How to ensure your executive compensation package is effective, fair and legal Featured

8:00pm EDT March 26, 2010

Now more than ever, executive compensation plans are under the microscope. As a result, organizations must be careful when it comes to their executive compensation strategies.

In the past, many executives have been compensated purely on financial metrics. However, such practices do not recognize that successful financial performance is a result of successful operational strategies.

Moreover, with the current heightened level of scrutiny on executive compensation, many firms are actively benchmarking their compensation packages against those of their peers.

“Compensation packages require careful deliberation and should be tailored specifically to each organization,” says Harry Cendrowski, CPA, ABV, CFF, CFE, CVA, CFD, CFFA, the managing director of Cendrowski Corporate Advisors LLC.

Smart Business spoke with Cendrowski about the issues surrounding executive compensation packages and the strategies you can use to make sure your package is effective, fair and legal.

What current issues do you see with respect to executive compensation?

Many public corporations compensate executives based on earnings, revenue and market share growth — in other words, they look largely at financial metrics in assessing an executive’s performance. However, financial metrics are the output of successful operations, product quality and a significant focus on the customer. Success in these areas often foreshadows successful financial performance, not vice versa.

For instance, Toyota was long revered for its customer-first focus. This intense focus produced successful financial results: The company was building products consumers were willing to buy, and many became repeat buyers of Toyota products.

More recently, however, a former high-level Toyota executive stated that ‘anti-family, financially oriented pirates hijacked’ the company, implying that some recent Toyota executives became too focused on finances instead of Toyota’s customers.

The actions of these individuals, arguably, caused Toyota to perhaps grow too fast, too soon.

Do some executive compensation packages overcompensate executives for excessive risk taking?

I’m not sure I’d phrase it that way. We’d first have to define what it means for risk taking to be ‘excessive.’ For instance, is it fair to state that banks were taking ‘excessive’ risks when many other financial institutions were taking similar risks? Weren’t their policies simply competitive?

Of course, hindsight is 20/20. Congress and many in America would like to point the finger at banks for taking excessive risks, but the financial policies of banks allowed them to deliver stellar returns to investors for many years. In fact, rather than discussing ‘excessive’ risk taking in the financial sector, I’d argue that we should really be investigating why so many institutions took similar risks. Such actions only serve to increase the correlation between portfolios of differing banks, exacerbating the effect of any shocks to the economy. This, in my mind, is really a fundamental causal factor of the credit crisis.

Are executive compensation practices to blame?

In part. There’s a great push within public companies right now not to establish ‘competitive’ executive compensation practices. The way this is achieved is by establishing a peer group of similar companies and benchmarking pay packages with respect to these peers. One might also argue that similar practices occur within the strategy groups of organizations because no one wants to be outdone by a competitor.

Unfortunately, one of the byproducts of such benchmarking is that groupthink can manifest itself within a peer group. For example, a firm implements a new policy that is highly controversial but also successful. Another firm then implements this policy hoping to achieve similar success, and then another and another, etc.

Pretty soon, several firms have implemented this once-controversial practice, not because their executives think it’s in their best interest, but because other firms are doing so. This is particularly dangerous, especially if some executives and board members don’t really understand the underlying dynamics of the practice, such as collateralized loan obligations and collateralized debt obligations.

How can that follow-the-leader strategy be overcome?

Perhaps the best piece of advice I’d give executives and those devising compensation packages is to listen to their private beliefs and select actions that they feel are in the best interest of the firm. Don’t switch strategy simply because another competitor does so. While they may experience high returns in the short term by ‘following the leader,’ these practices may prove detrimental in the long run.

For instance, several years ago, when oil prices hit $145 per barrel, many in the industry felt the price had appreciated too quickly. However, it kept rising and rising, arguably because investors dismissed their own private beliefs, instead telling themselves, ‘I’d better get in on this before the price goes even higher.’ Then, Goldman Sachs famously stated oil prices would soon hit $200 per barrel. Well, it never happened.

Oil subsequently crashed to about $35 per barrel, and with rapid speed. It just goes to show that, more often than not, what goes up does comes down, especially when prices appreciate rather quickly.

Harry Cendrowski, CPA, ABV, CFF, CFE, CVA, CFD, CFFA, is managing director of Cendrowski Corporate Advisors LLC. Reach him at (866) 717-1607 or cs@cendsel.com, or visit the company’s Web site at www.cca-advisors.com.