Remuneration Rumination

As say-on-pay becomes law, will U.S. shareholders give executives the thumbs up on compensation? Experts say the compensation structure should contain sufficient equity in the form of stock and options to align the executives' interest with shareholders. Executive stock awards should have long vesting periods, and pay plans should reward executives for outperforming peer groups at other companies. By The Wharton School Top corporate executives of U.S.-listed firms will have a new worry this year: Their pay packages will be scrutinized as never before. Starting this month, shareholders by law will be able to vote regularly to approve or disapprove executive-pay packages. What will investors consider before casting their votes? Will they put their foot down if they think a pay check is overly generous or simply rubber stamp what corporate boards put before them? And when they do cast these non-binding votes, how much influence will their views actually have on pay levels and the metrics against which performance is measured? The so-called say-on-pay advisory shareholder vote was first required by law for U.S. financial institutions receiving bailout funds under the Troubled Asset Relief Program in 2008. About 70 other U.S. companies have adopted similar voting voluntarily in recent times. This past summer, the Obama administration went a step further, with the Dodd-Frank Wall Street Reform and Consumer Protection Act. Starting with annual shareholder meetings taking place after Jan. 21, the Act requires all public companies to conduct say-on-pay votes at least once every three years and ask shareholders to vote on the frequency of those votes every six years. Shareholders will also be asked their views on golden-parachute awards after a merger, acquisition or any other type of restructuring. Meanwhile, the country's pension funds and other large institutional investors that will be casting ballots must disclose publicly how they voted and why. While the general public will be disappointed that the new law won't necessarily put an end to fat-cat pay, it should go some way toward raising the accountability of many executives who have been paid handsomely despite shoddy performance that has harmed, rather than helped, increases in the value of their companies for shareholders. But casting votes that push firms to link pay to performance requires careful analysis by investors, according to experts from Wharton and compensation advisers. Bailouts Fueled Outcry Fat-cat pay has drawn the ire of investors and the general public for years, but their outcry reached a fever pitch after the banking meltdown in 2008. Taxpayers, who were asked to bail out the banks, were particularly infuriated by compensation to Lehman Brothers CEO Richard Fuld in the years before the company filed the largest bankruptcy in U.S. history in September 2008. While Fuld said he received $310 million in compensation over the period between 2000 and 2007 and that he had not sold much of his stock, observers put his pay much higher, to as much as $500 million. Fuld wasn't alone. The reasons? The sector's excessive cash bonuses, a focus on short-term annual-growth measures and pay levels that were so high they effectively insured executives against failure and fueled an aggressive risk-taking culture, according to a new report by the Washington-based Council of Institutional Investors, which represents about 130 pension funds. The report found that Wall Street's median compensation levels were between two and three times the levels of the rest of the Fortune 50 during the five years from 2003 to 2007. The differential was driven for the most part by Wall Street's appetite for larger awards of time-restricted stock, notes the report's author, Paul Hodgson, a senior research associate at The Corporate Library, a Portland, Maine-based corporate governance research outfit. But experts question whether a mandatory say-on-pay system will help improve the size and structure of pay packages. The amount of work [institutional investors] can do [to analyze and improve pay packages] is trivial compared to what the board has already done, says Wayne Guay, a Wharton accounting professor who consults on executive compensation plans. The chance that they'll come up with a flaw in the plan is slim. I'm confident most boards are doing a pretty good job. According to the CII's report, say-on-pay votes should also be wielded carefully. A high say-on-pay 'against' vote is a blunt instrument, it states, adding that there are other, potentially more effective steps investors can take to voice their displeasure with excessive pay. Shareowners should ensure that if they do vote against compensation, they explain their objections in a letter to the company. ... If change is not forthcoming, owners can let the company know that they will vote against the re-election of compensation committee members. As a last step, [they can] consider filing a shareowner resolution seeking improvements in specific pay practices. Skin in the Game Despite the intense public scrutiny and frequent criticism of executive-pay packages in the media, however, most U.S. shareholders who have been able to cast votes on executive pay have been supportive of company practices. In 2010, only three companies failed to receive majority support for their compensation programs, and no company failed to receive majority support for pay programs in 2009, according to a recent newsletter from Towers Watson, a New York-based HR consultancy. A case in point: Aflac, an insurance firm that was the first company to voluntarily subject its executives' pay packages to a shareholder vote, including $11.96 million to its chief executive, Daniel Amos. More than 93 percent of the 200 shareholders who voted backed their board. According to Wharton finance professor Alex Edmans, short-term holders may have different objectives than long-term holders. Short-term holders usually don't have as much 'skin' in the game, so their focus when analyzing pay packages might be different than long-term investors, he notes. And regardless of the longevity, evaluation criteria can vary from one shareholder to the next. Michael Useem, a Wharton management professor, says large investors such as Fidelity, Vanguard, BlackRock and T. Rowe Price assign analysts to study the compensation of their holdings, develop broad policies and decide how the organization should vote. Smaller institutional investors are likely to rely on the formulas developed by proxy-advisory firms like Glass Lewis or RiskMetrics Group (formerly Institutional Shareholder Services). Their recommendations focus on making sure that executives' pay reflects their performance and that there are no egregious clauses, such as lifetime use of company planes. An example of RiskMetric's approach can be found in a report posted on its website recommending a vote against the 2008 compensation plan at tax-preparer Jackson Hewitt. Among other things, they did not like awarding stock options based on achieving an earnings-per-share goal for 2009 because the goal was not disclosed. Worse, the goal might have led managers to encourage franchise openings or acquisitions that are not beneficial for the long term. As for golden parachutes, Edmans says, even though they are usually frowned upon by the investor community and are not popular among the general public, shareholders should not automatically vote against them. Understandably, shareholders are unhappy when an executive who is asked to leave a company after years of poor performance walks away with a multimillion-dollar retirement plan. But in other cases, without a parachute clause, a CEO might try to scupper a takeover b