This paper, authored by Edward E. Lawler III, discusses how executive compensation systems are often criticized for rewarding the wrong things, ignoring shareholder objections, focusing on short-term results, and being too opaque. Despite these criticisms, there are rarely significant changes made. However, the current environment is one of sufficiently widespread economic frustration and resentment that boards and executives will likely have to take actions to address some of these criticisms.

Getting What You Pay For

Effective executive compensation systems will support an organization’s overall strategy as they impact many areas including cost savings, corporate culture, reputation, and attracting, retaining, and motivating leaders. Executive compensation is a business expense that should be reasonable and competitive because money spent on compensation is not available for other corporate projects or firm profits. The argument that U.S. corporations’ executive compensation is too high seems justified as American CEOs are the highest paid in the world. However, rather than just slashing compensation, companies need to ensure their pay plans are structured appropriately to attract and retain the right executives. Pay plans often need a mixture of short and long-term incentives tied to the CEO’s as well as the company’s performance to be effective.

CEO motivation is important to consider when structuring pay packages to ensure there is a clear connection between performance and reward. Focusing pay incentives too heavily on short-term results can lead to excessive risk taking and a short-term focus, so increasing the focus of pay packages on long-term corporate performance is often beneficial. The organization’s reputation is also important to consider as unusually high compensation, especially when combined with poor corporate performance, can easily damage the company’s credibility. Bringing CEO compensation more in line with that of other workers can also increase CEOs’ credibility as leaders, allowing them to voice a commitment to cost-efficiency and fairness in the organization.

Possible CEO Compensation “Fixes”

One solution to excessive compensation that is not too likely to happen on a wide scale is voluntary reduction in compensation. Another potential fix is increased federal regulation, which is already occurring by means of an executive-pay cap for organizations that received bailout money. Regulation could stop with the bailed out companies or expand to control compensation in most publicly traded companies. Hopefully, widespread government regulation of executive compensation will not come to pass because previous efforts to this effect have produced unintended negative consequences and failed to accomplish their objectives. Furthermore, it is unlikely that regulations would be able to be developed to adequately take into account the wide range of strategies and needs of different corporations.

Building a Better Executive Compensation System

Boards are positioned to take a leadership role in improving executive pay if they are willing to institute new governance and compensation practices. There are three key governance changes that could have a positive effect on the creation of more effective executive compensation plans:

1. Boards should have a separation of the role of CEO and chairman and should have an independent chair. This is likely to lead to boards being more willing to make tough calls about executive pay.

2. Boards should develop principles and objectives to guide decisions. These principles should include pay matching the competition and reflecting relative performance, a majority of compensation being based on company performance, the pay system aligning CEO and major stakeholder interests, and transparent determination of compensation.

3. Boards should put executive compensation plans to a shareholder vote. While the vote may begin as an advisory vote, it should move to a mandatory shareholder vote.

By putting these governance changes into practice, boards may be able to change executive compensation to foster more effective organizations.

Shareholders can also take action when boards are hesitant to implement changes. Shareholders can nominate and elect directors who are committed to altering executive compensation. Shareholders can also submit resolutions limiting executive compensation, although this would likely target a single practice rather than a total compensation system.

Responsibility of Boards and Compensation Committees

Boards of directors, and compensation committees in particular, have failed in risk management, which is a determining factor in designing executive compensation. Boards in general have set pay according to artificial formulas tied to artificial comparables and have set bonuses tied to overly flexible benchmarks. While boards have the primary responsibility for poorly designed pay, shareholders have permitted this to occur by reelecting directors who approve these pay plans and by voting in favor of excessive stock option plans. Some believe the best way for shareholders to make a difference is with an advisory vote on the entire compensation package. However, shareholders may be able to influence pay even more by refusing to vote in favor of compensation committees that agree to unreasonable pay.

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ERM Enterprise Risk Management Initiative 2009-07-01