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The year 2010 may be remembered for its impact on the design and governance of chief executive and senior executive compensation programs, particularly if financial system reform becomes law. In light of all this, what issues are boards and compensation committees facing today, and what will they see in the near future? Given our experience as compensation committee advisers to companies in the Dow Jones Industrials and S&P 500, we'd like to share what we see.
WHAT'S HAPPENING TODAY?
Executive pay levels are recovering from the late 2008-early 2009 economic and stock market downturn. The widely reported decline in executive compensation during 2009 has not been sustained. It was driven by a fall in stock prices, with a corresponding impact on the value of long-term incentive grants, both of which have largely rebounded. Values of long-term incentive grants are up by roughly the amount of decline in the late-2008 or early-2009 grants, which averaged about 15 percent.
Salary budgets for 2010 are formulated with executive merit increases of 2 percent to 3 percent, with amounts of up to an additional 1 percent budgeted for promotions and special increases. Companies are restoring salary cuts but not the value lost from salary freezes.
Annual incentive target awards as percentages of salaries are stable.
Incentive compensation delivery is becoming more differentiated and strategic and less competitively driven. Companies are aligning financial goals more closely with earnings guidance—and earnings guidance with company budgets.
We saw in this year's proxies an increased use of nonfinancial measures and discretion and a higher weighting/greater differentiation for business-unit results. We also saw that adjustments for calculating financial performance are more often defined up front rather than after the fact. There was, as well, continued movement to a balanced long-term incentive approach for executives, combining options, time-based restricted stock, and performance shares. This occurred along with a continued downsizing of special benefits, perks, and severance. Further, more companies required stock retention (e.g., 25 percent to 50 percent of net shares from option exercises and other stock payments) where ownership guidelines had not been met within required time periods.
Financial reform legislation will happen in 2010, and it will affect executive compensation and board action taken through compensation committees. Shareholder advisory "Say on Pay" voting will be a part of it. Look for Say on Pay as a mandated item in time for spring 2011 proxies. Whether it will be an annual requirement or a less frequent one remains the big question. We also expect the law to mandate independence of compensation committee members and advisers, with the Securities & Exchange Commission charged to develop independence standards for compensation consultants. The law will likely mandate even more disclosure in the proxy, and there likely will be a requirement for policies to claw back "erroneously paid" incentives (including options) if there is an accounting restatement due to material noncompliance with financial reporting requirements under federal securities laws.
Adapting to Say on Pay voting will prove a challenge for compensation committees. Shareholder advisory votes will quickly become meaningful, and significant opposition to an executive compensation program could occur, even if a majority of shareholders approve it. Pressure will increase for dialogue with investors in order to identify and address concerns. A majority vote against a compensation program will have serious results, including pressure to make corrective changes. If a board fails to act, it will likely mean withheld or negative votes against directors held responsible in the next election. Moreover, the threat of a director not being reelected is real, especially if reelection is coupled with the proposed majority voting requirement and elimination of the broker discretionary vote in uncontested board elections.
Boards should expect the influence of proxy advisory firm RiskMetric Group to remain strong. RMG continues to pressure companies it sees as underperforming peers. The firm wants at least 50 percent of shares granted as equity compensation delivered in performance-vested vehicles, as opposed to time-vested, which in RMG's vernacular includes regular stock options and restricted stock. As a result, we expect to see greater use of performance-vested equity awards. There will be some movement to cash-based, performance-vested, long-term incentive plans as well, in part to conserve shares where companies may not be able to increase available shares in stock plans because of already high outstanding grants.
RMG also will continue to track other issues, such as severance payments in connection with performance failure. It will focus, too, on change-in-control-related compensation payments to executives still employed. In other words, RMG wants double triggers (i.e., qualifying termination after a transaction) rather than single triggers (i.e., only transaction closing) as conditions for paying severance and accelerating equity vesting in change-in-control transactions.
We also think RMG will continue to criticize overly generous perks, including personal use of corporate aircraft, personal security systems, car allowances, and post-retirement death benefits. It will highlight any excessive differential between a CEO's total pay and the next-highest proxy officer, which is viewed as an indicator of a lack of a CEO succession plan or a weak compensation committee.
Compensation committee accountability is on the rise and will be an issue beyond 2010. The committees are more active than ever contending with human resource policy issues, such as succession planning and diversity, in addition to their normal work. Committees have been addressing performance measurement and goal-setting for some time, but the intensity is increasing. In addition, committees have new issues to address and work into their charters and calendars. One such issue is considering whether company incentive compensation plans, at all levels, contribute to excessive risk-taking by management and what the company is doing to manage and mitigate such compensation-related risk. Another is greater committee autonomy and interaction with major shareholders and their advisers because of Say on Pay.
While most compensation committees have been independent for some time, independence under pending legislation would be required to meet the standards set by the Sarbanes-Oxley Act of 2002 for audit committees. What's new for 2010 is that companies must disclose fees provided to compensation consultants advising the committees if they or their firms provide "additional services" of $120,000 or more. This has caused, and will continue to cause, companies that use full-service human resource consulting firms to go elsewhere for advice to the compensation committee on executive compensation matters—or to grapple with additional reporting and disclosure requirements if they do not.
The reformation in executive compensation practices that advanced in 2009 will continue for years to come. While it is too early to say that changes will address criticism of CEO pay and restore public trust, the reformation will significantly change how CEOs and senior executives are remunerated as well as the transparency of executive compensation. Look for greater shareholder input on CEO pay and more opposition from investors. Annual meetings will become battlegrounds for companies with outlier practices, and senior executives will have to defend their compensation more often in terms of the corresponding organizational performance. How this affects the overall amounts and structure of executive compensation in years to come is still an open question.