Executive Compensation

A Guide to Executive Compensation in the Dodd-Frank Act

How to Evaluate Exec Comp

Responsible investors will take the three votes (say-on-pay, say-on-frequency, and say-on-severance) seriously, even though they are non-binding. Asset managers may have clients that review how the fund votes, and in many cases (for Form 13F filers) will need to disclose publicly these votes in annual SEC filings.

So, how should a thoughtful portfolio manager evaluate compensation? Below we provide some guidance, in these sections: general principles, the typical components of exec comp, and questions to ask about exec comp.

General Principles

There are all sorts of frameworks for understanding and assessing exec comp. A particularly useful one comes from the Independent Directors Executive Compensation Project (IDEC), an initiative of over 40 directors, executives, academics, and other comp experts that The Delves Group helped to organize in 2009. IDEC advocates evaluating exec comp with respect to six principles:

❖Fairness
❖Accountability
❖Alignment
❖Transparency
❖Engagement
❖Objectivity

They elaborate on these principles here. The IDEC website also has numerous other resources for those interested in more detailed work on exec comp.

Exec Comp Components

While investors can refer to numerous exec comp frameworks, actual exec comp tends to fall into fairly standard areas.

Base salary: every executive of every company gets this, of course. Reported as an annual figure, it ranges from $1 for Steve Jobs at Apple to millions of dollars per year for many executives in the Fortune 500. Most observers think of base salary in terms of covering an employee’s ongoing basic personal expenses.

Cash bonus: most every executive also receives some form of annual cash award. Companies typically use a formula for determining the minimum and maximum amount of cash bonus, usually calculated as a multiple of base salary (i.e., 50% of base, 1.5x base). Companies frequently evaluate the formula, though, using subjective factors, such as “achieving personal goals” or something similar. A cash bonus rewards achieving individual goals more than company-wide financial results.

Long-term incentives: these include the whole range of equity and equity-like compensation, such as stock options, restricted stock, and many, many other similar plans. These seek to reward employees for the company’s financial results.

Perquisites and benefits: these sound exactly like what they are, additional things that companies provide to employees to attract and retain them. These include health benefit plans, pension and retirement plans, life and disability insurance, and all the other things that get publicity, such as automobile allowances, club memberships, and other stuff too numerous to list here.

Attentive investors will evaluate these components with respect to a set of principles, such as the IDEC principles. Well-run and governed companies also do other things:

❖The more senior the executive, the more long-term compensation (and less cash) they receive.
❖Set long-term compensation to reflect ambitious goals that make executives think and act more like investors.
❖Use investor-oriented goals, such as cash flow returns or return on investment, and not conventional accounting goals such as EPS or EBITDA.
❖Limit perquisites and benefits.
❖Disclose all this in elaborate detail.

In general, investors should evaluate how the company pays its executives (compensation structure and goals), in addition to how much.

Questions to ask about Exec Comp

Base Salary

❖Why does any NEO have a base salary in excess of $1,000,000?
❖What is the ratio (and relationship) between NEO base salary and cash bonus opportunity?

Cash Bonus

❖How does the cash bonus link to individual, group, and company performance?
❖How does the cash bonus align with the company’s short-, mid-and long-term strategy and objectives?
❖Do the specific performance goals and metrics match the strategy and objectives?
❖How can the cash bonus payout vary (e.g. threshold, target, maximum/caps)?
❖How much of the cash bonus is guaranteed?
❖How much discretion does the company have in determining the cash bonus based on non-financial measures?
❖How does the minimum and maximum relate to the threshold and expected bonus, and are they balanced so that NEOs have similar opportunities to earn the minimum and maximum?
❖How does the cash bonus vest following the performance period? Fully and immediately, or with accrual over time?

Long-Term Incentives

❖Does long-term incentive comp depend on performance or merely on years served?
❖If performance-based, do the performance metrics correspond to the company’s relevant economic value drivers?
❖What specific vehicles (stock options, restricted stock, etc.) does the company use, and do they serve both the NEOs’ and company’s objectives (retaining talent, tax effective, etc.)
❖Do the long-term incentives promote appropriate NEO risk-taking?