Executive Pay: What to Expect for 2015

Executive Pay: What to Expect for 2015Download PDF

It’s that time of year when compensation committees and management teams are contemplating changes to executive compensation for 2015. Committees want the changes to be business-based, competitive, and responsive to the market and investor priorities. While not the only consideration, a key input to committees’ decision-making will be looking at hot-button changes on the horizon.

In recent years, executive pay has evolved significantly, influenced by Say on Pay and related investor and proxy advisory firm guidelines. A number of market trends have emerged and taken hold: a decline in the use of stock options, a greater emphasis on performance-based shares, reductions in non-performance based pay such as SERPs, perks, severance, and supplemental benefits, and an undeniable trend toward using relative total shareholder return as the yardstick for performance. Complementing these design changes are more transparent shareholder communications that discuss the rationale for pay decisions: CD&A’s are clearer, and shareholder outreach has become prevalent, proactively, as well as reactively. These trends seem here to stay.

Underlying the trends: Shareholders are becoming less tolerant of continued high pay without demonstrated business results and value growth. Shareholders, now more than ever, want to see a return for their money.

It would be nice to create a checklist that covers such concerns, tic the boxes, and feel reasonably assured that a company’s executive compensation program is consistent with “best practices.” However, that approach ignores the energy behind the shareholder message about linking pay and performance. Therefore, it behooves directors to ask: What are we missing? What trends are evolving and picking up steam? What are we not talking about?

As we look into 2015, we believe compensation committees need to be ready to respond to three areas of concern:

Increased Scrutiny of Performance Goals

The scrutiny of, and pressure on, goal setting will grow. Shareholders are essentially drawing a line in the sand: They do not want to reward executives for declining performance…period. Setting relatively low goals, even if based on budgets, doesn’t please shareholders. As such, boards will feel compelled to demand continuous improvement in value to support incentive pay. As evidence, over 40 percent of institutional shareholders responding to the most recent ISS policy survey agreed with the following: “If performance goals are substantially reduced from one performance period to the next, target award levels should be commensurately [reduced].” While we acknowledge that many boards do not agree with this philosophy in all situations, it is important to be aware of shareholder concerns.

A Higher Bar for Special Treatment and Special Awards

With their focus on continuous improvement, shareholders are less willing to accept the use of discretionary payments as an incentive for continued engagement and retention. Historically, companies have frequently turned to discretionary awards to aid retention in times when performance was more challenging. Others have adjusted performance goals to continue to keep executives engaged. Even when these special awards and adjustments are targeted to key contributors, shareholders have been skeptical. A number are now asking if pervasive special awards indicate issues with the design of underlying pay programs. Underscoring the emerging trend, Glass Lewis just added an explicit policy that sets a higher review bar for “one-off” awards. Committees will need to rethink any use of discretion that appears to be making up for underperformance.

Reduced Tolerance for Dilution

Finally, an increasing number of shareholders are taking up the issue of share dilution from equity incentive plans. As a result, the size of equity authorizations has shrunk, and the number of employees receiving equity has fallen in many companies. Bowing to shareholder criticism, even Coca-Cola recently announced that it was going to reduce the number of executives in its equity incentive plan—despite ultimately getting approval for a large new authorization earlier this year.

Equity compensation continues to be an important means to align executive and shareholder interests. However, companies and directors need to face a new reality: shareholders are pushing for more targeted equity use to ensure that they are really getting a return for their added dilution.

What does all this mean for directors on the compensation committee? It doesn’t mean that you can’t exercise your judgment to do what is right for the business. But it does mean that you can expect scrutiny of your decisions to ramp up in 2015. Therefore, you need to prepare more than ever to explain your decisions clearly and transparently.

The era of heightened pay for performance is here to stay. The compensation committee’s decision-making and disclosures need to reflect this shift in the market.

About the Authors

Blair Jones and John Borneman are Managing Directors at Semler Brossy Consulting, a premier executive consulting firm. Jones can be reached at bjones@ semlerbrossy.com or 212-388-9776. Borneman can be reached at jborneman@semlerbrossy.com or 310- 943-8366.

This article originally appeared in Directors & Boards, Fourth Quarter 2014.