Executive pay under attack: how to develop a strategic response - includes related article

HR Magazine, June, 1994 by Ira T. Kay, Gary M. Lawson, Diane Lerner

Six steps your organization can take to keep pace with changes while still maintaining effective, successful pay programs.

Despite many economic indicators that show a correlation between executive pay and company performance, the heated debate over executive pay levels continues unabated and companies--particularly public companies--must learn how to respond. While it may have been acceptable in the past to relegate executive pay planning to a few specialists, it is now critical that human resource leaders understand the impact of the regulatory and legislative environment, and develop a strategic response.

FORCES OF CHANGE

Executive pay seems to be under attack from all directions. The attack comes from five major forces converging, all of which increased their influence on executive pay during the 1990s: the Financial Accounting Standards Board (FASB), the Securities and Exchange Commission (SEC), the Internal Revenue Service (IRS), institutional investors and the media.

While most of these influences are focused on publicly traded companies, they affect all companies to some extent since most private companies look at the compensation practices of public companies as a benchmark.

HOW TO RESPOND STRATEGICALLY

The outcome of the five major forces of change can be summarized as follows:

* The accounting treatment for stock compensation, particularly stock options, is in the process of change. This may make some stock vehicles less attractive and others more attractive than they have been in the past from an accounting perspective.

* Executive pay is subject to more detailed reporting in the proxy statements. Pay decisions must be considered in light of increased disclosure.

* Public companies must now say not only what they are doing with executive pay, but also explain why they are doing it.

* The new tax bill limits tax deductibility to $1 million and makes certain types of plans more attractive from a tax perspective than others.

* Shareholders, particularly institutional investors, and the media have increased the exposure of executive pay and placed it more directly in the eye of the general public.

How should your organization respond to these changes? There are six steps you can take to develop a strategic view of the organization's executive pay program.

1. Clearly articulate year company's executive compensation philosophy. The SEC, shareholders and other stakeholders will be better prepared to understand executive pay decisions if they are communicated as part of an overall executive compensation philosophy. Your philosophy should address the following issues:

* The desired competitive pay positioning.

* The emphasis on fixed pay compared to variable pay or "pay at risk."

* The importance of security-oriented vehicles such as pensions and perquisites.

* The importance of executive stock ownership.

* The desired balance between short- and long-term compensation.

Once articulated, it is equally important to dearly communicate this philosophy to employees and shareholders. A strong philosophy and strong communications will help shareholders understand and approve executive pay programs that may be right for the organization, but at the cutting edge or slightly outside the market norms.

2. Review all executive pay plans for consistency with your philosophy. Often, companies have certain pay programs that were developed years ago based on a previous management or prior philosophy, but they no longer fit with the current pay philosophy. For example, we have worked with companies that spin off from large corporations and adopt an entrepreneurial philosophy but may still have their old perquisite package from their prior company. It makes sense to review all programs at one time to ensure that each one of them is integrated with the others and meets organizational objectives.

3. Examine the alignment between executive pay programs and broad-based programs. Many organizations have a multitude of short- and long-term incentive plans, each with its own performance measures. This can create a situation in which some plans pay out when others do not. It is important to study the alignment between your various plans; especially look at the connection between the plans covering executives compared to plans covering lower-level employees. One of the worst events to explain to employees and shareholders is why an executive plan is paying out more in one year than the broad-based plans. The degree of alignment between the plans and the performance measures should be assessed to avoid this possibility.

4. Analyze the changes needed to obtain performance-based exclusions for short- and long-term incentive plans under the new tax bill. Many organizations will need to change their annual incentive plans to obtain a "performance-based" exclusion. Changes that may be required to your plan:

* Switching from subjective to formula-based performance measures.

* Eliminating board discretion (the rules do not allow for this; however, "negative discretion" by the board is allowed, which would enable the board to reduce a formula bonus amount but not to increase it.)