formerly ACA Journal

Volume 12 Number 4 Fourth Quarter 2003

Cover Story

What's Next for the Compensation Committee?
Exceeding Expectations in a Difficult Time

Blair Jones, David Leach and Jesse Purewal, Sibson Consulting

The world in which directors of today's public companies live has irrevocably changed. The wave of corporate scandals that occurred in the United States over the course of 2001 and 2002 created a widespread mistrust of corporate executives, leading shareholders to seek regulatory action and motivating lawmakers to stiffen current governance standards. The Sarbanes-Oxley Act began to formalize this process in the summer of 2002, accompanied by proposals to the Securities Exchange Commission (SEC) from U.S. stock exchanges offering guidance on improvements to corporate governance. These initial reforms targeted the more visible targets of depressed confidence: financial reporting standards and audit committee practices. In September 2002, The Conference Board's Blue Ribbon Commission on Public Trust and Private Enterprise followed these mandates with suggested changes to executive compensation practices and compensation committee actions. While full boards and audit committees certainly are facing heightened exposure and greater responsibilities, the new corporate environment also has put increased pressure on the decision-making processes, accountabilities and actions of the compensation committee.

A number of parties already have provided input as to what is needed from compensation committees to make companies more accountable to their stakeholders. The New York Stock Exchange (NYSE) and Nasdaq have weighed in on the committee's need for independence and its basic duties by issuing proposed reporting standards for companies listed on their exchanges. The popular and business media continue to report on the unfortunately familiar sagas associated with egregious executive pay. And during the most recent proxy season, shareholders at major companies began to vote down proposals that would make more company shares available for executive rewards.

To help restore public confidence in the boardroom and executive suite, compensation committees need to heed the message being sent to them by the exchanges, the general public and investors: "You've got to do this right, and you've got to figure out how." Where should committees focus to ensure that they do their part to meet -- and exceed -- the demands of the groups invested in their actions? Who are the best people for this job, and how can they become even more qualified for the role? Most important, how will we know if committees have been successful?

The Charter: Accountabilities Defined
Many public companies have charters outlining the compensation committee's purpose and basic responsibilities. Historically, many committees have adopted these charters somewhat arbitrarily (for example, to comply with NYSE standards or to simply align with typical practice). Given the increasing prominence of decisions made by the compensation committee, however, this type of "vanilla" charter may not be robust enough to withstand the scrutiny of today's environment. Committees need to work with the board to establish and define their responsibilities, then make these accountabilities clear to shareholders in a charter outlining not just the committee's basic duties, but also a list of items the committee will recommend to the board for approval, a basic outline of programs it oversees, and the positions of officers whose compensation and performance goals it will review and approve. The committee should plan to conduct an annual review of this charter and make amendments or changes as dictated by business imperatives or competitive realities. Figure 1, highlights the difference between a "vanilla" charter and a more inclusive "best-practice" charter.

Consider the case of a mid-size technology company that went public in late 1998. Around the time of the IPO, the compensation committee outlined its first charter, and the board and HR staff thoughtfully developed a compensation philosophy. Like many of its competitors, the company attracted executives with aggressive upside potential (in the form of stock options), but offered lower cash opportunities. When the company's stock began to dip and share authorizations began to run out in 2000, the committee had to not only revisit its strategy for retaining its key talent, but also to outline -- in the charter -- the way it would function going forward. How closely would it need to scrutinize every staking grant? Would it turn to outside advisers to ensure that the design of the company's programs was still attractive? Would it need to add another member with more experience in the cycles of technology companies? The company found that its operations, though thoughtful, needed to be consistently revisited as the company evolved. The members learned that the first step in ensuring that they remained accountable to the board, the company and the shareholders was to continually refine the charter to keep pace with their changing duties and responsibilities.

A thorough charter adds value because it is at once a mission statement (the organization's purpose), an outline for expected behaviors and a set of clear accountabilities to shareholders and the board. Because most directors have full-time jobs and many responsibilities in addition to their duties as committee members, clearer accountability means more efficient and effective work during the time the committee has together. The most thoughtful charters include a universe of items above and beyond basic duties and responsibilities. See Figure 2 for a more complete list of relevant inclusions to committee charters.

Accountability for the Charter
Who should be responsible for writing the charter? Every committee has its own working style and methods for making effective decisions, so there is no single answer to this question. Typically, the committee chair is accountable for the charter's accuracy, completeness and updates. For committees adopting a charter for the first time, it is important that the full board be involved in the initial determination of roles and responsibilities of the committee so that every director is clear about his or her duties to the board and to the committee(s). Even if compensation committee members have worked to determine their duties apart from the full board, the charter should be given final review and approval by all independent directors. A company's HR team may have an opportunity to work directly with the committee by taking a leadership role in the organization of this effort.

At first glance, developing a charter may not seem like a groundbreaking action. In fact, many committees writing a charter for the first time may simply be documenting actions their members take as a matter of course. But being able to act on a charter that addresses the total focus of the committee is similar to a pilot's ability to get guidance on flying from cockpit instruments: The tool is not especially useful on its own, but it serves as both a guide for and a backup to its user's decisions and actions.

Consider the committee of a mid-size manufacturing company that wanted to determine an appropriate annual incentive for its CEO based on company performance. The financial results were clear, but the organization's compensation philosophy suggested that elements such as sound leadership, peer development and global applicability of decisions were to be considered when making awards. To determine the CEO's achievement against these kinds of metrics, the committee determined that some sort of qualitative performance review was in order, but the committee had no established method of conducting one. The company added to its chartered responsibilities an open annual evaluation of the CEO for incentive determination purposes. This addition catalyzed a discussion of how the process would work:

• What questions should be asked in the review?
• Should the review be done with the input of other executives? If so, how should their input be solicited?
• How would the review be defended and communicated to the CEO?
• How would the results impact the incentive award?

Perhaps more important, the chartering of the review made the committee more accountable to the board (by fulfilling the tenets of the organization's compensation philosophy) and to shareholders (by ensuring that the CEO's pay reflected a fair assessment of the CEO's total performance). Thereafter, the charter not only served the committee with inputs needed for an important decision-making process, but it also allowed the committee to fulfill an accountability to the organization by making sure that the CEO's pay and performance were properly aligned.

Most important, the committee has to have the wherewithal to implement and truly act on its charter. Too often, the process of drawing up a very inclusive charter simply ends with its inclusion in a proxy statement or annual report to shareholders. Committees need to view the charter as a means to an end -- and "walk the talk" of better governance, more sound decision-making and a clear understanding of their responsibilities.

Assembling the Best Team
Increased director responsibility has led to two competing tensions that make securing director talent more difficult:

• Many companies are looking to sharpen or complement the existing skill sets of their committees to meet heightened director workloads
• Well-qualified directors are likely to limit the number of boards on which they serve to assure investors and fellow board members of their commitment to the director role.

Despite this lack of congruence between supply and demand, boards are still accountable for populating their compensation committees with capable, committed independent directors who evaluate and make compensation decisions in the best long-term interests of the business and its shareholders.

As a group, compensation committee members must have the technical expertise to understand how to interpret competitive pay data and consider the basic design elements associated with types of compensation plans. More important, however, committee members need a sufficient level of business acumen, financial savvy and strategic focus to appropriately apply this information in the specific context of a company's pay philosophy, objectives, talent needs and constraints.

As an example, consider the Financial Accounting Standards Board's (FASB's) likely mandate that stock options be charged to earnings. This phenomenon would demand that the committee be able to understand the accounting and economic effect that an option expense would have on the company's bottom line, and also be able to evaluate the strategic benefits and costs to the company associated with other long-term incentive vehicles (such as restricted stock and multi-year performance plans) relative to stock options. Committees are not expected to possess the knowledge of tax advisers or accountants in determining the economic viability of various incentive plans -- companies should rely on independent expert advisers for this level of detail. Another example: A committee does not need to understand the CEO's rationale for every single adjustment when approving annual bonuses for senior executives. But its members do need to make decisions that support the organization's compensation philosophy, be aware of the individuals in the most business-critical roles, and understand the total effect of the incentive compensation on the company's expenses.

Though it is favorable for a committee to have some degree of technical knowledge, the most important qualifications for committee service are more strategic in nature. See Figure 3, for independence criteria and committee regulations proposed by the NYSE and Nasdaq, as well as a sample universe of qualifications that may be employed by boards when determining the composition of the compensation committee.

Assessing Performance for Growth Opportunities
Another practice typical of well-performing committees is performance assessment. Becoming increasingly prevalent in response to public and shareholder demands, assessments are designed to help committee members objectively determine the strengths and growth opportunities of the group. They also create an opportunity for members to provide one another with feedback on each other's contributions to the committee, with the objective of improving the committee's overall effectiveness. Different committees will conduct assessments in different ways. The charter should elaborate on how, and how often, a committee conducts assessments so as to maximize the benefits of going through the exercise. Some committees choose to have each member anonymously evaluate the group as a whole and then complete a self-assessment, which is followed by one-on-one conversations with the chair and/or lead director. Other committees conduct peer reviews of each member, which serve as the foundation for a conversation between the chair and each member. Still other committees may simply engage in a candid discussion where both effective behaviors and "good work" are praised, and areas for improvement are noted. The net result of the process should be a committee member who understands the skills and behaviors that will continue to add value to the committee's function and also is cognizant of the areas in which he or she may need further development.

The sensitivity of performance assessments may suggest that committees are best served by conducting them via an objective third party. An objective facilitator -- particularly one who has been retained by the committee rather than by management -- can conduct an unbiased review of evaluations, facilitate a discussion among committee members, help the group to identify specific evidence of success and opportunities for growth, and ensure that a sufficient degree of expertise will be used in the assessment's design and administration. Though any committee assessment should be done as part of a larger process in which the full board conducts a self-evaluation, the design and administration of this process is another opportunity for the HR team to provide strategic assistance to directors.

The Ultimate Test
Of all the responsibilities incumbent upon the compensation committee, perhaps none is as important as the accountability for linking pay to performance. The renewed emphasis on effective shareholder-centric governance has focused investor, media and public attention on the committee's responsibilities, with particular emphasis on the degree to which executive pay levels reflect company financial performance and long-term shareholder wealth creation. The committee should be responsible not just for demonstrating this correlation, but for making clear the rationale behind each move it makes with regard to pay.

The committee's first charge in this regard is to establish the right performance goals. Having reviewed management's annual and long-term forecasts, the committee needs to make sure that its company's executives are focused not just on attaining goals, but on pursuing the goals whose completion will have the strongest impact on the company's short- and long-term results. A firm in a turnaround situation, for example, may need a sharp focus on EPS as it works to evidence the health of its operations to Wall Street. An established financial services company growing steadily each year, however, may be best served by emphasizing an aggressive return on assets. After a committee agrees on the most sensible mix of measures, its members need to recommend to the board performance goals, with regard to these measures, against which executive rewards will be determined.

After the goals are in place, how is a committee to determine the appropriate size and structure of a short- or long-term award? How does a committee know the "right" amount to pay for a given level of performance? It might seem fairly straightforward, for example, to determine an annual performance bonus if the company's annual incentive plan has very well-defined mechanics. But how much is "fair" to award an executive for target performance? For levels of performance above and below target? Peer company practice is certainly one benchmark. The organization's compensation philosophy is another. Knowledge of an executive's current holdings may be yet another. But how does a committee ensure that it's doing its job -- to take all these inputs, and others, into consideration to determine the pay for performance relationship?

Before making any awards, it may be beneficial for the committee to look forward at the level of potential risk inherent in the executive's role and the company's strategy so that an adequate reward opportunity may be crafted. In addition, the committee needs to understand the degree to which business performance and executive compensation have been historically aligned. A historical perspective gives the committee a healthy sense of whether executive compensation has been commensurate with levels of corporate performance, so that any necessary adjustments may be made to ensure future performance/pay alignment.

To look forward and assess this potential risk, committee members need to thoroughly understand both their company's business and the range of incentive alternatives available (which will vary by individual company situation). It is here, when looking at pay under a variety of performance scenarios, that committee members will draw on their qualifications (skills and competencies) as outlined above and in Figure 3. For instance, a committee might choose to move an airline industry CEO's target cash pay from a 50-50 base/incentive mix to a more highly leveraged ratio to lower current fixed costs and create additional incentive for reaching goals in a turbulent market where profits have evaporated. The committee also might choose to grant shares of restricted stock that would vest more quickly if long-term performance goals were met. The committee would then draw on its understanding of the company's strategy, market position and financial standing to calibrate the incentives against performance goals.

To help companies look back at the historical relationship between pay and performance, Sibson has worked with a number of committees with a tool called the "pay paradigm." (See Figure 4.) This test empirically determines the alignment between historical company results, as defined by the short- and long-term performance measures relevant to a company's success (total return to shareholders, ROE, etc.), and historical compensation levels of the CEO and other top executives (salaries, bonuses, and the value of long-term incentives). This analysis has the advantages of presenting results in the context of an appropriate peer group, being applicable to a range of historical timeframes (e.g., three years, five years or the length of an executive's tenure) and providing objective data that a committee can use to make ongoing pay decisions.

The pay paradigm was especially useful for the compensation committee of a large southern financial services firm. The CEO had been recruited five years earlier, and over his five-year tenure, the company's annualized return to shareholders (TRS) was more than 16 percent. The committee found this number impressive enough to wonder: Are we rewarding the CEO adequately? The pay paradigm analysis determined that salaries were at median, and that annual bonuses were well aligned with operating results (ROA, EPS). However, the committee found that the CEO's long-term pay and performance were, in fact, not well linked. Whereas the company's five-year return to shareholders (TRS) was at the 70th percentile of its financial services peer group, the paper value of the CEO's total compensation over the five-year period was at the 34th percentile. (See Figure 5.) Since the company's stock obviously was outperforming the peers' stocks, the mismatch between pay and performance was the result of an extremely conservative compensation opportunity that the committee chose to adjust after seeing the results of the pay paradigm analysis.

Keeping Shareholders' Best Interests in Mind
The challenging corporate environment is giving corporate boards a chance to shine. As leaders, such as Lou Gerstner, Phil Jackson and Nelson Mandela have shown, strong guidance and example-setting can turn around the reputation of entire companies, franchises and economies. Though we can't burden America's directors with the responsibility of reviving a weakened global economy, we can ask them to do their part to make sure their companies are doing the right things during an era in which investor confidence is shaky and public perception of corporate ethics is tainted. For compensation committee members, this means being explicit about their responsibilities and how they intend to fulfill them; getting the right team in place to do so; and making every move in the best long-term interests of the company's most important customers: its shareholders.

Authors

Blair Jones (bjones@sibson.com) senior vice president and practice leader, leadership performance and rewards, Sibson Consulting. She helps clients motivate and retain their talent in ways that contribute to sustained shareholder value creation. Jones has expertise in performance management and executive rewards design and has worked with leadership teams across a number of industries, including health care, retail, telecommunications, professional services and consumer products. She works extensively with companies in transition.

Before joining Sibson Consulting in 1991, Jones worked for Bain & Company, helping clients develop pricing and marketing strategies.

David Leach (dleach@sibson.com) senior vice president, Sibson Consulting, advises senior management and boards of directors in linking compensation with corporate strategy. Working with a broad range of clients in industrial, technology and service sectors, Leach specializes in assisting companies and their boards in the design, development and implementation of executive compensation and corporate governance programs.

A frequent speaker on executive compensation issues, Leach has been interviewed and quoted by The Wall Street Journal, Fortune Magazine, Business Week, Forbes Magazine, The New York Times, The Los Angeles Times, CNBC and CNNfn.

Prior to joining Sibson Consulting, Leach served as national director of compensation consulting, Buck Consultants, New York; national practice leader, Compensation Resource Group; and principal with Towers Perrin in Los Angeles and Cincinnati.

Jesse Purewal's (jpurewal@sibson.com) experience focuses on aligning human capital investments with business strategies. He has played leading roles in engagements related to the development of annual and long-term incentive plan designs, behavioral competencies and sales effectiveness programs. By understanding external competitive environments and internal business objectives, he is adept at crafting financial reward programs. Purewal has served public and private clients in a variety of industries including software, engineering and design, telecommunications, investment management, and professional services.

Purewal earned a bachelor's degree with honors in mathematics and sociology, with a minor in German, from Northwestern University.

© 2003 WorldatWork, 14040 N. Northsight Blvd., Scottsdale, AZ 85260 U.S.A.; 480/951-9191; Fax 480/483-8352; www.worldatwork.org; E-mail journal@worldatwork.org