Despite popular belief—or perhaps to the disbelief of many shareholders—corporate governance reforms and market pressures may finally be squeezing at least some parts of executive compensation packages.
That’s according to a recent survey by professional services consultant Mercer, based on the findings of 350 companies within the Fortune 1000. According to the survey, total compensation for chief executives declined in 2007, a year when corporate performance also tumbled. Total pay dropped 15.8 percent to about $14 million on average for CEOs at the 50 biggest companies. For the group of 350 overall, pay declined 5.5 percent, the survey said.
The report also found that while the average base salary actually increased a small amount, 42 percent of companies did not raise their CEO’s base pay at all last year. Moreover, performance-based long-term incentives were almost as common as stock options, a likely response to shareholder demands that pay be linked to performance.
That tilt toward equity compensation may be proving unpleasant, given the current market and new financial reporting rules. The decline in overall compensation, experts say, is probably linked to many reasons: volatile share prices, increasing shareholder complaints about bloated CEO pay, and new accounting rules that make equity-based compensation more expensive.
Others, however, say the reasons are not clear. “You’ve got the economy the way it is, and debates over time-based versus performance-based incentives, and then you’ve got compensation accounting issues, so it’s really hard to put one word, phrase, or theme on why this is happening,” says Mike Halloran, a senior executive compensation consultant at Mercer.
The wild card, Halloran adds, is that many companies are moving away from awarding options and fixed-price equity awards, which came to be lightning rods for controversy amid numerous options backdating scandals over the past three years.
“Stock awards often give the worse headaches to internal accountants and the outside auditors they work with,” he says. “Even if the bottom drops out on the options, it’s still booked as an expense from an accounting perspective, so what we’re seeing in some areas is a shift away from options into more performance-based incentives based on stock as well as cash.”
A Changing Tide
Yet another impetus for the decline are the disclosure rules established by the Securities and Exchange Commission and other regulators in 2006. Those new disclosure rules force boards to define the criteria they use in calculating performance awards.
“It’s a different ball game these days, with the ‘say on pay’ movement gaining traction,” says Ed Lawler, director of the Center for Effective Organizations at the University of Southern California. “There is a growth in concern about the way compensation is determined and if the board grants pay that isn’t warranted by its formula, it has to say why. Also companies must report the estimated value of the stock options they grant to executives.”
The following excerpt from FAS 123R reviews the measurement practices to be used for equity-based compensation.
The measurement objective for equity instruments awarded to employees is to
estimate the fair value at the grant date of the equity instruments that the entity is
obligated to issue when employees have rendered the requisite service and satisfied any
other conditions necessary to earn the right to benefit from the instruments (for
example, to exercise share options). That estimate is based on the share price and other
pertinent factors, such as expected volatility, at the grant date.
To satisfy the measurement objective in paragraph 16, the restrictions and
conditions inherent in equity instruments awarded to employees are treated differently
depending on whether they continue in effect after the requisite service period. A
restriction that continues in effect after an entity has issued instruments to employees,
such as the inability to transfer vested equity share options to third parties or the
inability to sell vested shares for a period of time, is considered in estimating the fair
value of the instruments at the grant date. For equity share options and similar
instruments, the effect of nontransferability (and nonhedgeability, which has a similar
effect) is taken into account by reflecting the effects of employees’ expected exercise
and post-vesting employment termination behavior in estimating fair value (referred to
as an option’s expected term).
In contrast, a restriction that stems from the forfeitability of instruments to which
employees have not yet earned the right, such as the inability either to exercise a
nonvested equity share option or to sell nonvested shares, is not reflected in estimating
the fair value of the related instruments at the grant date. Instead, those restrictions are
taken into account by recognizing compensation cost only for awards for which
employees render the requisite service.
Awards of share-based employee compensation ordinarily specify a performance
condition or a service condition (or both) that must be satisfied for an employee to
earn the right to benefit from the award. No compensation cost is recognized for
instruments that employees forfeit because a service condition or a performance
condition is not satisfied (that is, instruments for which the requisite service is not
rendered). Some awards contain a market condition. The effect of a market condition
is reflected in the grant-date fair value of an award.10 Compensation cost thus is
recognized for an award with a market condition provided that the requisite service is
rendered, regardless of when, if ever, the market condition is satisfied. Illustrations 4
(paragraphs A86–A104), 5 (paragraphs A105–A110), and 10 (paragraphs A127–A133)
provide examples of how compensation cost is recognized for awards with service and
The fair-value-based method described in paragraphs 16–19 uses fair value
measurement techniques, and the grant-date share price and other pertinent factors are
used in applying those techniques. However, the effects on the grant-date fair value of
service and performance conditions that apply only during the requisite service period
are reflected based on the outcomes of those conditions. The remainder of this
Statement refers to the required measure as fair value.
FASB (December 2004).
Lawler also says boards are increasingly sensitive to corporate governance scores outside firms place on their companies, as well as to scrutiny from independent auditors and other outsiders who historically didn’t give much attention to CEO pay.
For example, last year Moody’s Investors Service adopted a guideline that figured executive pay into bond rating calculations, stating that CEO pay, in particular, “should not exceed three times the average of the other executives named in the proxy.”
Changes in corporate by-laws have also made it easier for shareholders to oust directors who dole out undeserved, oversized pay packages. In the last two years, institutional investors have organized efforts to oust directors at nearly 100 major U.S. companies, according to a study published earlier this year by RiskMetrics, which advises big shareholders on corporate governance issues.
‘New Middle Ground’
In addition, several regulatory changes are afoot that will also affect the size and composition of executive pay packages going forward.
Among those standards are Rule 409A of the federal tax code, which limits the tax deductions companies can claim on large CEO pay packages; and Financial Accounting Standard No. 123R, Share-Based Payment, which obligates companies to expense stock option grants. Observers say compliance efforts around these plans could change trigger dates for stock awards, bonuses, and other compensation programs that usually inflate the total of the pay packages of top brass at public companies.
“Those two standards are going to have a big impact on how plans are structured and may affect the size of compensation in the future,” says Randy Ramirez, a compensation specialist at BDO Seidman. “What [FAS 123] and other standards like it did was level the playing field for equity compensation across the board, because while it used to be that pay had little impact on financials, performance-based incentives have changed that.”
Ramirez says companies should continue to be aggressive on CEO compensation and think about the issue on an ongoing basis rather than just when earnings are off or shareholders are clamoring for someone’s scalp.
“It‘s important now more than ever for companies to focus on long-term goals but structure their executive pay in a way that focuses on short-term incentives, such as internal benchmarks and not necessarily traditional financial performance metrics, which can fluctuate based on unforeseen circumstances,” he says.
Ramirez suggests that these changes be gradual and not a reaction to temporary market conditions. One good start, according to him: Structure pay packages so that less than two-thirds of compensation for C-level executives and other top managers is based on equity awards.
“It may take awhile,” Ramirez says, “but eventually I think a lot of these trends are going to lead to fundamental changes in performance-based programs, and ultimately a standardization of accounting and reporting rules, given increased transparency—whenever that happens.”