Should Executive Pay At Companies That Have Accepted Bailout Money Be Capped By The Government?
Reprint: R0909L Wall Street may have ignited the outrage over executive bounty, but it's now affecting all public companies. Believing that corporate pay practices encourage excessive take a chance taking, policy makers feel compelled to arbitrate, and shareholders are angrily demanding input. The battle will rage in boardrooms and almanac meetings for years, and information technology won't exist pretty. A bill that will give shareholders a "say on pay" is winding through Congress, and if passed, could bear on how U.S. companies pay key employees—and mayhap open other operational decisions to shareholder approval. That would hamstring companies competitively, some argue. Complicating matters, the experts are deeply divided on how to tie pay to operation. Moreover, by attempts to regulate pay spurred companies to find loopholes, such equally bonuses, deferred compensation, and huge subconscious perks that weakened the link betwixt compensation and company results. Though the answers aren't clear, the practices of household products maker Reckitt Benckiser offer a potential model. Reckitt has overhauled compensation throughout its ranks, linking performance-based pay for all executives to economic value added to the business organisation. No ane receives a bonus for private performance; a split up long-term incentive program rewards private performance with shares and options, which belong but if the visitor grows earnings per share by more xxx% for three years. This simple arrangement helped Reckitt plough itself around and generate strong growth—and the executives, in turn, have been well paid for their efforts.
The Idea in Brief
• You may think the battle over executive pay is happening under the spotlight in Washington—only in reality, it's coming to an almanac meeting near you. The damage done past financial services companies' pay practices volition plague public companies for months and years ahead.
• Because business leaders have been reluctant to address the trouble, a whole new grouping of song stakeholders are taking on the job—and that may not be good for companies in the long run.
• Experts are securely divided on whether aggressive compensation practices can spur ameliorate corporate performance—but in that location is new thinking on best practices.
Jeff Immelt is not happy.
The GE principal was ane of the few CEOs to voluntarily forgo a huge functioning-based bonus this year: In Apr he declined a $12 million payout that the GE board had canonical. At a time when the public'south fury over executive pay was cresting and GE'southward own earnings had fallen, information technology was an important gesture for him to make. "When nosotros're doing such massive restructuring, where the financial performance of the company has been better than the stock cost, I wanted to send a bulletin of loyalty and support to the employees," he told Harvard Business Review.
Merely it'southward non giving upwards the sizable bonus that's vexing him. It's the other casualties the focus on executive pay might cause. A beak that will give public company shareholders "say on pay" is at present winding its way through Congress, and if it becomes police force, it might impairment GE in the long term, Immelt worries. He's not agape of shareholders' weighing in on his own pay bundle, which was more than than $3 million in cash in 2008. "No thing what is decided, I'll work only as hard tomorrow as I piece of work today," Immelt says. "Merely what I have to fight for is the ability to decide how the other 300,000 people in GE are paid. I tin can't run this company if I have to worry virtually request for shareholder approval to decide how the guy who is running, say, the free energy business is paid. Nosotros won't be able to compete with the Chinese, the Japanese, and others who will accept more freedom to make decisions nigh talent and leadership."
In the past yr public outrage over executive pay has pushed the issue to the top of the domestic policy calendar in the United States and Europe. It's been widely recognized that the excessive bonuses and bounty paid past fiscal services companies not but rewarded risky behavior merely encouraged information technology. That, says U.S. Representative Barney Frank, leader of the House Committee on Fiscal Services, has compelled the government to intervene. "I practice remember it's important to respond to the public anger," Frank says. "The business community needs, to some extent, to exist saved from itself."
"The business community needs, to some extent, to exist saved from itself."—Congressman Barney Frank
"Conservancy" could well come up in the form of federal oversight. The Obama administration appointed a compensation czar for TARP companies in June and supports a "shareholder bill of rights" put forrard by Senators Charles Schumer and Maria Cantwell. The bill would require, amid other things, that all public companies hold an advisory shareholder vote of approval on executive compensation—something Obama himself had proposed as a senator. Most observers think that, at a minimum, the SEC will exist given some form of discretionary oversight over executive pay. Every bit Frank sees it, the mission of saving concern from itself is greatly important. "We're doing this," he explains, "to not take more than TARP companies in the future."
The ripple effects on business could be huge. "I think what is really at pale here is the manner publicly listed American companies are governed," says V.G. Narayanan, who leads Harvard Concern School'due south executive education plan on compensation for directors. Twenty-four hours-to-24-hour interval and major operational decisions, he believes, are a dangerous matter to open up upwards to a democratic shareholder process. One time shareholders and policy makers accept a say on executive pay, what's next? Will shareholders await a say on employee working conditions? How big a carbon footprint the company leaves? Where to build a new plant? "Each one of these issues seems very reasonable," observes Narayanan. "But taken together, we could accept as well much interference in how companies are run. My business organisation is, we are swinging wildly to the left from the right, when the eye seems a much better place to be."
The public contend has focused on how pay should exist linked to company performance, but academics and other compensation experts are securely divided on whether high pay tin can motivate executives to evangelize ameliorate performance. (For ii contrasting views, see the sidebar "Can Operation Exist Linked to Pay?") And though the spotlight at present is squarely on the financial services industry and companies receiving bailout money, the real battle will be waged in boardrooms and at almanac meetings outside Wall Street for years to come. Information technology won't be pretty. A whole new bandage of characters who believe they accept a stake in the event take loudly entered the contend. In short, the challenge of setting executive pay sufficient to attract, motivate, and retain acme talent only got a lot harder, and the stage on which corporate decisions will play out a lot bigger.
Where Did Things Go Wrong?
Outrage over executive pay is not new; sporadic shareholder revolts accept plagued annual meetings for decades. Only it has never before been so white-hot. Executive compensation is at the center of a complex mix of societal issues, most notably the increasing gap betwixt rich and poor and the economic crunch. "Executive bounty has go the symbolic consequence for the style we want to create wealth in the future," explains Fabrizio Ferri, an assistant professor at HBS who has studied the event. "It's non but nearly whether bad guys are making too much money but about figuring out a sustainable economic system."
Defining what's incorrect with C-suite pay isn't easy, because at that place are and so many things to throw into the mix. Peter Drucker famously decreed that CEOs should not earn more than 20 times the boilerplate salary in a company. Many top execs earn far more that now—some studies suggest as much as 300 times the average bacon. The most common criticism, however, is that smart executives, boards, and their key advisers have been able to game the organisation and then that comp packages skirt taxation penalties and mechanisms that peg pay to performance—near guaranteeing that executives accept picayune incentive to mitigate risk taking or to focus on long-term performance.
Despite regulatory attempts to prevent gaming, companies have typically found new loopholes to exploit, observes Carol Bowie of RiskMetrics Group, an independent shareholder advisory grouping. IRS rules, for instance, state that performance-based compensation does not count toward the $1 million maximum deduction that companies can have on bounty paid to top executives. That has led to the proliferation of bonuses and deferred compensation. One time an executive has left a visitor, the IRS restrictions are relaxed—hence the increment in generous golden parachutes and postretirement perks.
In contempo years, standard executive pay packages began to include all kinds of new trimmings: Gilt parachutes whose details were not revealed until the moment shareholders got to vote on a desired merger. Restricted shares that vest over time (what Narayanan calls "pay for pulse"). Extraordinary noncontributory pension plans. Some companies, says Bowie, have granted alimony plans that credit newly recruited superlative execs with up to vi years of alimony funding for each year they're at the company.
A lot of executive compensation comes in the course of unique arrangements that aren't subject to public scrutiny and have largely stayed out of the spotlight. When the details of such arrangements emerged during former GE CEO Jack Welch's divorce six years ago, they inspired media attention, the public's ire, and an SEC probe. (A year subsequently GE settled the matter with the SEC.) In the years ahead, shareholders are going to demand transparency near these special arrangements.
What has really thrown bounty practices out of whack, argues Rakesh Khurana, an HBS professor, is companies' growing trend to hire external CEO candidates. The pay of the CEO used to be benchmarked against the pay of all the executives below that position, especially the next-highest one. But with the emphasis on recruiting outside stars, the benchmarking has get lateral. A CEO'south pay is at present typically compared with the pay of CEOs in other companies, which has acquired compensation levels to rise. That, in plough, has thrown off relative bounty down the corporate ladder—and led boards of directors to rely more than on the communication of outside bounty consultants. The list of "wrongs" goes on and on.
There is, clearly, a lot to fuel the outrage.
The British Model
As a result of the uproar almost pay, compensation decisions normally handled within boardrooms and bounty commission meetings volition exist subject field to input—and rejection—from a whole new gear up of stakeholders. The events that took place at annual meetings throughout the United States and Europe last spring made it clear that say on pay—shareholders' right to an advisory (though non binding) vote on the proposed compensation plans for height leaders—is coming to the United states of america, whether legislated or not. (It was start mandated in the Uk in 2003. Commonwealth of australia, Sweden, Norway, Kingdom of spain, and the Netherlands take also adopted some version of information technology in recent years.)
Shareholders demanded a nonbinding vote at Apple'due south annual coming together in Apr, for instance, and the company has since agreed to give information technology to them. Partly because they feared that anger at Wall Street would be redirected toward Silicon Valley, other tech companies fell into line. Intel and Hewlett-Packard announced that time to come almanac meetings would include shareholder advisory votes on pay. Fifty-fifty companies in countries that already mandate a shareholder voice in executive pay have felt the heat. In June, Royal Dutch Shell faced an investor mutiny on compensation—despite the fact that shareholders had previously approved its remuneration arrangement.
Until this year, however, very few companies already field of study to say on pay saw dramatic shareholder vetoes. Virtually UK companies addressed potential investor anger in the run-up to the annual coming together, consulting cardinal investors about the details of compensation and other governance issues before announcing them. Institutional shareholders have privately forced some companies to go back to the drawing board, simply compensation proposals were considered a success as long as no issues were flagged during proxy season and the company stayed out of the headlines.
In practical terms, the just teeth institutional investors have is in exercising their right to not reelect board and remuneration committee members. Still, that threat has proved compelling. "In the UK, companies are far, far more than concerned about non risking offending institutional shareholders, who are very powerful," observes Towers Perrin's John Carney, a UK-based bounty specialist who advises boards. "It's easier to continue your head down."
"In the UK, companies are far, far more concerned nigh not risking offending institutional shareholders."—Towers Perrin's John Carney
At present key institutional shareholders are gaining clout outside the United kingdom of great britain and northern ireland as well. In contempo months organizations like CalSTRS, CalPERS, the AFL-CIO, the Consumer Federation of America, the Council of Institutional Investors, and the American Federation of State, County and Municipal Employees, amongst others, have been song about demanding a say on pay in almanac meetings beyond the world. "I recollect that the affair of pay has moral connotations, when you consider that regular working people accept lost half of their 401(k)south, and many have lost their jobs, simply to run into over-the-top bonuses paid out to those responsible for the mess. That moral outrage needs to exist acknowledged, and if companies don't respond to the issue, the government will," explains Anne Sheehan, the director of corporate governance for CalSTRS, the California Country Teachers' Retirement Arrangement.
"That moral outrage needs to exist acknowledged, and if companies don't respond to the issue, the government volition."—Anne Sheehan, CalSTRS
To some extent, the truthful power lies with the contained informational firms that make recommendations to shareholders voting on key issues. Look at what happened at Shell. Afterwards former chief executive Jeroen van de Veer received a discretionary $one.9 meg bonus from an incentive program, even though the company had failed to meet performance targets for iii years, RiskMetrics recommended that shareholders reject the company's remuneration policy. In May 59% of Beat out's shareholders voted against information technology. RiskMetrics has become so influential that many companies now pay information technology to review their plans before rolling them out publicly, so they tin can make the adjustments needed to garner a good rating.
RiskMetrics recommended against about xx% of the 300 or then proposals it had evaluated equally of June. In addition to the TARP companies, most a dozen U.S. companies voluntarily immune a say-on-pay vote, Bowie says. However, as of press time, none of the votes disclosed had resulted in a rejection past the majority. One of the largest known opposition votes was at Motorola, where more than than a third of shareholders voted against the company's compensation plans in May.
From Bowie's perspective, say on pay has one clear do good—increasing artlessness between companies and shareholders—but is far from a "silver bullet" for much bigger business issues. Those, she suggests, will take years to resolve.
What's the Reply?
While say-on-pay voting might seem cathartic to frustrated shareholders, HBS's Narayanan says, the real problem is that the argue has focused on what'due south wrong with executive compensation—and in that location's no consensus on what might be right. Adds Ferri, "A lot of investors are concerned with how executives are paid, but not so many have proficient suggestions on how to amend it." It's clear that the era of stock options and preset bonuses based on curt-term results is over. But experts don't agree on what "good" bounty practice should exist in a postdownturn world.
Then what should companies exercise? In response to the furor, a few pinnacle executives have already voluntarily taken pay cuts or, like Immelt, declined bonuses in 2009. According to Alex Cwirko-Godycki, research manager for Equilar (a house that analyzes and benchmarks executive and director compensation), more executives or executive teams voluntarily reduced their compensation in the first vi weeks of 2009 than in all of 2008.
Firms with annual revenues under $500 meg business relationship for 56% of all executive salary reductions reported between June one, 2008, and June 18, 2009.
In general, however, business leaders take been reluctant to participate publicly in the discussion; near are keeping their heads depression.
"In the wake of the crunch, what's actually impressed me virtually the business community is their deafening silence," observes Khurana. "The lack of business leaders standing up and proverb 'Here's what went incorrect with compensation, here's what we're doing' is disappointing. What y'all see instead is backroom lobbying when they should be engaging in public discourse virtually the goal of compensation."
"The lack of business organization leaders maxim 'Hither's what went wrong with compensation, here's what we're doing' is disappointing."—Rakesh Khurana, HBS
Aflac CEO Dan Amos was among the few business organization leaders to face the say-on-pay issue voluntarily; he also gave up his golden parachute and 2008 year-stop bonus, even though neither gesture was demanded by shareholders. "I just felt in this period of controversy, information technology took another thing off the table for our visitor," he explains. "All in all, I think the say-on-pay movement has been a good movement on our part and has allowed us to concentrate on other issues much more than important than compensation."
In one of the few public counter-arguments, UBS'southward group chief executive, Oswald J. Grübel, informed his staff in June that the bank would not succumb to public force per unit area to further cut compensation. (It had already reduced the bonus pool by 78% in January, later racking up a staggering loss.) In an internal memo to employees, he defended the ongoing pay practices: "As you have probably read, we have had to make some exceptional salary increases within the Investment Bank. These investments were necessary to safeguard our profitable business areas and to secure their success. Following meaning cuts in variable bounty, we had fallen well behind the market in certain areas, and that is unsustainable in the long run. We have to pay our employees in line with the market. We will stick to this stance, even if it is criticized in the emotional debate over salaries."
Narayanan thinks more companies should exist making it articulate how much is at pale, every bit Grübel did. He suggests that those that have been made an example of by angry shareholders are at adventure of losing top tier talent to competitors. Maybe even worse, Narayanan says, would be a world in which the most talented businesspeople pass up to go corporate executives, opting instead for consulting deals that volition escape public scrutiny.
Equilar's Cwirko-Godycki suggests that the real showdowns over executive pay may notwithstanding lie ahead. Some institutional investors and other activists may have cut companies a fiddling slack by acknowledging that information technology'south not possible to wipe out an existing compensation structure overnight. But they will expect things to be on the correct track by the end of this year, in time for the 2010 proxy season.
Is Whatsoever Visitor Already on Track?
Some all-time practices in compensation are showtime to proceeds notice. Narayanan points to those of the Anglo-Dutch company Reckitt Benckiser Grouping, a global manufacturer of household and health-care products, which overhauled compensation throughout its ranks in 1996. The revamp turned around the company'south performance and led to years of acquirement and profit increases; in 2008, for example, net revenues grew a remarkable 25%, from £v.three billion to £6.half-dozen billion, while internet income rose by 19%, from £938 million to £i.one billion.
Deputy chairman Peter Harf was one of the architects of the improved organisation. It links performance-based compensation for all executives to economic value added, measuring cyberspace sales growth, profit after taxes, and net working capital letter throughout the company and within business organisation lines and divisions. No 1 receives a bonus based on individual performance. "It's very elementary, very straightforward," Harf says. "Everybody in the company understands the organization and knows where she or he stands about on a daily basis. That'south why this has worked so well."
The company has an entirely separate long-term incentive program, which grants shares and options annually on the basis of position and individual operation. In the long-term plan, earnings per share growth is a key performance measure. "EPS has to abound past 30% over 3 years for the options and the shares to fully belong," Harf explains. "That's well alee of EPS growth for our peer group and general manufacture. Some shareholders would prefer other functioning indicators, such as full shareholder return. Nosotros take stayed away from that, because it tin can lead to outcomes that are completely uncoupled from the visitor'southward performance."
With the company's revenues and share toll rising steadily since the program's implementation, Bart Becht, Reckitt'south CEO, has been ane of the UK'due south highest-paid main executives in recent years. (He earned more than £iv.75 meg in 2008.) Although RiskMetrics has raised some caveats nigh the compensation plan, noting the absence of maximum limits on private awards, overall information technology has given its qualified support, and its April report on Reckitt does observe that "a link between operation and pay has then far been demonstrated."
Steve Kaplan, a University of Chicago Booth Business School professor who is on the compensation committee for the financial information visitor Morningstar, believes that exemplary companies redefine "long term" in a more meaningful mode. Kaplan points to Exxon Mobil as a skillful example. Though the oil giant'southward executives are extremely well paid (Exxon's CEO, Male monarch Tillerson, earned $22.four million last year), their bounty pays out slowly, over many years. Half of executives' restricted shares vest over five years; the other half must be held for x years or until retirement, whichever is later.
Kaplan argues, yet, that a dramatic overhaul of tiptop executive pay is not necessary. "Information technology is certainly not broken," he says. "Is it perfect? No. Simply it is not the runaway train that everyone portrays it as."
The Long View
Whether the changes that take identify in the next year are voluntary or mandated, the more interesting question is, Will any of this matter when the economy recovers?
Steven Hall, an executive compensation consultant who advises boards of directors, hopes the effect will blow over when the economy turns around. "When boards of directors ask me, 'How do I ensure that I'm not going to exist criticized for my compensation recommendations?' my smart-donkey answer is, 'Make certain the company performs well, because in that case, nobody cares what you pay executives.'"
Larger business concerns could potentially push the executive pay problem aside. "If yous really think about it," Aflac'south Amos says, "compensation is and so small in the big scheme of things. We make over $ii billion in profits. And we're talking about $x million [for top bounty]. Which is a lot of money. Simply equally a percent of what the company is earning, not actually. CEOs make decisions every day which are far more than expensive."
Ultimately, HBS's Ferri says, serious business concern issues are at pale. "The really of import question is actually how do you lot motivate the guys below that superlative level," he says. "That's where y'all get into important issues around succession planning, sense of fairness, and balancing new ideas and taking global risks."
Will the current scrutiny of pay mean that the next generation of leaders will demand to be motivated differently? What remains to be seen, suggests Ben Heineman, GE's former general counselor and a senior fellow at Harvard'southward John F. Kennedy Schoolhouse of Government, is whether this crash will chasten upward-and-coming leaders in a way that the dot-com bust did not. "Is the age of avarice over? Will people go into business to serve, non just to get rich; to atomic number 82 a vital and vibrant institution with a multifaceted part in club—the smashing corporation—rather than pursuing selfish agendas? The Low was a searing event that affected a generation. Will the same be the case for the emerging business organization leadership class? That is your question."
For Khurana, the public fence over excessive pay "has non been good for club." But he remains skeptical virtually whether there is whatsoever solution on the horizon. "If history'south any guide, we'll see an arms race between attempts to fix the issues around executive bounty and an army of lawyers, compensation consultants, and boards that are pretty good at finding a fashion around rules. This is going to be a meaning consequence for a while, because the causes of these problems are complex, and the solutions are going to be complex, also."
A version of this article appeared in the September 2009 issue of Harvard Business Review.
Source: https://hbr.org/2009/09/the-coming-battle-over-executive-pay
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