Executive Compensation

by Tom Lovett, President, Lovett and Lovett Executive Search

Executive compensation packages are not what they used to be just a few years ago. Slowdowns in the economy due to corporate scandals, the dot-com bust, and outsourcing have made recovery a slow and painful process. Companies have had to work a lot harder to become profitable, and cannot afford to pay their executives like they did in the past. They now have to plan carefully to develop compensation packages that not only attract and motivate executives, but simultaneously keep costs down.

Factors affecting executive compensation

Corporate scandals such as Tyco, Enron and WorldCom have caused investor confidence to plummet. Accountability from top executives is high on the average investor’s wish-list. Equity compensation plans now require share-holder approval.

Wendy’s International Inc. recently announced that it is seeking shareholder approval for 3.6 million common shares to be granted to directors, management and other employees over the next three years, as part of the fast-food chain’s transition from stock options to a combination of restricted stock and stock units.

The accounting climate has also seen changes that have lead to more transparency. Stock options granted to executives provide all the benefits of share price increase, with none of the risks of share price declines – basically rewarding share-price volatility, a measure of investment risk. Also, stock options given as rewards are not required to be expensed if the number of options, and the exercise price per option, is fixed at the date of grant. The value of the option is merely set forth in a foot note to the company’s income statement In April 2003, the Financial Accounting Standards Board (FASB) proposed that this should be recognized as an expense in income statements. This standard has been promulgated as FAS123R and is expected to go into effect in 2006; a large number of companies have already complied with this requirement.

The regulatory environment has become very stringent, with legislation such as the Sarbanes-Oxley Act. The Securities and Exchange Commission (SEC) has proposed that companies furnish tables in annual filings showing the total yearly compensation for the chairman and the next four highest paid executives. The real costs of their compensations packages to the bottom line, including stock options, must be clearly stated.

The growing demand for competent personnel is spurring organizations to come up with innovative compensation packages to attract the most qualified people, a big challenge in a recovering economy. Lastly, there is a need to align today’s compensation policies with the requirements of the business environment.

A recent study of 5,000 companies by Aon Consulting, a Chicago-based firm, shows that 40 percent of the organizations developed their compensation policies more than five years ago. Many of the organizations (51 percent) did not even have a defined compensation strategy in place. Clearly, companies need to reassess their compensation goals to gain competitive advantage in the present environment.

Emerging Trends

One trend that has not changed is that executive pay levels continue to rise. In 2004, CEO pay levels grew by over 10 percent for early S&P 500 filers. Growing company earnings resulted in increased bonuses. Top-notch CEOs received their rewards for outperforming others in a highly competitive economy. Factors driving higher pay levels are increased responsibilities, time-commitment and liability.

However, the compensation mix has changed over the years with fewer stock options, more restricted stock and other performance based incentives. The New York Times reports that stock options make up just 31 percent of a typical CEO’s compensation, down from 69 percent in 2001. Also, mandated disclosure of pay and perks has resulted in executives demanding more “soft” benefits that cannot easily be quantified.

There has also been a surge in activity for compensation and audit committee members. The median number of audit and compensation committee meetings rose to nine and six respectively in 2004, according to Equilar, a compensation analysis firm. The biggest challenge faced by these committees is structuring plans to meet increased shareholder scrutiny.

According to a survey conducted by Clark Consulting, an executive benefits and compensation consulting firm, director independence and accountability will remain hot-button issues and board compensation programs will reflect the heightened commitment required and the potential risks of board service. Senior Executive retirement Plans (SERPs) are also expected to play a larger role in executive compensation, the survey found.

To summarize, the three emerging key trends are that companies will go to great lengths to ensure bonuses and other executive incentives are firmly tied to an organization’s profitability, demanding more accountability. Director pays will continue to increase, even as the supply of well qualified executives diminishes. Equity compensation will undergo fundamental change, moving away from stock options and increased use of performance based vesting requirements.

All of these point to one irrefutable fact – executives will have to work much harder for their share of the profitability pie.