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Trends
& Practices
Inside this issue:
Executive
Compensation Hot Topic
Director
Compensation Rising
Sarbannes-Oxley
Compliance Costs
Stock
Grant Plans and Practices
Shrinking,
Changing U.S. Job Market
Plus:
Special
Report on Principles for Managing Executive Compensation
Special
Report on the Jobless Recovery, Job "Offshoring" and Comp Trends
The issue
that won’t go away.
Executive compensation practices remain a central
concern for shareholders and regulatory agencies.
Public companies are reporting record numbers of shareholder proposals
for this Spring’s proxy season, with a majority of the proposals seeking
more shareholder control over executive compensation. Further, the SEC has begun examining corporate reporting of
related-party transactions—business relationships involving outside
directors, senior executives, significant shareholders and their
relatives—looking for conflicts of interest that enrich the related parties
at the expense of other shareholders. The
IRS has also entered the fray, conducting audits of executive salaries and
fringe benefits. A recent NY
Times article by Gretchen Morgenson called for more detailed disclosure of
executive benefit arrangements—deferred compensation, supplemental
retirement plans and split-dollar life insurance—which increasingly provide
massive amounts of “unreported
(to shareholders)” compensation for executives.
Suffice to say, this topic is not fading away quickly or quietly, as
many Boards and executives had hoped.
Corporate Compensation Committees should review
recent reports on executive compensation practices issued by The Conference
Board Commission on Public Trust and Private Enterprise, the National
Association of Corporate Directors and The Business Roundtable. “Pay for Performance” guidelines published by the
Institutional Shareholder Services (ISS) are also instructive for Directors.
Summaries of these reports can be found in a Special Report here in
CompNews.
An analysis of Director compensation indicates that total
compensation for members of Corporate Boards is rising rapidly, in line with
increases in job demands and job accountability.
On the cash side, retainers and Board meeting fees have only increased
modestly while pay for Committee service has jumped substantially—premium
retainers for Chairpersons, premium meeting fees for some committee members
and greater frequency of committee meetings.
The single largest component of Director compensation, even in mid-size
companies, is now the value of equity grants—stock options and/or restricted
stock grants. Recent increases in
the size of such awards are consistent with the philosophy of aligning
Directors’ interests with those of other shareholders.
In many instances, the larger equity grants are intended to help
Directors to comply with newly established stock ownership guidelines. Recent survey reports indicate that the number of public
companies with stock ownership guidelines for Directors (and/or top
executives) has increased over the past year from about 25% to at least 30%.
Experts expect that the structure of Corporate Boards and the independence of
Directors will continue to receive close scrutiny from shareholder interest
groups.
Shareholder focus on the Board of Directors in public companies has caused a
record number of Directors to resign their positions and many candidates to
decline invitations to join public company Boards.
It’s likely that many companies, particularly poor performers, will
need to continue increasing Director compensation to entice qualified, quality
candidates to join their Boards. Look
for greater use of cash and stock sign-on bonuses for new Directors and
retention incentives for current Directors.
Corporate leaders acknowledge that the Sarbannes-Oxley Act has brought about
better financial controls and more reliable reporting for investors, but they
complain that the cost of compliance is far greater than anticipated.
CFOs report costs for staff time, systems development, and outside
consultants and auditors are running into the hundreds of thousands and even
the millions of dollars for mid-size and large companies.
The task of compliance is compounded these days by a lack of clear
implementation rules from the Public Company Accounting Oversight Board on
critical issues like Section 404 of the Act.
Accounting for Stock Options. The International Accounting Standards Board announced in
February, 2004 that companies which follow international accounting rules will
be required to expense stock options beginning in 2005.
The rules cover stock options granted after November, 2002.
This move, while expected, puts added pressure on the U.S. Financial
Accounting Standards Board to put similar rules in place for public companies
here. FASB had previously
announced that its final proposal would be released before the end of March,
2004 and would take effect for fiscal years beginning after December 15, 2004.
FASB has been attempting to reconcile its approach on the subject with the
IASB’s rules. It’s not yet
clear how closely the two sets of rules mirror one another.
Grant Rates, Overhang Expected to Decline.
In response to shareholder concerns about stock dilution and the
pending changes in stock option accounting rules, most experts expect that
companies will reduce the number of stock option recipients and the size of
typical grants. The thrust of the
effort is to bring overhang down to a more acceptable level for shareholders.
For many, that means reducing overhang from the prevailing 12%-15%
levels to a more modest 8%-10%. Because
of the large number of options outstanding, the change cannot happen
overnight. Reducing future grants
helps, but a significant drop in overhang is dependent upon current options
expiring or recipients exercising their options.
Much has been written and said of
late about the absence of job growth in the domestic economy and the
increasing tendency of companies to outsource jobs to other countries.
The short-term effects are relatively clear—unemployment remains
high, financial stability and capability among the consumer class is
weakening, “career quality” of new jobs is suspect.
Longer-term, systemic changes in the domestic labor market,
specifically outsourcing of jobs to other countries, may help U.S. companies
to overcome the impact of baby boomer retirements. See our Special
Report on the U.S. Job Market here in
CompNews.
Over the
past eighteen (18) months, leading business and investment advisory groups as
well as regulatory agencies have issued a wide range of suggestions and
guidelines for effectively managing executive compensation.
While the recommendations of one group may conflict with the thinking
and approach of other groups, there are a number of common themes and
principles that have emerged from these studies.
SCP has reviewed reports from The Conference Board
Commission on Public Trust and Private Enterprise, The National Association of
Corporate Directors (NACD) Blue Ribbon Commission on Executive Compensation,
Business Roundtable’s Principles of Executive Compensation, as well as the
New York Stock Exchange and Nasdaq Corporate Governance Listing Standards, to
construct a practical, common sense guide to establishing and managing an
effective executive compensation program.
Here are the five (5) basic standards that all of the groups appear to
agree on:
-
A
Strong, Independent Compensation Committee.
All of the industry group reports as well as the stock exchange
listing standards endorse the concept of a compensation committee made up
of at least three (3) to as many as five (5) independent directors.
Further, the committee members should be knowledgeable on the topic
and willing to ask hard questions of themselves and the executive team
(what the NACD report termed “constructive skepticism”) about the
structure of the program and the bases for both short- and longer-term
rewards.
-
A
Comprehensive Statement of Compensation Philosophy, A Clear Charter for
the Committee. The
compensation committee needs to evaluate available compensation elements
and determine which of those components reflect corporate values and will
support attainment of corporate goals and objectives.
Further, the committee should have a clear charter from the full
Board, delineating the scope of its responsibilities and the processes it
will undertake to maintain fair, competitive compensation opportunities
for executives: goal setting, performance assessment, reporting to the
Board and shareholders, etc.
-
Full
Disclosure of the Total Compensation Program.
While many company’s have made significant strides in their
public reporting on executive pay, many more need to improve their
disclosure about current practices and program costs.
Descriptions of policies and practices related to short- and
longer-term incentive awards are often vague—bases for earning awards,
methodology for determining award size, etc.
Of particular concern today are special benefits and employment
contract provisions for top executives, especially severance arrangements. Most often the full cost and funding implications of
these compensation program features are not revealed to shareholders and,
occasionally, not even to other Board members. (Expect further voluntary improvements on these items in
future proxy statements and SEC filings.)
-
Committee
“Ownership” of the Consulting Relationship With Outside Consultants.
In the interest of having fair, unbiased input about industry
practices and trends, the Compensation Committee should hire and manage
the services of outside consultants who provide executive pay information
and programming suggestions. In
following this approach, it is important that top management continue to
be an integral part of the program management process.
Consultants need to understand the roles, expectations and
requirements of top jobs and the operating conditions of the
organizations, all factors that will influence their evaluation of current
pay practices and their recommendations to the Compensation Committee.
-
Pay
for Performance: Aligning Executive Pay with Long-term Shareholder
Interests and Corporate Goals.
The Conference Board, NACD and the Business Roundtable all seem to
agree that a significant portion of total compensation for executives
should be tied directly to performance of the business.
The focus here, however, is on rewarding sustained, longer-term
results rather than shorter-term, annual results.
These groups believe that executives should be
required to own some reasonable amount of company stock.
While restricted stock appears to be the preferred method of
assisting executives in achieving this objective, study reports also
recommend that company’s establish minimum stock holding requirements
for executives following exercise of stock options; eliminate cashless
exercise.
For both short- as well as longer-term incentives,
the groups suggest that companies employ a variety of quantitative and
qualitative measures that reflect longer-term corporate goals and
shareholder interests, without focusing on stock price directly.
All of the major reports recommend expensing of stock
options.
One of the emerging side issues in this area of
pay-for-performance is the use of employment contracts with senior
executives. Some Boards are
seeking elimination or at least a scaling back on use of employment
contracts; reducing guarantees about compensation and employment and
placing stronger focus on performance as the means of earning compensation
and retaining one’s position in the executive suite.
It is not yet clear what executives may get in return for giving up
the protections and the certainty provided by an employment contract.
These recommendations on managing executive
compensation are not new, but it is clear that not enough organizations have
yet adopted these approaches in their entirety.
Compensation Committees must be independent representatives for the
shareholders of their respective companies.
They must strike a balance when designing and managing compensation
programs between the interests of shareholders and the company’s executives.
To read the full reports and recommendations of the
groups cited in this
SCP
Special Report, please visit the web sites listed below:
www.conference-board.com
www.nacdonline.org
www.businessroundtable.org/pdf/ExecutiveCompensationPrinciples.pdf
Not many months ago, an editorial in the Wall Street Journal asked
the question, “Who’ll Sit at the Boomers’ Desks?”
The writer was sounding the alarm about the coming labor shortage in
the U.S. when baby boomers retired. Since
that time, however, the media has focused on the opposite issue—not enough
jobs to re-employ available U.S. workers.
We’ve all heard of the jobless recovery, complicated by trend of
“offshoring” an increasing number of technical and administrative jobs to
Asia and Eastern Europe.
Perhaps the U.S. will experience a labor shortage
when baby boomers retire, but that problem seems a long way off right now.
The immediate concern of creating jobs here in the U.S. is real.
It’s having an effect on compensation trends today and will likely
influence compensation practices in the future as well.
The Short-term Situation
Since 2001, the U.S. economy has reportedly lost
over two million jobs. Manufacturing
was the big loser, but every industry and every job discipline has been
affected. Most of the job losses
are the result of a soft economy, with less than 10% of the job losses
attributable to “offshoring” of business activities.
Corporate profits are improving, inventories are at
historically low levels and, yet, the economy is not producing new domestic
jobs in the numbers needed to re-employ available U.S. workers.
Productivity gains, the rising cost of healthcare and other labor
costs, and “offshoring” opportunities are all cited as contributing
reasons for the absence of new job growth in the domestic economy.
The net effect of this sluggish jobs market is
stagnation in pay rates for all types and levels of jobs (with the exception
of executive positions).
The reality of the matter is that right now, the
abundant supply of labor in today’s market—from new college graduates to
skilled craftspersons to experienced engineering and IT professionals and
accomplished middle mangers—has eliminated the need for most employers to
provide anything more than the barest of maintenance pay increases for most
workers. When turnover occurs,
employers feel they have ready options—replace from the domestic labor pool,
outsource domestically, offshore. The
latter options in many instances are proving to be more financially attractive
to the employer than simply replacing the position with another direct
domestic employee.
The current situation is further complicated by the
transition of many displaced employees to new career opportunities.
Some manufacturing industry workers, for example, are re-training
themselves for new job opportunities in healthcare and other service
industries. These new job
opportunities often pay less than the individual’s former manufacturing
position and usually offer fewer benefits. The
net effect is the loss of job skills that may be needed in the future and a
lower standard of living for American workers.
(This trend is rapidly spreading to the professional and managerial
ranks as companies eliminate high paying positions, forcing displaced workers
to seek other types of employment at lower pay rates.)
Longer-term Outlook
The U.S. is likely entering a prolonged period of
slower but steady economic growth. Companies
will continue to focus on productivity gains as a means of sustaining profit
growth. In this mode, we can
expect employers to seek further opportunities to outsource and offshore jobs.
Large companies like Siemens and IBM have already announced longer-term
plans to relocate thousands of highly skilled engineering and IT positions to
lower cost labor markets.
The adjustment of the U.S. labor market to these
systemic changes in the way businesses operate will come slowly.
An increasing number of individuals, at all levels of the labor market,
will find it necessary to change career paths.
Competition for available jobs will remain strong, even as baby boomers
begin to retire from the full-time domestic workforce.
The continuing transition to a truly global economy will
have a moderating effect on pay opportunities and pay growth for many in the
U.S. labor market, but it will also create some new job opportunities for
those who coordinate and integrate the efforts of workers operating in several
countries with different work methods, technologies and cultures.
Individuals in these pivotal positions will be highly prized in the
market and should see strong compensation growth opportunities, along with top
executives whose success will be measured on global results.
The bottom line here is that pay will be relatively
flat for large segments of the domestic workforce during the foreseeable
future, while pay will continue to increase for the mid-level
coordinators/integrators and the executives who manage the overall enterprise.
These divergent trends in pay practice will
unfortunately lead to more economic polarization in the U.S., increasing the
living standard gap between the “haves” and “have nots”.
As always,
because of the size and diversity of the U.S. economy and labor market, the
effects of current business conditions on labor supplies and pay practices
vary from employer to employer. The
observations offered here reflect broad trends noted among a wide range of
companies in many different industries.
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