, not to mention stakeholder capitalism, that job has become even more critical and challenging. Committees must be aware of governance guidelines, investor and proxy advisor views, and market data to inform the process. While all this information provides important context, Committees should decide based on what will best drive the company’s intended business and talent outcomes. As Committees set compensation amounts and structure, five key questions can inform their decisions. 

1. How do our decisions affect our competitive positioning, and is this positioning aligned with the Company’s philosophy and executive performance? 

Always start with understanding the executive’s position relative to the Committee-approved peer group from the prior year (the baseline). Is this positioning consistent with the company’s pay philosophy, and with the executive’s role and value to the organization – current performance and potential? Do we need to make up for a lower positioning? Or is the baseline in line with or high compared to the market? 

Once the Committee has a preliminary view of compensation decisions for the current year, it should request updated benchmarking to reflect these decisions. Since benchmarking is backward-looking, it will be important to project how the market will move in the current year, and then review the proposed pay increases vs. the adjusted benchmarks. Do the range of proposed increases feel justified given the company’s performance? Is the positioning for the executives appropriate relative to their performance and value to the organization? Does the Committee have a strong rationale for the positioning based on performance and other factors?  

To promote retention, it is essential to have a philosophy about how much ‘holding power’ your equity program should provide, and to ensure your grant practices align with that philosophy

2. What is the right mix of pay? 

The structure and mix of compensation matter just as much as the overall amounts. Key elements are base salaries, annual bonuses, and long-term incentives. Base salaries (often supplemented by annual bonuses paid in cash) provide a competitive and desired level of annual liquidity for executives. Investors and proxy advisors naturally prefer conservative salaries. They favor at-risk pay, with a sizable portion tied to long-term performance and shareholder alignment. However, from a motivation and retention perspective, executives often like the recognition of periodic base salary increases. When combined with a cash bonus, these amounts should be competitive with the market and provide appropriate annual liquidity for executives. Executives early or mid-career may have more annual cash flow needs than more established executives. The Committee must balance sometimes opposing views when making these decisions. 

The Committee should also consider the Company’s philosophy on mix of pay. Some technology companies provide low base salaries and no cash bonus, preferring to rely on frequent equity vesting to provide liquidity. At other companies, once salaries are at median, they may choose not to make any additional increases to salaries. 

As for long-term incentives, for public companies these consist mainly of equity grants, often with significant amounts contingent on future performance. These pay structures can create the greatest alignment with shareholders and drive sustainable performance. They also give executives an opportunity for long-term wealth creation. Indeed, investors typically prefer executives be paid mostly in long-term equity, with at least half of that equity tied to future conditions. This structure also works well to motivate the executive team, provided the goals are clearly defined and attainable. Boards will frequently choose to provide the largest portion of pay increases in equity, particularly once base salaries are at the market median or higher given unvested outstanding equity creates holding power (see question 3).  

Sometimes this bias for performance-based long-term incentives does not make sense. For example, when the company is going through a major transition, long-term goal-setting may be difficult.   In these situations, a slightly higher cash mix, or a greater share of time-based equity, may make more sense. The Committee must take all these factors into account to develop a compelling offering for executives with a defensible rationale for the structure it sets. 

3. What kind of holding power do existing arrangements provide? 

Retaining high-performing talent is a priority for every company. The competition for talent today is more robust than ever. Before deciding how much equity to grant, Committees should review the outstanding unvested holdings of the executive and compare that both to historical amounts and market data. In addition to assessing the magnitude of the hold, it is also good to look at how that equity will vest over the next few years. It is important to be aware of any upcoming cliffs where unvested holdings will decline materially.  

To promote retention, it is essential to have a philosophy about how much “holding power” your equity program should provide, and to ensure your grant practices align with that philosophy. Many Committees intend to have unvested values grow over time and target at least 2-3 times the annual equity amounts based on market data.   Some technology companies have shorter vesting periods and then focus on future annual awards and the potential to increase those amounts annually, to drive performance. However, most companies across industries still use vesting as a retention tool. The important thing is that Committees have an intentional philosophy and a plan to stick with that philosophy. 

4. How will proxy advisors and investors view the decisions? 

Proxy Advisors (Institutional Shareholder Services and Glass Lewis) select their own peer groups (which often vary from Company-selected peers) and use a variety of quantitative tests to assess the pay-for-performance alignment. They also have their own guidelines on pay structure and governance policies. They are primarily concerned with pay and performance misalignments – e.g., pay increases significantly despite  disappointing business performance. 

The Committee should have a good sense in advance of how Proxy Advisors will view their decisions, and the likelihood of getting their “FOR” or “AGAINST” recommendation on the say-on-pay vote. Proxy Advisors typically drive 25-30% of this vote. The company’s proxy solicitor can also provide input on how large shareholders who do not follow Proxy Advisor recommendations are likely to vote. As with the rest of the data above, this information is helpful input. Committees can still make decisions for business reasons that are likely to be viewed unfavorably by these groups – but then they should plan to engage with shareholders and proxy advisors to explain the rationale. 

5. Are decisions made consistently, and with an eye to pay equity? 

The Committee should have a consistent philosophy and approach for determining pay for each executive. They should clearly document the data reviewed and the process followed. They must also review proposed outcomes relative to both external and internal market data and performance. Do the results make sense for each executive? Are the pay outcomes equitable, including when comparing outcomes for diverse executives? 

Answering these questions will help guide a robust process and provide a strong rationale for the Committee’s decisions. 

View the full article as it was originally published.

Deborah Beckmann

Blair Jones

Jason Oney

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