Will “Say-on-Pay” Change Executive Compensation?

By Tomilee Tilley Gill, President

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Corporate America isn’t what it used to be. There was a time when top executives joined a company and stayed for the long haul – ten years or more. Today, executives typically change jobs every three to five years, creating a continual need for companies to recruit new talent.

These short-term tenures have transformed the compensation structure for top executives. In an article published last year, Jay Lorsch and Rakesh Khurana of Harvard Business School pointed out that, in recent decades, non-financial rewards such as “future promotions, the intrinsic satisfaction of achieving results, and the pride taken in belonging to a successful company” have been cast aside in favor of explicit monetary “carrots.”

The trouble with this approach is that heavy reliance on financial incentives can create a vicious cycle whereby executives demand progressively greater amounts of money to validate their achievements and self-worth.

One of the biggest components and incentives of an executive compensation package has, historically, been stock options. Unfortunately, while such programs are popular, stock options often allow executives to obtain massive payouts from short-term stock spikes or industry movements, even if their own company is underperforming. For the executive who doesn’t intend to stay more than a few years, the potential windfall of such payouts can create temptation to manage company figures for short-term gain and not long-term growth.

Love it or hate it, that’s the way it’s been. And, based on the first round of “say-on-pay” votes on executive compensation as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act, that’s the way it’s going to stay. At least for a while.

Shareholders Overwhelmingly Vote “Yes”  

New rules adopted earlier this year by the Securities & Exchange Commission (SEC) require shareholders to take part in “say-on-pay” votes at least once every three years beginning with the first annual shareholders’ meeting on or after January 21, 2011. While these votes are not binding, they encourage boards of directors and compensation committees to critically evaluate their executive pay programs.

It was expected that publicly traded companies would come under heavy pressure from investors to scale back incentive programs that were unrelated to performance. Surprisingly, that did not happen. According to the Rockville, Md.-based Institutional Shareholder Services (ISS) U.S. 2011 Postseason Report, investors at annual meetings held before September 1, 2011 overwhelmingly endorsed their companies’ existing executive pay programs, with 92 percent of shareholders voting “yes”.  Just 1.6 percent (38 of the Russell 3000 index companies that voted before September 1) voted against management executive compensation packages.

Shareholders Vote to Re-Vote Every Year

That doesn’t mean things aren’t going to change, however.  The new SEC rules allow investors to decide how often to vote on “say-on-pay” proposals. The options include annual voting, every other year, or every three years.

The results of that vote give us an inkling of what the future may hold. Because, while investors overwhelmingly supported their current executive pay plans, they also overwhelmingly supported annual voting. As of September 1, 80 percent of companies in the Russell 3000 index had gone on record supporting yearly votes on executive compensation. Clearly investors want to keep an eye on those paychecks.

As the momentum builds for basing executive pay on measurable performance and long-term sustained value for the company, we may see more investor groups flexing their muscles and voting against executive pay proposals. Already this year, ISS noted, “say-on-pay” votes prompted some companies to make last-minute changes to their pay practices to gain shareholder support.

So…What’s a Corporation to Do?  

The challenge for corporations is to find a balance between corporate responsibility and the desire to attract top-notch executive candidates.

While incentive programs have long been a fact of life in corporations, it’s clear there are flaws in how they have been implemented, particularly for executives. For years, business experts have urged companies to stop relying so heavily on financial rewards, and to strengthen share ownership requirements and stock-vesting conditions for top management.

These ideas make perfect sense. The reality is a little harder. Consider the needs of one of our clients, a privately held manufacturer that plans to go public in the near future. They would like us to recruit candidates from publicly held companies. The client can’t match candidates’ current salaries but they can offer stock options that will allow candidates to benefit when the company does go public.

We agree that executive pay should be based on performance, but we also understand that expertise has a value of its own. If proven experience isn’t recognized and rewarded, good candidates will go someplace else. So, how does this company – and others – balance the interests of investors with the need to use stock options as a recruiting tool?

One way companies could keep executives motivated would be to require them to retain all shares, purchased or awarded, until several years after they leave the company. Correspondingly, the vesting period for conditional share  awards – that is, shares that will be turned over to an executive only if specified performance targets are met – could be extended from the standard three-year term to five years or longer.

These measures would compel executives to consider their impact on the company beyond their own tenure and provide greater incentive for them to leave the company in better shape than when they started. Such measures may also motivate executives to groom strong successors.

Moreover, the performance conditions for those shares should be allowed to run their full course even when an executive leaves the firm. Currently, these awards will usually vest according to a preset formula or be forfeited upon an executive’s departure.

Develop a Clear Compensation/Expectations Plan  

Companies must refocus on long-term thinking and the development of a well thought-out executive compensation plan. These important steps will enable them to provide clear direction and specific expectations to executives. Once such a plan is in place, the principles behind it should be communicated to shareholders and other employees in order to establish credible justification for how such pay programs will drive the company’s growth.

At the end of the day, we are all dealing with this economy and the changes it is bringing to corporate America. As a search firm, we understand and appreciate the challenge companies are facing – how to balance responsibility to shareholders with the corporate desire to hire the best and the brightest. Recent “say-on-pay” votes mean that, for most companies, it will be business as usual – for now. But, with our crystal ball out for cleaning, and new votes to be taken every year at most companies, who knows what next year or the year after may bring. Hold on, because we suspect the ride is just beginning!