The New ROI of Executive Pay

Fred Whittlesey
Compensation Venture Group, Inc.

In May 2006, I presented at WorldatWork’s Annual Conference a session titled “The Real Meaning of ROI…for HR Professionals.” It was a financially-oriented look at how HR professionals should present their ideas – in dollars, just like the other areas of the business organization. It has been named “Best of Conference” and I have been invited to present it again, as a webcast, on 01 November. It is telling that such a highly technical and complex topic was so well-received by an audience not known for its financial savvy. This shows that the notion of ROI is now a central topic in compensation.

We are beginning to discuss this with regard to executive compensation but we have not yet begun to call it “ROI.” The analysis of executive pay has focused on two metrics: The total dollar amount paid to executives (numbers that are usually misrepresented in the media and by proxy advisory groups) and the associated return to shareholders over a period of time (which typically is misaligned with the purported pay period). This forms the basis for the “pay for performance” analysis.

The idea of relating executive pay levels to company performance is an important one, and continuing work must be done to ensure both the measurement of pay and the relation to performance are correct. We might consider this “external ROI” – the return realized by shareholders as a result of their investment in an executive team.

This pay-for-performance focus has overshadowed what may be an equally important analysis, however, in light of the growing complexity of pay plans and the new governance environment. The cost of designing and administering executive compensation plans, particularly equity-based plans, is significant and more so for global plans. As accounting and tax rules have both constrained and enabled the features of these plans, the design and administration costs have increased. The new SEC disclosure rules add still more cost, due to both the processes required and the documentation and reporting of those processes and decisions.

As a group of professions (consultants, accountants, HR executives, lawyers, plan administrators) we have never calculated the total cost of the intricate executive compensation programs we collectively design, and related that cost to the compensation delivered through those plans. As one lawyer asked during a recent conference panel discussion, “Is it costing us ten dollars to deliver one dollar of perks?” We might consider this “internal ROI” – the relative efficiency of expenditures. When we donate to a charity we often ask what the administrative expense ratio is so we understand how much of the dollar we give actually goes to those in need. In executive compensation, we need to be asking how many of the dollars we pay actually go to the executives to reinforce the corporate goals of retaining those executives and focusing their efforts on value-creating activities.

The new disclosure rules will provide more fodder for shareholders, pay critics, and the media to take potshots at executive pay practices and, more critically, the members of the Boards of Directors approving those practices. There will be knee-jerk reactions, poor decisions, and then revisiting of those decisions a year later. That will create more work, and more professional fees and internal costs, and will reduce ROI.

This year’s executive compensation reviews must focus on ROI, both external ROI (eROI) and internal ROI (iROI). These analyses should form the underpinning of the narrative required by the new SEC disclosure rules and ensure that the Compensation Committee and the executive team are able to address those requirements within a data-based analytical framework. It will be unfortunate if resources are focused solely on compliance activities indicated by the rules rather than the structure and operation of the programs that led the government to perceive there was a need for those rules.

Welcome to The Compensation Committee Adviser

Fred Whittlesey
Compensation Venture Group, Inc.

The recent article "Shaping Strategy from the Boardroom" in the McKinsey Quarterly begins by stating "As companies turn their attention from compliance to growth and innovation, boards must focus on strategy." The article goes on to say that since boards of directors have now "come to terms with the new governance rules...it's time to move on." While that may apply to the overall activities of the Board, there are areas of Board responsibility where this is not yet so - like those of the compensation committee.

It is critical for Compensation Committees to focus on strategy and avoid letting the compliance tail wag the design dog. Most Compensation Committees, having now gotten through FAS123R accounting, option valuation, and most of 409A deferred compensation rule changes are again besieged with the option backdating scandal, new SEC disclosure rules published last week, and continuing changes in investors' criteria. Just about the time they digest the new disclosure rules they'll be seeing Institutional Shareholder Services' 2007 Policy Statement.

I agree with the McKinsey authors' statement that "too many (boards) simply lack directors who have the industry expertise to participate effectively in shaping strategy - much less to reshape it on the fly as the business climate changes." When we view "industry" as the "compensation industry” we find this statement applies to compensation committees as well. But in the directors' defense, no one - consultants, accountants, lawyers - has much "experience" with these new rules. What is needed is a strong commitment by compensation committee members, and their advisers, to devote the time and attention needed to communicate, understand, assimilate, and act upon the continuing changes in the executive compensation environment. This requires a multi-disciplinary approach, not an accounting viewpoint from the auditor, then a tax viewpoint from the CPA followed by a legal viewpoint from the lawyers.

The Compensation Committee Adviser is a resource for clients, colleagues, and interested parties to maintain a day-to-day awareness of the changing landscape in executive compensation in the hope that we can indeed balance the attention to compliance with sound strategy, good design, and effective execution. Like our firm’s compensation consulting practice, it emphasizes a multi-disciplinary approach to decision-making in the complex executive compensation environment. I hope this resource, plus additional education opportunities you will find listed on our website, provide valuable support for the difficult job of compensation committee membership in these turbulent times.