The annual review and analysis of corporate filings for public companies in full swing. Almost invariably, this scrutiny brings with it an outcry concerning the exorbitant levels of executive compensation and the lack of a direct relationship between what some executives made and the financial performance of their companies. In addition to articles that highlight some of the more there are typically investigative reports that identify illegal, or at best, highly questionable activities. Given the propensity of the public and investors to recoil at the issue of excessive executive compensation, it’s no wonder that these two groups have put considerable pressure on regulators to control and/or reduce executive in recent years.
With recent regulations and structural changes as the baseline, this raises the question of what the future holds. In trying to answer this question, it is important to understand how compensation levels are set. Assuming that the underlying purpose is to enable an organization to recruit and hire the best talent to meet its business needs, it naturally follows that a company will be very interested in what the competitive market levels are for the position to be filled. This places a great deal of emphasis on the availability of reliable market data that will be used to determine what an individual should be paid.
Recruitment of executive talent is typically not as competitive as it is for salespeople or other professions. On the upper rungs of the corporate ladder, multiple offers are rare, since fewer companies are competing for the same individuals. On the other hand, ideal executive candidates can typically raise the ante on their total compensation levels, since oftentimes the individual being recruited is still employed somewhere else. The company then must try to lure them away with an enticing total compensation package, which often requires buying out an existing package. The “golden handcuffs” that a previous employer put in place to retain executives probably won’t stop them from leaving, but it will have the effect of raising the stakes for the next employer.
If the marketplace is intended t dictate the amount of compensation, the specific design considerations of pay programs covering executives are equally important. The basic principle of executive compensation programs, particularly equity-base plans, is to maximize the after-tax dollar to the individual while minimizing any negative tax and accounting consequences to the organization, such as those set forth by the IRS, FASB and IASB. In addition, Executive compensation plans must adhere to all regulatory requirements, including Sarbanes-Oxley (SOX) the SEC and similar governing bodies.
Ceiling or Floor?
Some experts say that the latest requirements, including the proposed SEC regulations on enhanced disclosures, which spell out the use of tally sheets, identification of perquisites down to a lower level, and more transparency - will achieve the long sought-after-effect goal of reining in excessive compensation. Unfortunately, there’s a good chance that recent and proposed requirements will have the opposite effect: namely, to show an increase in the level of reported total compensation, as the combined value of the diverse components of pay come to light and a total dollar value of the executive compensation package is shown.
In a bumber cases, past legistation and IRS changes actually had the effect of raising compensation, setting new “floors” rather than “ceilings” as originally intended. One example of this is the infamous “million dollar rule” of Code Section 162(m), which requires base compensation above $1 million to be performance-based in order for a public company to deduct the expense for tax purposes.
Instead of lowering pay, it actually increased the base salary and expanded the amount of performance-based pay. Section 162(m) was one of the main drivers of the increased issuance of stock options in the 1990s; since stock options are considered performance-based compensation for IRS calculation purposes. In addition, there has been a huge increase in the upside potential of annual incentives. Typically performance-based, they provided the opportunity to raise total compensation without negatively affecting the million-dollar rule.
Assuming that the performance measures are real, and actually drive the business - and in turn help to increase shareholder value - additional performance-based pay is a little like apple pie and motherhood: a concept that few can argue with. When above-average performance is achieved and increased compensation justified, this concept does work. However, it only takes one rotten apple to spoil the barrel and raise the red flags of what is perceived as excessive" compensation.
Given this, is history destined to repeat itself? Will the new crop of regulations have the effect of lowering pay levels as intended? If the past is any indication, probably not. For awhile, at least, they will make Boards and Compensation Committees more cognizant of their responsibilities to better tie compensation to defensible performance standards and achievements.
But the bottom line is that the market will continue to be a major driver of what an organization needs to pay in order to attract top talent, retain proven individuals and reward them through pay plans tied to the achievement of appropriately selected performance metrics.
Compensation Resources, Inc provides consulting in Executive & Sales Compensation, Salary Administration, Stock Option & Performance Management Plans.
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