A compensation committee’s essential ongoing role boils down to ensuring the alignment of pay with performance.
The strategic needs of any company are many and complex. These needs include developing leaders, balancing performance and retention needs, and creating and maintaining a performance culture. Board compensation committees play an essential role in addressing these needs.
Many compensation committees have significantly improved their performance in response to all of the compensation committee governance requirements and guidance promulgated by legal, regulatory and shareholder advocacy groups over the past decade. Whether publicly or privately held, for-profit or not-for-profit — responsible compensation committees are following the principles and rules found in “Say on Pay”, “Intermediate Sanctions”, “ISS” and “Sarbanes Oxley”. In our compensation consulting work with clients in and around Baltimore, Maryland, we’ve seen significant improvements in compensation committee process and compliance. We see compensation committees giving appropriate consideration but not slavish deference to “best practices”, “competitive practice” or “market data”. These committees focus on what your business needs, recognize the unique challenges and situations facing their organization and consider alternative pay strategies in light of the organization’s strategy and under the known facts and circumstances.
In our opinion the compensation committee’s essential ongoing role boils down to ensuring the alignment of pay with performance. The basic question is whether or not the amount paid to an employee is appropriate in light of company, unit and individual performance. Committees now perform more in-depth analyses to examine this relationship, and record the rationale and the results of their pay decisions.
We see compensation committees using healthy doses of common sense in analyzing the pay-and-performance relationships. Designs and decisions typically look at the broad context by taking into account factors including specific performance against goals, the state of the economy, industry trends, the total compensation package, changed circumstances and how they were handled, and owner and employee perspectives.
Committees are focused on adopting balanced compensation program designs to ensure a meaningful pay-performance alignment. Balanced programs reinforce the pay-performance relationship and promote appropriate risk management. A well-balanced total compensation program should typically incorporate the following features:
- Include both short and long-term performance
- Consider both absolute (targeted) and relative (compared to peers/industry) performance
- Include a balanced portfolio of performance measures (e.g. financial, operational, strategic, risk)
- Consider company, team/division/function and individual performance
- Balance of formulaic and qualitative performance metrics
We also see committees improving of their understanding of program designs by reviewing modeling of the program results under various performance levels, and by closer monitoring of results. By “stress testing” proposed compensation designs companies and committees can be proactive in both the design of programs and explaining the rationale for the rewards that result from these programs. As part of the process, they ask themselves the following questions:
- What is the range of total compensation that could result from our programs under various performance scenarios?
- What are the upside/downside values if both short and long-term incentive plans pay out at threshold and max performance?
- What is the impact of different stock price assumptions over the next several on total realized value of compensation?
- How is compensation affected under different risk scenarios such as changes in interest rates, asset quality, stock market, or customer retention?
- Can we document a meaningful link between pay and performance relative to our decisions over time?
- Can we relate compensation received by executives to company performance relative to peers/industry over multiple years?
- Are levels of ownership sufficient to ensure executives, employees and board members interests are aligned with shareholders? Do our executives and board members hold and retain stock over the long-term?
With this type of due diligence we see committees significantly increasing the likelihood of achieving a proper relationship between pay-performance, addressing shareholder and regulatory concerns, and implementing programs that help the company attract and retain the talent needed to ensure the company’s long-term survival and success.