8.4 Executive Compensation: Best Practices

The challenges facing compensation committees today are formidable. Increased public scrutiny, stronger pressure from shareholders, new regulations, and intense competition for executive talent are causing compensation committees to change their focus beyond providing transparency and compliance to creating value by adopting compensation policies and structures that assist in attracting, developing, and managing executive talent and driving performance.

A review of best practices of companies with a track record of overseeing successful management teams suggest that the most effective compensation committees do the following:

• Think strategically about executive compensation. Proactive compensation committees integrate their compensation policies with the company’s overall strategy. A move to a new business model, for example, may require different incentives from other growth strategies.
• Integrate compensation decisions with succession planning. Very few events have a more dramatic impact on a firm than the unexpected loss of a successful CEO. Winning companies have a succession plan in place that not only addresses “who takes over and when,” but also “why” and “how.” This requires that the board agrees on the set of skills and competencies needed to execute the company’s long-term vision—that is, adopts an objective framework for identifying the right talent to implement the company’s chosen strategy.
• Understand the limitations of benchmarking. External benchmarking is widely blamed for escalating executive pay levels. Analysis methods should not be blamed, however. The problems arise in their application. Benchmarks can be useful for assessing the competitiveness of compensation packages but should only be considered within the context of performance.
• Understand how executives view compensation issues. Executives often take a different perspective from directors in looking at compensation issues. Whereas boards are preoccupied with issues, such as the associated accounting expense, tax consequences, potential share dilution, alignment with the business strategy, and administrative complexity, executives often take a more personal, risk-based perspective.
• Communicate with major shareholders. Investors increasingly value an open dialogue about matters, such as potential board nominees or equity grant reserves; their input can give compensation committees a sense of broader shareholder views.
• Carefully select, monitor, and evaluate their advisers and advisory processes. NYSE listing standards require boards to evaluate themselves at least annually, and board self-evaluations are quickly becoming a governance best practice. The evaluation process should include the performance of consultants and other outside advisers.