Feature: Down, but Not Out
Shareholder activists have been grousing about executive pay and benefits for years but are getting results now. “Populist pressures to limit executive pay are taking a toll,” says Scott Olsen, a Principal in the HR Services Group at PricewaterhouseCoopers LLP in New York. Executive plans have been under scrutiny for some time but, because of the financial crisis, they are under more scrutiny than ever, and shareholders are flexing their muscle, says James Scannella, a Senior Consultant with Towers Watson in New York.
Public and shareholder pressure now has led to executive plan redesigns. In the last 24 months, one in three Fortune 500 companies has made changes to executive plans, says Frederick.
When changes are made, there have been material changes in the objectives of these programs. “Executive plans are still highly relevant, but play a different role than three years ago,” says Doug Frederick, the Head of Mercer’s Executive Benefits Group in Louisville, Kentucky. For one thing, companies now are creating executive benefits programs that are more “sticky” and give shareholders more rights, says Roberts. Program redesigns also have led to the overall levels of executive benefits going down, says Frederick. Executive benefits had been on a continual upslope for more than a decade, and that seems to have stopped in 2008 to 2009, confirms Scannella.
One notable trend in the redesigns is to make executive benefits be more restorative and less supplemental, says Frederick. Firms still are providing executives with plans that compensate for Internal Revenue Code qualified plan limits, he says, but true SERPs, where executives get benefits above and beyond the rank and file, are less popular. In 2009 and 2010, says Scannella, the trend was for companies to freeze or terminate SERPs.
Additionally, as firms freeze and terminate qualified defined benefit plans, they are doing so for executives as well, adds Frederick. Eight out of 10 Fortune 500 plans that changed their qualified defined benefit plan changed the executive defined benefit plan as well, he says.
There also have been a lot of changes in the way equity grants are made to executives, says David Roberts, Head of Equity Plan Services at Bank of America Merrill Lynch in Scottsdale, Arizona. Previously, stock options and restrictive stock were the types of equity most often granted. The new trend is to grant restricted units tied to a performance factor, he says, such as stock price growth in relation to peers. Equity grants also have longer vesting periods, moving from a typical three-year period to one that is now five to seven years long.
Perhaps one of the biggest changes has been to the methodology for determining executive pay and benefits. Setting executive compensation only in relation to peers has lost favor. Previously, says Olsen, the primary driver of executive pay packages was peer group/benchmarking. This, however, was criticized as creating the so-called “Lake Wobegon” effect of spiraling executive compensation. Now, peer group/benchmarking is lower down in overall consideration, says Olsen. The new way, he says, is to look at pay and benefits more holistically and determine how a compensation program fits the overall goals of the company.
Historically, agrees Frederick, the primary analysis was whether a package was defensible in relation to peer group or industry pay. Now, he says, other factors are being heavily considered, including whether the compensation is internally defensible.
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One reason for the changes is shareholder pressure. Shareholder opinions are being communicated to management, and compensation committees now look for the valid business purpose to providing the benefit, says Scannella. If there is no valid business purpose, he says, the discussion then turns to whether it should be continued.
Shareholders want more alignment between their interests and executives’, says Olsen. Shareholders, he says, believe retirement programs provide no real incentives, and want programs that provide guaranteed and fixed-income compensation abandoned.
While shareholders are exerting pressures to rein in executive pay programs, employees exert even more curbing pressure. Rank and file now can see when benefits are structured differently for executives because of the 2006 disclosure rules, says Olsen. The new attitude in setting executive compensation, says Frederick, is that executives should lead by example, so executive pay has to be internally defensible. For example, when qualified defined benefits are being frozen or terminated, it now is viewed as inappropriate to maintain nonqualified defined benefit plans for executives. In these difficult times, it is realized now that you cannot ask people to take a cut in pay if executives are not sharing in the pain, adds Frederick.
Repercussions from section 409A’s passage continue to ripple through the industry as well. Because section 409A complicated administration, there has been a tremendous move to outsourcing nonqualified deferred compensation (NQDC) plans, says Roberts. The consequences of violating the rules can be severe, he notes, so companies now want administration of these plans in the hands of administrators with subject matter experts. Expect that the movement to outsource administration of executive benefits will gain ground in coming years, adds Scannella.
Executive pay also is still feeling the aftershocks of the 2006 requirements for proxy disclosure of executive pay and benefits. The disclosure rules have led to anything doing with contractual severance payments or change of control payments moving in the direction of being less favorable to executives, says Olsen.
In 2010, expect a continued whittling away of executive perks, says Scannella, with shareholders continuing to play a role in the shaping of executive pay and benefits. For example, he says, executive tax gross-ups on change of control benefits are coming under intense shareholder scrutiny now. If an executive contract comes up for renewal and contains a gross-up, institutional shareholders are likely to vote out the compensation committee.
In addition, although they have lost favor in recent years, expect to see more NDQC plans. In the last few years, because of regulatory pressures and lack of interest, voluntary deferred compensation plans lost favor, says Olsen, but there may be a comeback in the next few years because of possible tax hikes. Olsen says he has seen several clients that already are taking a new look at voluntary plans. Firms also are exploring mandatory deferred compensation plans with matches tied to performance, he says.
You will see continued innovation in the design of executive compensation in the next few years, says Roberts. As the rules change, there will be changes in the way packages are structured. With more scrutiny and disclosure, there will be more innovation in how these packages are designed, he says.
However, disclosures will be at the forefront of any executive plan redesign. “No one wants to be in the news regarding abnormal executive pay packages, so everyone is rushing to the middle,” says Roberts. “No one wants to be the poster child for executive compensation that is viewed to be egregious.”
This article originally appeared in the April issue of PLANSPONSOR magazine.