COMPENSATION COMMITTEE A partnership approach to executive compensation Five steps for improving the dynamics between management and the compensation committee in today’s governance environment. By Seymour Burchman and Blair Jones

he new governance environment concerned if management appears less than forth- has changed the dynamics between coming on certain sensitive matters or defensive management and compensation com- when challenged. mittee members. Not surprisingly, it is Instead of feeling threatened, both parties must taking a while for the issues to be sort- find more effective ways to work together under the edT out. At times, the dynamics can feel threatening: new rules. In an ideal collaboration, management It is not unusual for a previously amicable rela- and the compensation committee would develop tionship to become contentious on occasion, or for and implement an executive compensation pro- the boundaries between the decision rights for man- gram that aligns executive gains with those of share- agement and those for the compensation commit- holders; supports the business strategy; and enables tee to change without a thoughtful discussion of the the company to attract, motivate, and retain the tal- implications. Friction can occur if the compensa- ent needed to execute that strategy.An optimal part- tion committee suddenly becomes engaged on a nership between management and committee can topic that historically had been deferred to man- improve the business impact of a company’s exec- agement or if the compensation committee assumes utive compensation program. Such a partnership the primary relationship with an executive com- can also reassure both parties that the program’s ob- pensation consultant who had previously forged a jectives and implementation are as unassailable as relationship with management. Committee mem- possible in the eyes of the shareholders and the out- bers, for their part, will understandably become side world. To achieve these outcomes, all partners must be willing to create an environment that fosters conversation and trans- parency. It’s a matter of agreeing on the basic direction of the decision-making process and keeping the communication

Seymour Burchman and Blair Jones are managing principals of Semler Brossy Consulting Group LLC, an independent executive compensation consulting firm that advises management and boards of major U.S. companies on all aspects of executive pay (www.semlerbrossy.com). Both Burchman and Jones work with compensation committees and management teams, counseling them on compensation designs that best meet their business’ needs, ensure alignment with shareholders, and yield appropriate pay/performance relationships.

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flowing. An optimum approach to management/ policies and practices are in place to ensure the de- committee collaboration involves five steps: velopment of management talent, effective corpo- rate governance, and the establishment of compet- Step 1: Clarify expectations and itive and effective management compensation. As articulate decision rights shown in Exhibit 1, decision rights specify the gov- A critical first step in getting the relationship off ernance item (director compensation, CEO com- to the right start (or to take an existing relationship pensation, etc.), the specific actions (e.g., initiate, to a new level of effectiveness) is to step back and develop, review, approve), and accountabilities of have a candid conversation about expectations. This management, the compensation committee, the full is a natural conversation to have when a new com- board, and the compensation consultant. mittee chair comes on board or after the commit- One decision right that is gaining prominence fo- tee’s self-evaluation. The objective is to discuss how cuses on choosing the compensation consultant and management and the compensation committee can “owning” the consulting relationship. Historically, best work together to achieve the committee’s char- the compensation consultant was hired by and re- ter. The conversation should ported to management in virtually all companies. focus on questions such as the This clearly is no longer the case. An increasing When committee following: number of compensation committees are hiring the • What elements of their consultant, typically with management assisting members import charter do the compensation in the screening and credentialing. In some cases, committee members consid- a single consultant is hired to serve both manage- pay practices from er most important? Is the ment and the committee. In other cases, the com- charter still appropriate, or mittee and management have their own consul- another board on does it require modification? tants, particularly when a second opinion is sought • How well has the com- or when the company’s compensation program has which they serve, mittee adhered to its charter? come under close scrutiny. Discussion of decision Specifically, what has it done rights helps start the conversation about critical they run the risk of well? Where does it need to issues such as these. improve? What are the rea- a bad fit. sons for any shortfalls? Step 2: Understand the implications • How can management of business issues and talent needs for best help the committee fulfill its charter? To what rewards design extent has management been doing this already? The next step in forging understanding and collab- What is working well? What areas could be oration is for management and the compensation improved? committee to articulate how the company’s business • How can the committee help management de- issues and talent needs should influence rewards de- liver to the committee’s expectations? sign. Exhibit 2 illustrates how one company sum- • Do the committee members feel as if they are marized the executive rewards implications of its getting the right information in a timely manner in key business imperatives. order to fulfill their fiduciary obligations? Articulating business and talent needs lays the • How do the committee members want to be in- groundwork for structuring a rewards strategy that volved in the making of critical decisions? responds to the company’s business situation and When expectations are clear, management and provides necessary guidance as programs change. A the committee will understand each other’s expec- rewards strategy must go beyond “motherhood and tations and have a basis for periodic discussions (at apple pie” to summarize a company’s enduring be- least once a year) of how the relationship is work- liefs about compensation and help ensure that re- ing. Management may choose to have individual wards align with and support the vision, mission, conversations with directors first on these matters business strategy, and financial priorities of the and then aggregate themes for full committee dis- company. The rewards strategy provides a yardstick cussion. Alternatively, a third party might facili- for retrospective evaluation and a framework to tate this process. guide the future direction of program design and These discussions can lead to greater clarity administration. It becomes the means for estab- around decision rights, an important outcome. De- lishing agreement and commitment among man- cision rights define accountability for specific ac- agement and the compensation committee about tions and decisions related to compensation, ben- pay and performance principles. It allows manage- efits, and perquisites. They guarantee that the ment and the compensation committee to make de-

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exhibit 1 Decision rights matrix

Decision Roles Compensation Governance Item Description Management Committee Corporate Board Frequency Director The compensation, benefits, Initiate, Develop Review, Review, Approve Annually Compensation and perquisites provided to Recommend directors (policy) CEO Qualifications The skills and experience Initiate, Develop Review, Approve Review, Approve Annually (review) required of CEO As Needed (recom- mend, approve qualifications) CEO Compensation The compensation, benefits, Provide Input Initiate, Develop, Review, Approve Annually and Performance and perquisites provided to the and Tools Recommend Evaluation CEO; performance standards and evaluation process CEO Succession Succession process under Develop Initiate, Review, Review, Approve Annually Planning various scenarios Recommend (review process)

As Needed (develop process) Officer The compensation, benefits, Initiate, Develop Review, Review, Approve Annually Compensation and perquisites provided Recommend to officers (Approve) Stock Options The issuance of stock options Initiate, Develop Review, Approve Review Annually to employees subject to Rules 16b-3 and 162(m) Officer Appointment Decisions regarding the Initiate, Develop Review, Review, As Needed and Promotion appointment, promotion, Recommend Approve and continuing service of management Officer Removal The removal by the CEO or Initiate, Develop, Review Review As Needed officers for cause and/or Approve performance Compensation The guidelines that shape the Initiate, Develop Contribute, Review Annually (review) Philosophy and corporation’s compensation Approve Principles strategy and approach As Needed (approve) Corporate Social Policies and practices Initiate, Develop Review, Monitor, Review Annually Responsibility regarding corporate social Approve (policy) (review policy) responsibility issues (e.g., Equal Opportunity Employment) Periodically (monitor compliance) Board Presentations to the board that Initiate, Develop Contribute, Review As Needed Communication explain the business impact of Approve the compensation committee’s actions

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cisions within a mutually agreed-upon framework, • Comparative Framework — the companies rather than face each pay decision as if for the first used for pay and performance comparisons. This time. involves establishing a peer group of industries/or- Rewards strategies typically define the follow- ganizations to compare pay practices and perfor- ing principles: mance. • Pay Prominence — the visibility and impact of • Pay Positioning/Mix — targeting pay levels rel- pay relative to other programs that influence be- ative to companies in the comparative framework havior. Prominence is influenced by pay variability, for different levels of performance (e.g., 50th per- executives’ influence over performance results, and centile versus the 40th or 60th percentile). Pay mix the explicitness of communication about the addresses the proportion of fixed and variable com- pay/performance relationship. pensation components, e.g., what percentage of pay • Emphasis — the primary goal of pay (e.g., at- will be delivered in salary versus incentives, what traction, motivation, or retention). Typically each percentage will be based on annual versus long-term component of the compensation program has its results, etc. own focus. • External/Internal Balance — the relative in- fluence placed on external market com- petitiveness in determining pay levels exhibit 2 How business needs influenced versus internal factors, such as the strate- gic importance of jobs to the company. one company’s rewards strategy • Performance Measurement — the measures, standards, and time frames for evaluating performance. What are the What are the implication for compensation? Some companies also define expecta- key business Annual Incentives tions for executive stock ownership, the imperatives? • Reinforce key strategies and intermediate-term operat- process and criteria for CEO evaluation, • Rationalize the ing and financial results (e.g., reduction of operating and the desired nature and scope of brand portfolio costs and increase in same-store-sales) needed to communication. through ongoing promote progress toward longer-term results To provide further useful context, assessment of the management can help the committee • Incorporate shared accountability for results in order strategic understand the historical evolution of to promote collaboration among members on the issue significance of each the company’s rewards strategy, program of brand portfolio management brand design, and pay levels. An historical pay • Utilize discretionary pools to reward for innovation audit, conducted by pay component and • Promote brand overall, can show the compensation innovation while • Reward innovative and breakthrough performance committee how pay has changed over continuing to support through increased leverage and upside time, what factors influenced design re-branding initiatives • Set individual or team goals for those accountable for changes in the past, and how the design • Address the strains building and maintaining infrastructure by examining key must evolve further to meet current de- on infrastructure operational/service metrics that would be improved mands arising from changes in the busi- that have resulted through a more effective infrastructure (e.g., service ness or the need to attract, motivate, and from rapid growth data could be collected through franchisee satisfaction retain key executives. in recent years survey) Exhibit 3 illustrates the executive compensation history that management • Sustain current Long-Term Incentives at a public utility prepared for its com- growth levels • Reward innovative and breakthrough performance pensation committee. The exhibit covers through period through increased leverage and upside three elements of the compensation phi- of economic losophy: pay prominence, pay compara- growth • Consider the use of a special multiplier if some specified level of improvement is exceeded tors, and pay positioning for salary and incentives. Management used the exhib- Special Entrepreneurial Plans it to explain the changes in pay com- • Create an entrepreneurial-based incentive plan that parators and positioning, which reflect- would provide individuals and teams a ‘stake’ in new ed deregulation in the late 1990s and the concepts/platforms increasing pressure to attract and retain key executive talent whose roles were be- coming more like general industry exec-

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utive roles. As the industry changed the pace of its mittee as a partner in the design process rather than movement into unregulated businesses, the com- just an approval body. The process raised issues parators reverted back to a blended utility and gen- early and ensured buy-in, enabling the committee eral industry group. members to understand and trust the objectives and mechanisms of the designs. Step 3: Seek committee input on compensation designs Step 4: Analyze and communicate com- Rather than present a compensation design as a fait pensation program outcomes to ensure accompli ready for the compensation committee’s the program delivers as designed stamp of approval, management teams are includ- Communication is critical in helping compensation ing committee input throughout the plan devel- committees understand the implications of com- opment process. This input starts with involving pensation decisions and proactively guiding them committee members in initial interviews as well as to an appropriate conclusion. Management can play providing for multiple touch points during the de- a central role by ensuring full transparency about sign process. For example, a retail company in the the facts and figures that support compensation de- midst of changing its incentive design and mix in- cision making. volved its committee at the following four different Tally sheets, prepared by management or an out- checkpoints: side consultant, can help explain the total finan- 1. Initial input (through individual interviews) cial impact of rewards decisions and identify po- about what changes needed to occur. tential issues with pay programs. Tally sheets can 2. Review of executive and committee interview provide the complete picture of compensation, for findings and the results of a competitive assessment, both the CEO and the executive group as a whole. with a focus on understanding the implications A tally sheet might include base salaries and an- for the rewards strategy. nual incentives for the last three years, plus long- 3. Preliminary review of alternative design term incentives and gain opportunities for the same changes. three years. It also could illustrate likely realized 4. Approval to proceed with the final version of gains under various performance scenarios. Added the new design. to that would be retirement income at different Management benefited from having the com- points in time and potential payouts if executives

exhibit 3 Compensation history for a public utility

Compensation Plan year philosophy element 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Pay Moderate to high pay (i.e., pay is a secondary driver of executive prominence actions and decisions behind the company’s vision and shared values) Comparators Average of the general General industry General General General General and pay industry median and the median for all industry industry industry industry positioning utility industry 75th executives median for top median median for median for (salary) percentile for all top 2 executives; for all top top 2 top 2 executives utility industry executives executives; executives; 75th percentile utility utility for others industry industry 75th per- 75th per- centile for centile for others others Comparators and pay General industry median for all top executives positioning (incentives)

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were terminated or retired. Tally sheets can prompt fore. Management must remain open to ideas in- meaningful conversations about stewardship and troduced by the committee or evident in the mar- fiduciary responsibility — discussions that can head ketplace and help committee members objectively off embarrassing “surprises.” evaluate appropriateness of these ideas for the com- The committee and management should also pany’s situation. identify and agree on the metrics that will show Many compensation committees set aside time whether the compensation program is meeting its during one of their regular meetings for a proactive objectives. Metrics should focus on whether the discussion of current trends and their implications compensation program is: 1) motivating and re- for the company. This often occurs in the summer, warding the right results, 2) succeeding in the at- after proxy season. Other companies prepare white traction and retention of key executive talent, 3) papers for their boards on issues and questions re- achieving the right relationship between pay and lated to the applicability of certain practices for the performance, and 4) adhering to key elements of company. Such discussions can provide important the rewards strategy. The metrics can be based on: context and avoid situations in which committee • Specific Outcomes (e.g., executive turnover members feel compelled to follow prevailing trends rates, success in hiring sought-after recruits). or other companies’ practices. • Targeted Analyses. For example, some compa- When committee members import plans and nies use a three-part test to evaluate pay/perfor- practices either from their employer or another mance relationships. These tests focus on answer- board on which they serve, they run the risk of in- ing the following questions: troducing plans that will not fit the given company’s — How well correlated business and talent needs or its culture. Before su- have pay and performance perimposing another company’s “best practices,” Many compensation been over time relative to cor- committees and management must ensure the prac- relations in peer companies? tices are appropriate to the company’s situation, and committees schedule — Is there appropriate evaluate the potential for any unintended conse- value sharing between exec- quences. For example, one company examined pre- a trends discussion utives and shareholders? vailing practice with respect to the replacement of — How well are pay and options with some form of restricted stock. Howev- into one of their performance aligned relative er, the company — a start-up company looking to to the company’s peer group? attract young, entrepreneurial talent motivated by regular meetings. • Interviews/Surveys of large upside opportunity — found that conven- Plan Participants. For exam- tional, or even performance-based, options met its ple, one company conducts periodic surveys of plan unique business needs much more effectively. participants to gauge the effectiveness of their plan Given the amount of information available and designs and their implementation. The survey ad- the visibility of executive compensation decisions, dresses issues such as how well participants under- committees sometimes need to reach out to other stand the program, whether the right measures are resources to ask questions, validate points, or sat- being used, how effective the goal setting process is, isfy curiosity. Management should not be threat- and how well bonus decisions are communicated at ened by the committee’s desire to seek other opin- year end. ions. In fact, management should adopt a proactive These metrics provide a “report card”for the pro- stance and invite committee members to consult the gram and open the door for constructive dialogue company’s HR, finance, and legal resources as well about the compensation program’s effectiveness. as outside advisers. These individuals should be pre- The metrics also allow management and the com- pared to expect committee interaction and advised mittee to proactively address any issues instead of on how to handle a call. being on the defensive. In today’s governance environment, it is chal- lenging to address the issues surrounding executive Step 5: Remain open to new ideas and pay. But if the five steps outlined above are followed, provide committee with the right we believe the result can be more effective executive resources pay programs that successfully balance the interests An atmosphere of transparency breeds more dis- of all key stakeholders — the company, the share- cussion. Many committee members serve on mul- holders, the board, and the executives. ■ tiple boards and are exposed to a wealth of ideas. More information and opinions about executive The authors can be contacted at sburchman@semler- compensation practices are available than ever be- brossy.com and [email protected].

® 60 DIRECTORS & BOARDS Reprinted from Directors & Boards First Quarter 2006 © MLR Holdings • 1845 Walnut Street, Suite 900 • Philadelphia, PA 19103 (215) 567-3200 • www.directorsandboards.com

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