As the world continues to evolve, it’s important for businesses to evolve with it. In light of social justice issues that arose over the summer, many CEO’s pledged they would strive for more diversity and inclusion within their organizations.
This line of thinking starts from the top, meaning executive compensation plays a critical role in whether or not these goals are actually achieved.
Korn Ferry, in partnership with The Aspen Institute, recently released the “Modern Principles for Sensible and Effective Executive Pay,” which is designed to advance boardroom dialogue, taking into account new market priorities, shifting public attitudes toward the role of business and fundamental changes in the role of the CEO and executive teams.
“If you read through a bunch of annual reports, you will often see very impressive aspirational statements the CEO makes in the letter to shareholders about the company's higher order purpose in the world and what it hopes to achieve for customers, communities, and society at large, not just shareholders.,” said Don Lowman, global leader, rewards and benefits at Korn Ferry and one of the authors of the report.
“Yet, when you look at the way their compensation programs work, most of them are driven almost entirely by financial metrics and total shareholder return, especially the long-term incentive parts. So it's not clear that executive compensation programs are actually aligned with or geared toward reinforcing the purpose of the company.”
In total, Korn Ferry and Aspen developed five principles as a guide for boards:
- Principle One: Pay is unambiguously tied to the company’s purpose and the drivers of its long-term success.
- Principle Two: Executive pay outcomes are fair.
- Principle Three: Goals used in incentive plans are credible and their outcomes difficult to manipulate.
- Principle Four: The executive pay program is fully described in clear, jargon-free language.
- Principle Five: The board bears ultimate accountability for making decisions about executive pay and for aligning pay with the long-term health of the enterprise.
Transparent and Fair
Lowman noted that executive compensation programs have gotten unnecessarily complex and generally difficult to understand. This is illuminated by company proxy statements that spend dozens of pages describing minute details, making it difficult to get to the essence of what the compensation program is actually designed to do.
Principle four asserts that a well-designed executive pay program can be summarized in two pages or less, to include an outline of the overall structure, intent and key features of the pay program. The pay disclosures should also promote transparency and an understanding of executive pay.
Lowman said there’s an opportunity for boards to simplify these programs so pay is directly tied to the company’s purpose and, as principle one highlights, it needs to avoid an excessive focus on total shareholder return as a measure of performance.
And, as the second principle notes, it’s imperative that the pay outcomes are fair. Fairness is assessed internally across at least three dimensions:
- The pay for the CEO is appropriate relative to that of the rest of the executive team.
- The balance of pay between the executive team and the rest of the employee population is reasonable.
- Rewards for company financial success are shared fairly with and between workers and shareholders.
In developing this principle, Lowman said they referenced Korn Ferry research, which found that compensation for CEOs at the top 300 U.S. corporations over the last 10 years has gone up by 7.3% annually. Comparatively, pay for middle management and pay for the average employee has gone up just 3%.
“We know we have a wealth gap in the country and based on those statistics that wealth graph is increasing,” Lowman said. He added that in his experience working with compensation committees, the conversation is rarely about how their executives are paid relative to the everyone else in the organization. Rather, it’s about how their executives are paid in comparison to other companies’ executives and how they are paid relative to change in total shareholder return.
“There's almost no conversation about fairness and equity within the organization,” Lowman said. “And we think that's increasingly a concern for companies.”
Goals and Incentive Plans
A theme that has come up in recent years from institutional shareholders is that the goal-setting process seems slanted toward benefiting management.
“There’s really no stress testing or a real process to validate and understand the stretch that are built into these goals,” said Irv Becker, vice chairman, executive pay and governance at Korn Ferry and one of the authors of the report. “We think there should be more rigor in the process of setting these goals and they should be stress tested to understand the difficulty of the achievement.”
Elaborating on that point, Korn Ferry’s report provides some examples of how the goal-setting process could become more rigorous:
- Goals are challenging but achievable and are clearly aligned with core strategic priorities.
- Goals focus on objective measures of non-financial performance that are within the executive’s ability to impact and influence.
- The financial rewards for achieving/exceeding targets are reasonable and do not encourage excessively risky behavior.
From an incentive standpoint, Korn Ferry’s report asserts that they should include meaningful financial downside for under-performance. Additionally, long-term incentives should align with at least a full business cycle for the company or industry and incentives for executives in charge of compliance, risk management and audit function should be designed to curb rather than encourage risk-taking.
Per principle four, boards should also actively seek to reduce the complexity in exec pay packages, meaning to avoid the inclusion of too many incentive metrics and/or methods for delivering pay.
Ultimately, the report concludes that board members are accountable for making decisions about executive pay and for aligning pay with the long-term health of the company.
While this fifth principle might seem obvious, in the world of executive compensation, this isn’t so straightforward. Many board members rely on proxy advisory firms such as Institutional Shareholder Services (ISS) and Glass Lewis for voting advice. Korn Ferry’s principle isn’t a condemnation of such an action, but rather placing an emphasis on the fact that the board members bear ultimate responsibility for whatever decision is reached.
“It's important to seek independent outside advice and perspective and to listen to it. ” Lowman said, “But ultimately the comp committee needs to use their own best judgment in reaching decisions, taking into account all of the facts and circumstances as they understand them.”
The report notes that boards can improve this process by determining pay levels with an independent board committee that assesses the role, responsibilities and contribution of each executive. Other suggestions:
- All directors fully understand the executive pay program before approving it.
- The perspectives of qualified outside advisors inform but do not dictate the board’s decisions.
- Proxy advisors’ expectations do not override the board’s judgment about pay.
- The board thoroughly evaluates the key metrics and performance standards used in the incentive plans to ensure they reflect business priorities and uses discretion, as appropriate, to set associated rewards.
Lowman and Becker said they know the principles aren’t the end all and be all for executive compensation decisions, but they’re hopeful they will be used to inform important conversations that should be had by public company boards.
“We think that the timing is good and hopefully a lot of companies will take these very seriously,” Becker said. “That doesn't mean the company has to adopt every principle or check the box of every question. The purpose of this is to ensure that the committees are having these conversations and that these issues are being discussed.”
WorldatWork is publishing the fourth edition of an executive compensation book in collaboration with Korn Ferry that will be available for purchase in 2021. It is an update of the third edition, which can be purchased here.
About the Author
Brett Christie is the managing editor of Workspan Daily.