How to stay in front of new regulations and public perception about executive pay Featured

8:00pm EDT September 25, 2010

After two years of declining compensation, weary U.S. executives should be thrilled by projections of a modest increase in their average pay for 2010. But with shareholders, legislators and media watchdogs fixated on executive paychecks and layers of new regulations on the horizon, companies are still striving to fine tune compensation programs and strengthen the link between executive pay and performance.

A June flash survey of 251 companies by Towers Watson revealed that few were prepared to submit their executive pay practices to a shareholder vote as mandated by the new financial services reform bill. Although companies are waiting for further clarification on several provisions in the Dodd-Frank bill, more than two-thirds were taking action by proceeding with changes to executives’ annual incentive plans, and more than half were altering their long-term performance plans to ensure their programs do in fact align with performance and reward the right results.

“Now that the economy is improving, retention of key executives is re-emerging as a concern,” says Ann Costelloe, CFA, senior consultant for the Executive Pay Practice at Towers Watson. “Although preventing executive defections is a priority, companies must cautiously and thoughtfully alter compensation plans, given company goals and performance as well as the increase in regulations and scrutiny surrounding executive pay.”

Smart Business spoke with Costelloe about how companies are strengthening governance and addressing retention by altering their executive compensation programs.

What are the key regulations impacting executive pay?

The Dodd-Frank Act’s say-on-pay provision, among other things, requires public companies to fully disclose executive pay packages and conduct nonbinding shareholder approval votes at least once every three years, possibly beginning with the 2011 proxy season. Theoretically, shareholders could render a negative vote, making it imperative that companies proactively explain the rationale between the executives’ pay and the company’s performance and address shareholder concerns before they become issues.

Another key provision requires companies to disclose the median total compensation for employees and report the ratio of CEO-to-employee pay. While awaiting further clarification, it’s assumed that companies will need to substantiate higher ratios through better financial results or by demonstrating that their CEOs have greater experience, performance or capabilities than their peers.

Are there other significant regulations affecting executive compensation?

A provision in the Dodd-Frank law takes Sarbanes-Oxley up a notch by requiring clawbacks of executive pay in cases of fraud or criminal misconduct, and in situations where the company’s financial results were materially restated. Companies must develop policies to recoup improperly awarded compensation from current or former executives for three years preceding the required restatement filing date. Finally, a rule designed to prevent conflicts of interest requires members of the compensation committee, legal counsel and other compensation advisers to disclose their fees and be independent. Factors to assess independence are to be defined by the SEC.

How are companies adjusting executive compensation programs to comply?

The good news is that 49 percent of the surveyed companies expect to make modest increases in 2010 bonus funding for executives as a result of the improving financial conditions, while about a third expect to make larger long-term incentive grants. Although cost containment continues to be a priority, companies are being cautious about changes in pay and benefits, with only one in 10 respondents reporting that executive retention is not an issue. The survey revealed other trends in executive pay for 2010 and beyond.

What’s out:

  • Grossing up parachute payments and providing perquisites like cars, spousal travel benefits and country club memberships
  • Golden parachutes and hefty severance packages
  • Change-in-control (CIC) protection and single-trigger CIC vesting of long-term incentives
  • Supplemental executive retirement plans
  • Employment contracts

What’s in:

  • Incorporating tangible performance measurements into annual and long-term incentives such as operating profit, EBITDA, revenue growth and cash flow
  • Incorporating nonfinancial operating measures into annual incentives such as strategic initiatives and satisfaction measures
  • Stretch goals and increases in target award opportunity levels
  • Higher grant values due to rising stock prices with fewer shares awarded

What else can companies do to stay in front of the new regulations and public perception?

First, embrace the changes by focusing your annual and long-term executive incentive goals and aligning them with the company’s performance through measurable goals. Next, address public scrutiny by clearly communicating your philosophy (and results) so your proxy and compensation discussion and analysis (CD&A) tells an accurate and compelling story. It’s vital to understand the hot buttons of shareholders and stakeholders and address them proactively in meetings. Research industry pay practices and conduct scenario modeling on proposed plan changes to understand how each element will perform under various conditions. Compare the total pay-out to other industry executives delivering a similar performance before fine-tuning your plan. Finally, watch for clarifications from the SEC while being mindful of the public perceptions that precipitated the regulations. Legislators won’t stop drafting new laws until they’re confident that executives have accepted their message about pay.

Ann Costelloe, CFA, is a senior consultant for the Executive Pay Practice at Towers Watson. Reach her at (415) 733-4244 or Ann.Costelloe@towerswatson.com.