Executive Perquisites are Alive and Well

Recently, we analyzed the prevalence of executive perquisites and benefits for a client and dusted off a 2005 Clark survey of Fortune-1000 sized companies. The survey showed a significant prevalence (30% and above) for perquisites such as personal use of company planes, auto allowances, country clubs and financial planning services. Our assumption was that there has been a significant diminution in the prevalence of these perquisites since 2005 due to changes in SEC disclosure requirements and increasing public and shareholder skepticism about all things executive pay. Somewhat surprisingly, however, based on our own survey of recent corporate proxies, executive perquisites are alive and well. The resilience of perquisites highlights their potential business value.

In 2006, the SEC finalized new rules that required enhanced disclosure of perquisites in proxies. If the total value of perquisites is greater than $10,000 than the total value must be disclosed and each individual perquisite identified. Further, if the cost of any individual perquisite exceeds the lesser of $25,000 or 10% of the total, its cost must be identified. Prior to this rule, the value of perquisites only needed to be disclosed if they exceeded the lesser of $50,000 or 10% of compensation. Individual perquisites only needed to be identified if they exceeded $25,000.

Following the more stringent SEC rules, we have had a deep recession and public and congressional distress over large bonuses paid to executives preceding bankruptcies and/or government bailouts of their companies. Our assumption was that company spending on executive perquisites would drop like the 2008 Dow Jones.

When we conducted our own analysis of recent (2008 fiscal year) proxies among Fortune 1000 sized companies, however, we still found a significant use of executive perquisites - down in some areas and up in others. For example:

• The 2005 survey showed 47% of companies provided an executive car allowance or leased car; our survey shows 44%.


• The 2005 Survey showed 30% of companies allowed for personal use of corporate aircraft; our recent survey showed 40%.


• A financial and/or tax planning benefit was provided by 66% of companies in 2005; our survey showed 38%.


• An annual executive physical was provided by 11% of companies in 2005 and 18% today.


• Country club memberships - 36% in 2005; 22% today.

Looking through the proxies, we were struck by the defensiveness of much of the language. Discussions of perquisites invariably include the word "limited" preceded by "very" or "extremely" as in "We provide a very limited amount of executive perquisites". When it comes to the personal use of aircraft, there is language describing the strict limits and controls on how it is used and there is usually language on how providing tax and financial planning services lets busy executives keep their minds on the business 24 by 7.

All this disclosure and sensitivity to shareholder reaction, raises the question: why go to all this trouble for perquisites that might add up to $20,000 or maybe $100,000 including personal use of corporate aircraft? The cost is not peanuts but is not particularly significant for executives making in low seven figures. Why not just pay them an extra $20,000 or $100,000 and be done with it? In fact, a small percentage of companies do just that - they provide an executive perquisite fund equal to a dollar amount for executives to spend on what they wish.

Why the resiliency of perquisites? In large part, because they are a very cost-effective form of compensation. They satisfy the urge in all of us, including highly paid executives, to feel special. Like a corner office or reserved parking space, having a company car, access to the corporate jet and membership in a country club are highly visible signs of success. We might not be able to go around boasting about our large paycheck, but we can proudly drive a company car or take our family on the jet. Perquisites can make an executive feel good in ways that dollars cannot.

Consider the most criticized prerequisite of all: personal use of the corporate jet. Executives use the jet to take their spouse on business trips or occasionally on vacation. While much ridiculed, the incremental cost of this benefit is often zero or trivial compared to the cost of owning and operating a jet. From a purely cost/benefit perspective, why not let the executive occasionally use it?

No doubt, there is also a bit of executive competition at work. Some executives feel that if they do not get perquisites at least as good as the other guy the Board does not appreciate them sufficiently. In fact, private companies are much less likely to provide executive perquisites than publicly traded companies.

Perquisites are still common and there is a good business rationale for them. A good business-focused perquisite program will look less to what other companies are doing and more around identifying perquisites that are worth more to executives than the cash itself.

Even More Proxy Disclosure

The SEC recently proposed new rules expanding the disclosure of executive pay and corporate governance practices. Like much of what is required to be disclosed in corporate proxies, the proposed rules have some superficial merit. And, who wants to be the first to raise their hand against disclosure?

But take a deeper look and the proposed rules add little value to an investment decision and have a Maginot line-fighting-the-last-war feel about them. In fact, taken together, the ever-expanding proxy disclosure requirements may very well be reducing management accountability rather than enhancing it.

The proposed rules are awaiting public comment and, if finalized, effective for Proxy’s published in 2010 based on fiscal years starting in 2009. The SEC has already put together a great summary of the proposed rules on their website so we will not regurgitate the details here. Below we briefly describe the five changes related to disclosure along with our comments.

1. Expand the the Compensation Discussion and Analysis Section (CD&A) of the Proxy to provide information on the relationship between risk and compensation; this disclosure covers compensation policies throughout the organization and not just for Name Executive Officers.

We have commented on this topic several times. Risk is an integral part of business and its assessment is subjective. It seems somewhat fatuous for the SEC to ask companies to identify those areas of compensation that encourage “excessive or inappropriate” levels of risk.

The bland generalities of four of the five examples provided in the proposed rules show just how problematic it is to disclose how risk may or may not be properly compensated. The SEC summary states that “situations that could potentially trigger discussion and analysis include, among others, compensation policies and practices:

• At a business unit of the company that carries a significant portion of the company’s risk profile;
• At a business unit with compensation structured significantly differently than other units within the company;
• At business units that are significantly more profitable than others within the company;
• At business units where the compensation expense is a significant percentage of the unit’s revenues”

Obviously, these examples could apply to just about any company and provide little or no guidance on when compensation policies might encourage inappropriate risk-taking. The last example the SEC provides is somewhat more useful: a company should consider disclosure and discussion around bonus practices when they “are awarded upon accomplishment of a task, while the income and risk to the company from the task extend over a significantly longer period of time”. It is not uncommon in our experience for companies to grant a sales compensation on the value of a long-term contract without regard to the ultimate revenue received from the contract or to grant a bonus based on closing a transaction without regard to the ultimate success of the transaction.

2. Change the Summary Compensation Table (SCT) to show the market value of an equity grant rather than the accounting value. For example, under current rules, if a company grants options to an executive in 2009 with a black-Scholes value of $6,000, that vest over a three year period, the Summary Compensation Table should show a value of $2,000 in the 2009, 2010 and 2011 fiscal year proxies. These values are consistent with how the option is expensed on the Company’s books. Under the proposed rules, the full $6,000 would be shown as compensation in 2009.

This change comes under the heading of six of one, a half-dozen of the other. Both the current and proposed changes have their pros and cons. The current approach smooths the costs of equity grants from year-to-year and provides more year-to-year stability to the list of “Named Executive Officers”. The proposed approach provides a better measure of the annual compensation decision made by the Board. However, as the full grant value is already disclosed to interested investors in the Grant Award Table, the change would not seem to be worth the effort – particularly as the SCT will need to be restated for prior years to provide consistent values.

3. Expand information provided around the relationship and compensation of any compensation consultants used by the Board. If an executive compensation consultant provides services to the Company beyond executive pay advice, then the Company would be required to disclose the compensation paid to the consultant for compensation-related services as well as any other services provided to the Company.

It is hard to argue against more disclosure – particularly around such a sensitive subject. However, we would prefer shareholders be encouraged to focus less on the underlying motivations of executive pay consultants and more on a) whether board members are rigorous and professional in their review of compensation and b) whether compensation is aligned with results and/or performance and is appropriately competitive. The publicly available information to make these judgments is plentiful.

4. Enhance the information provided about the background of Board Members and Nominees to describe the particular experience and skills that qualify that person to serve as a director of the company and as a member of any committee that the person serves on.

We are not sure we would want to invest in a company that was not already demonstrably choosing board members qualified for their posts. If a company changes board members or chooses more wisely because of required shareholder disclosure – we would be selling.

5. Provide information about the Company’s leadership structure and the Board’s role in the risk management process. In particular, disclose whether and why they have chosen to combine or separate the principal executive officer and board chair positions.

See comment on Rule 4 above.
________________________________________

Our general concern with increasing required disclosures is that after a certain point they run the risk of reducing Board and management accountability rather than enhancing it. Something along the lines of how credit card companies, by disclosing everything, disclose almost nothing.

Instead of focusing on results, Boards may be comforted by the ability to point to all the i’s they dotted and t’s they crossed. The executive pay program may have ineffective incentives and a counterproductive risk profile but the Board can point to the advice of a compensation consultant that has no conceivable conflict of interest and complete disclosure about their process for reviewing risk.

Companies must comply with the proxy disclosure requirements but it would be unfortunate if Boards let the disclosure rules distract them from the business judgments that they are paid to make.

How Not to Develop a Compensation Solution

Recently, my firm was engaged by a CEO who was grappling with the issue of retaining key talent in light of declining equity markets laying waste to option and restricted share value. A common issue these days. He had been working with his staff and external advisers as they explored various options including a deferred compensation program, option exchanges, re-pricings, phantom equity and variations thereof. The CEO was frustrated as no progress was being made and his neck was hurting from listening to the back-and-forth debate among the experts on the pros and cons of each alternative. This is a common blind-men-and-the-elephant situation.

Go to a cardiologist with a headache and you can be pretty sure that they will focus on the aspects of a heart condition that might cause a headache. Similarly, go to an accountant with a compensation issue and you will get an earful on Financial Accounting Standard 123. A tax attorney will tell you more about IRC Section 409A than you might wish and so on.

With apologies to my many brilliant colleagues who are attorneys and accountants (and to those who are sight impaired), our client made the mistake of asking a bunch of blind men to tell him what a retention program looks like. He spent his time listening to debates on whether the stock appreciation plan was “deferred compensation” under 409A and, if so, whether it was in compliance with the Code’s deferral and payment requirements. His outside counsel was concerned with whether a phantom equity plan needed to be a registered security or was exempt under Regulation D and his controller gave him a lesson in the accounting implications of an option re-pricing.

All of these are important issues that ultimately need to be considered but in order to effectively solve business issues through executive compensation design, the blind men (who also charge a lot per hour) should not be set loose without firm direction and a basic understanding of what the elephant looks like.

Commonly, after a business issue is identified, a team of experts is tasked with developing a solution. It seems to make sense. Let’s cut across the silos and deal with an issue holistically. This approach is also simpatico with our teamwork-oriented corporate cultures. But the silos have been built for a reason. Specialization brings economies of scale and is needed to deal with the complex US financial and legal structure. And, by definition, it brings a mode-of thought that is narrow. Starting with a team of silos can be a costly trap.

There is where a specialist-leader provides value. Usually that means an outside consultant but it can just as well be a strong internal compensation specialist or HR executive with compensation knowledge. Before even involving technical experts in a business issue that potentially involves pay and benefits, consider having a specialist-leader complete two broad steps:

• work with line management and staff to clearly define the business issue and business constraints around a solution. The latter may include cash-flow constraints, a can’t loose key employee, shareholder and key investor reactions, etc.
• develop a range of solutions in line with the business issues and constraints

Once a range of solutions are developed, by all means, let the finance types and attorneys have a go at it with the instructions that they are to apply their expertise to fine-tune the solution; not change it. Taking this approach will produce a business-oriented solution and save a lot of time, frustration and money.

Do Not Pay for Performance

The vociferous criticisms of the stay bonuses paid out at AIG, Sallie Mae and Merrill Lynch are a reminder that bad economic times have a way of stripping out the pretensions of business. When survival is on the line, there is less room for platitudes, conventional wisdom and faddishness. “Pay for performance” as it is commonly understood is one such nicety.

How could these companies pay retention bonuses to the same individuals responsible for the collapse of these entities? Don’t these companies pay for performance and the performance was poor, right? Wrong. When the going gets tough business is forced to face up to the reality of paying for future performance (PUP).

Professional sports teams are forced to recognize the harsh realities of PUP all the time. A team signs an athlete to a long-term contract and shortly thereafter he gets injured (see the Brave’s Mike Hampton). The team still has to pay him during his contract. When the athlete’s contract is up the team has to decide whether to “punish” him for taking their money without playing – pay for performance – or to pay him based on the team’s best estimate of performance for the coming season. Whatever their view of fairness, competitive pressures force the team to recognize that it must PUP; if it won't another team will.

So why in business do we get stuck on pay for past performance and too often relegate PUP discussions about employees to a quiet corner. For one thing, it is easy. At the end of the year, you give a performance rating to an individual on how they performed against their goals. Compare that rating against a table and you’ve got your merit pay increase and bonus. The practice is easy to support legally. Formulas are applied equitably regardless of race, color, creed, etc. There is no messy business of making subjective evaluations of future value and performance.

Unlike sports, business can get away with this because the competitive market for business talent is less public and much stickier than it is for athletes. Pay a key executive less than he or she is worth and in the short-term it probably will not result in a lost employee.

A strict pay for past performance approach works okay when there is plenty of money floating around. Business can still retain those employees who might not have performed well against goals for one reason or another through discretionary bonuses and pay increases. But when money is tight, strong business leaders acknowledge that they have to make some tough choices on talent with respect to pay and those choices cannot be made solely on the basis of past performance. PUP comes to the forefront.

Say you are running AIG’s financial services division. Your division is a party to thousands of complex trades. Most of those trades are in the red which has gotten your company into its present mess. But many of those trades are in the black and the counter-parties owe AIG lots of money. Who knows enough about the details of those trades to effectively collect? The very traders who also made the bad ones. Before you fire them, you need them to stick around to unravel the good deals and collect the money. You are not paying them for their past poor judgment and greed. You are paying them to make money for your shareholders going forward: PUP in its purest form.

No doubt about it. Past performance can be a good indicator of future performance. But there are enough instances when it is not the case that we need to remind ourselves that ultimately what we are really paying for is future performance.

Retrospective Leadership

Two of the most over-used terms in the business world these days are risk and leadership. Evidently, much of our economic problems are due to taking on too much of the former because of the lack of the latter.

It is certainly easy to find plenty of examples these days of poor leadership and over leverage. Just look at what those greedy fools at ________ (fill in the blank) did. Let us enjoy our brief moment of self-righteous satisfaction from pointing out the mistakes, greed, and inept leadership that is all around us. After we take that pleasant time-out, let us figure out what, if anything, we can do differently in our own businesses with respect to executive pay and risk management to avoid a similar fate. Unfortunately, it is a lot easier to point out poor judgment after the fact then to avoid it in the future.

I recently reviewed an employment agreement that allowed a CEO to be terminated “for cause” in the event that he made a decision detrimental to the Company’s financial well being without the board’s approval. The board was generous enough to allow the CEO complete flexibility to make all the good decisions he wanted without the board approval.

Similarly, at one company I used to work, leaders were encouraged to take “prudent risks”. Maybe this is a bit better formulation than the Employment Agreement but still, after watching a colleague get a dressing down for trying something that did not work out, you cannot help but puzzle over the meaning of Prudent.

Or, consider the TARP rules on executive pay. They require the Compensation Committees of companies taking TARP funds to certify that the compensation for senior executives does not encourage “unnecessary and excessive risks” that threaten the value of the financial institution. Further the rules require that executive compensation be aligned with creating long-term value. As I have commented previously, these are certainly good guidelines that Boards should be following whether TARP recipients or not. But no Board or management team that I have encountered has ever expressed a desire to create short-term value at the expense of long-term results or to take unnecessary and excessive risks.

While easy to poke fun at, who can argue with any of these? In all three cases management (or the Feds in the case of the TARP rules) are merely practicing good governance in trying to protect company assets against employees taking undue risks.

But let us face some perhaps uncomfortable facts about risk and pay. First, risk cannot be judged objectively. It is in the eye of the beholder. You can study the mathematics around standard deviations and VAR all you want but you cannot avoid the reality that one investor’s/executive’s idea of a reasonable risk is another’s imprudent and reckless adventure. Second, no amount of risk analysis can consider the unforeseen risk. Financial institutions like Freddie Mac, AIG and Lehman Brothers were highly leveraged in derivatives that ultimately were based on home prices and the ability of individuals to pay off their mortgage obligations. These derivatives seemed to be profitable in every situation except one: if the entire nation entered into a prolonged period of declining home prices and individual income.

And third, you cannot completely align the risk preferences of employees with the risk preferences of owners. Owners invest their savings. Employees invest their time and a portion of their compensation.

Business is all about balancing risk and rewards. Not only is there no government rule or reform that would have stopped or even ameliorated the current mess but there is nothing, except barring investment altogether, that will avoid the next systematic bankruptcy.

In one way executive compensation worked as it was supposed to. Most senior executives of large public companies receive 50%+ of their annual compensation in the form of equity grants that vest over a period of three years. While these individuals still received large base and bonus payments, the executives at the bankrupt or near bankrupt financial institutions have had their equity positions all but wiped out. They are not destitute but they are not laughing all the way to the bank either.

So what is to be done? A few suggestions:

Individual financial limits of authority need to be reviewed by Boards periodically along with stress testing of overall corporate investments.

Consider revisiting the mix of cash bonus and equity compensation to any individual in the organization who makes investment decisions. This would mean potentially granting larger equity stakes and smaller (or $0) cash bonuses to sales managers and traders as well as those members of the executive suite usually eligible for equity.

Consider stretching out vesting periods and/or stock holding periods from the more traditional three years to five or even 10 years depending on investment life-cycles. Perhaps the vesting period would vary by job.

To reduce the unfairness of the market, consider emphasizing relative stock performance when determining vesting thresholds and/or grant amounts.

Sales bonus/commission compensation should be tied to profitable cash flow rather than deal closings.

If Earnings are used to determine annual executive cash bonuses, adjust them by a measure of risk such as firm-wide leverage.

I have noticed that pick-up basketball games tend to be much cleaner and have fewer arguments when there is no referee. When a referee is added to the mix, players feel it is within their rights to push the rules to the limit as long as the referee does not call it.

All the risk management rules around compensation cannot substitute for management that is prudent and ethical. So my final bit of advice to Boards is to find the management team that does not need any of this sort of oversight.

The Small Business Owner Thinks Big on Equity Compensation

Early in my consulting career, I came to the realization that when a business leader uses the term “small business” as in, ‘I run a small business,’ it is purely a state of mind. And, when it comes to developing compensation approaches to drive growth, the generally poor economy is bringing out the most innovative and optimistic instincts of the small business leader.

I was reminded of my small business epiphany during a recent meeting with a CEO to consider a recommendation that would increase 2009 cash compensation by 3%. His reaction was “we can’t possibly afford that type of increase in this environment. We are just a small business after all”. This is not an exact quote as the CEO included some language that cannot be reprinted in a family business publication. But the point is that this CEO led a company with $250 million in revenue and 750 employees. And, like all “small business” owners this CEO was so close to how his organization makes and spends money that he felt like a small business owner with all the uncertainty, risk and tough trade-offs that implies.

I have commented previously on one characteristic of the small business owner. They can get stuck in a zero-sum way of thinking about compensation along the lines of ‘If I increase Joe Salesman’s commission by 5% that is 5% out of my pocket’ as opposed to the possibility that a well designed 5% increase in a commission might increase sales and net profit by 20%. No doubt about it, it is hard to resist the zero-sum thinking in a poor economy.

But the current economic environment has also brought out what I consider the best characteristics of the small business owner – the creativity and adaptability forced upon them by the perceived or real constraints they face. Many are reaching for any way they can to keep their key talent and poach on their slower moving competitors. They want to be prepared to come out swinging when the recovery comes.

While some small business owners remain reluctant to give up any share of ownership, many recognize that equity-type approaches to compensation are the best way to attract and keep talent during this economic environment when cash flow is at a premium.

This involves working through the pros and cons of a number of issues; and, as with many compensation issues, there is little in the way of best practice to turn to. Instead, every business has its own requirements, priorities and objectives.

For starters, what are the objectives of an equity program and what employees are being targeted? Am I trying to attract new talent, retain employees who might leave without a big pay increase or motivate employees to achieve particular goals? No one compensation program can ideally meet all three. A common mistake is trying to use one compensation program to achieve too many objectives or meet the objectives of too broad an employee base. The result is often an overly complex program or one that is not particularly transparent to the participant. An equity program that is overly complex or opaque is a waste of money.

Other considerations include:

• What percentage of ownership, profits, revenue, etc should be distributed?
• Should I use shares or options?
• How do I value the share price?
• Compliance with Federal and State Security laws and regulations (or preferably, identifying the appropriate exceptions).
• How do I divide up shares among the targeted employees?
• What kinds of restrictions or vesting should I put in place?
• What is the impact on a potential transaction?
• Should I add performance criteria to the equity grants?
• What is the cash Flow/accounting impact under various business scenarios?
• What is the time period for the grants?

The bang-for-the-buck of a well-crafted and communicated equity plan is tremendous. Designed correctly, it can replace the use of scare cash, send a positive message to employees and create a a compensation platform to grow on. Even a small business owner has to love this.

Surprise. The Government Has Some Good Advice on Executive Pay

Randomly pick a law, regulation or section of the tax code dealing with executive pay and chances are you could accurately describe it as superfluous, counterproductive, or inconsistent. My reaction when first hearing that the Troubled Asset Relief Program (“TARP”) would include executive compensation provisions was to wonder what kind of regulatory torture the government was going to inflict on the poor shareholders of financial institutions already sunk low. While there is a good deal of the aforementioned waste and counter-productivity in the TARP provisions, there is also some executive compensation wisdom that companies not partaking of TARP might consider.

As a recap, financial institutions seeking relief under one of several TARP programs implemented by The Emergency Economic Stabilization Act of 2008 (EESA) must enforce four broad rules around the pay of the chief executive officer, chief financial officer, plus the next three most highly compensated executive officers.

The rules along with commentary are as follows.

1. Companies agree not to deduct executive compensation in excess of $500,000 for each senior executive. This limit does not include the exception for performance-based compensation that is part of the existing executive compensation provision of the tax code limiting deductability to $1.0 million. It does not matter whether the deduction limit is a million or half a million. This rule will no doubt raise some needed tax revenue but otherwise it only serves to limit the flexibility and increase the costs for financial institutions trying to attract and retain the executive talent they need to get them out of their self-created mess. Conclusion: Counterproductive
2. A prohibition against making any golden parachute payment to a senior executive. This provision is more restrictive than the existing IRC Section 280(g) rules on golden parachutes that merely increase the cost of golden parachutes by disallowing deductions and imposing excise taxes. The TARP rules prohibit payments in excess of three times pay and define a parachute payment as due to any separation
   of service - not just those due to a change-in-control. The rule is not bad but somewhat superfluous as most companies do not pay out severance benefits in excess of three times compensation. Conclusion: Feels Good but Superfluous.
3. Executive pay programs must include “claw back” provisions requiring the repayment of any incentive compensation based on metrics that are later proven to be materially inaccurate. This rule sounds good on paper but requiring executives to pay back gains made on inaccurate metrics is impossible to consistently enforce outside of the obvious cases of financial restatements. For example, this provision would not have required a payback of the compensation gains made on the sale of mortgage-backed securities that turned out to perform more poorly than anticipated. Conclusion: Okay, but impossible to enforce
4. Ensure that incentive compensation for senior executives does not encourage unnecessary and excessive risks that threaten the value of the financial institution. This rule includes all sorts of procedures, timetables and CEO and Compensation Committee certifications to try and make it meaningful. It is, however, unenforceable as a practical matter. Risk is purely subjective and at the heart of business investment. A risky investment that turns out well was a “bold” decision and one that turns out poorly was "excessive and unnecessary". But just because the government rule is unenforceable as a matter of policy does not mean that it is not a good idea for compensation committees and Boards to formally review how executive compensation arrangements incent behaviors that may not be aligned with shareholder preferences and risk profiles. For example, I have written on several occasions around how excessive option grants can lead to a misalignment of shareholder interests and management interests. Conclusion: Good Corporate Governance but not an enforceable law.

The misalignment of rewards to risk, particularly in the financial services industry, has been disheartening as many executives who made what turned out to be very poor investment decisions reaped large paydays prior to losing their jobs. Taxpayers have demanded some reassurance that this will not happen again with their TARP investment and Congress has complied about as best as possible. Unfortunately, even the best managed companies cannot create a compensation program (for executives or otherwise) that will be deemed to be perfectly fair and accountable in hindsight. Business is just too messy. While perfection is impossible, improvement is very possible and Owners, Boards and Compensation Committees should take the TARP rules as a reminder to fully test compensation programs against incentives and risks.

Top People Management Stories of 2008

The following are our choices for the top five human resource-related stories for 2008 based on their long-term resonance.

College graduates know fear for the first time in 25 years. The end of “Wall Street” combined with what looks to be the longest and deepest recession since the early 1980s will cause a reshuffling of convenient generational descriptors. Recent college and MBA graduates (is it generation x, y or z?) here-to-now best know for impatience with corporate hierarchy, “portfolio careers” and placing a premium on work-life balance will begin to appreciate just having a job. This group will become the most productive and focused cohort of graduates in 25 years.

Unions have a dead cat bounce
On the face of it, 2008 would seem to be a great year for Unions. The election of Barack Obama and Democratic majorities in the House and Senate brought the passage of the Employee Free Choice Act closer to reality and the economic uncertainty has created a more union-supportive atmosphere.

Consider the success of the sit-in by laid-off workers at the closed Republic Windows and Doors plant in Chicago. A year ago, the protest would probably have been ignored, even in Chicago. But in 2008, the protest for severance pay gained national press and support. Ultimately it ended in the protesters favor when several banks that had done business with Republic agreed to provide “loans” to Republic (which will never be repaid) to pay some of the severance.

A number of signs, however, show no let-up in the general anti-Union trend in the US. The public was so resistant to a bail-out of the UAW that the Democratic controlled congress could not enact any legislation in that regard. Even the Obama administration has publicly stated that it will not favor a bail-out without significant concessions from the UAW. The Screen Actors guild could not maintain any semblance of solidarity in its negotiations with the Producers and has punted on a strike due to lack of Union support.

The NFL players union reminded the public why they are distrustful of the motives of the modern Union. It filed a grievance challenging the suspension and fine the Giants levied against receiver Plaxico Burress after he accidentally shot himself in a nightclub on Nov. 29.

While all the union bodies have not been buried, the graves have been dug. 2008 further demonstrates that a global economy combined with bipartisan support for free trade leaves little oxygen to sustain traditional unions.

401(k) plans take the place of defined benefit plans as a regulatory punching bag. Since the passage of ERISA in 1975, defined benefit plans have been the beneficiary of annual visits by legal and accounting regulatory authorities (e.g., TRA ’86, TEFRA, REA, FAS 158) making them too expensive, too risky and too unattractive to higher paid employees compared to defined contribution 401(k)-type plans. Not coincidentally, over this same period defined contribution plans have supplanted defined benefit plans as corporate America’s predominant retirement savings vehicle.

In 2008 Congress and the Courts began to catch up with the trend. The Department of Labor published proposed regulations defining the kinds of investment advice that can be provided to individuals with defined contribution accounts and significantly enhanced the disclosures that Companies must make to plan participants around plan investment and administrative fees. Congress has several bills in various stages of Enactment requiring even more disclosures than Labor’s regulations. The Supreme Court, in its “LaRue” decision allowed individuals to bring suit against 401(k) plans to recover losses when their investment instructions are ignored or the account is otherwise mishandled. Prior to this decision courts generally held that only suits on behalf of the Plan for plan losses could be brought.

With the increasing importance of 401(k)s, Congress and the Courts will continue to tighten the regulations and make it easier for individuals to bring suit. If 401(k)s were a stock, now might be the time to sell it short.

The era of big CEO pay comes to an end.
This is of course a relative statement. The ability to effectively lead a large public company is a rare skill that will, and should, continue to get richly rewarded. But, 2008 was a tipping point bringing to an end an era of CEO dominance in setting CEO compensation.

2008 brought no major government legislation or SEC rule making around executive compensation beyond restrictions for the relatively few companies participating in the TARP. Instead, a more powerful force was at work. It became impossible for anyone to ignore the leadership failures throughout Corporate America that went together with large paydays. It was just too obvious that General Motors, Bear Sterns, Lehman Brothers, et al., were mismanaged for a number of years while CEOs were given star ratings and big bonuses.

As in the past, Boards will remain at a disadvantage compared to CEOs in negotiating pay. CEOs and their executive teams have the advantage in information, incentives and leverage. But what will change is what will be considered an acceptable range and approach to compensation. CEOs will moderate their pay demands and recommend less compensation in the form of pure equity or options. They will ask for more compensation with objective performance thresholds, greater use of claw backs and more truly stretch performance goals.

The stars align for major health care reform
2008 was also a tipping point for health care. The year saw the election of a president who put major health care reform at the top of his agenda and big Democratic majorities in both houses of Congress.

The last time this happened was in 1992 and health care reform cratered barely two years later. Unlike in 1994, however, reform will not flounder on middle class fears of change, insurance company lobbying and the public’s general distrust of government intervention in the private sector. The middle class no longer believes that the health care system, while flawed, at least provides pretty good health care for them. The costs and managed-care bureaucracy have started to hit even those with the best corporate plan and Government intervention in a major part of the economy does not seem as radical as it did in 1994.

Expect to see major health care reform enacted in 2010.

Rethinking the Annual Bonus

The boardroom battle over John Thain's 2008 bonus as CEO for Merrill Lynch is over. It will not be as lucrative as years past for the Thain family; the Board has awarded Mr. Thain and other top executives zero. The board deliberations over Thain's bonus are an unusually public manifestation of discussions held all over Corporate America this time of year over who gets how much?

These discussion are always heated and stressful for the organization. Teasing out the contribution individuals make to results is often impossible as many goals are team-based, depend on contributions made over a period different than the bonus year or depend on factors exogenous to the individual (e.g., market forces). Allocating bonuses has a further, emotional, complication because most individuals work hard and make every effort to contribute to their organization's success.

The annual bonus exercise does not need to be like this. What follows is a broad bonus "philosophy" that simplifies the process, removes much of the organizational angst and separates the pay discussion from the performance and coaching discussions.

Start with the notion that from an owner's perspective, it would be ideal if everybody's pay was 100% variable based on the organization's profitability. That is clearly not common practice as everyone needs some measure of predictability in compensation. Further, as you reach lower into the organization, the administrative costs of managing a bonus outweigh the financial and incentive benefits.

So begin with mid- to high-level jobs in the organization where you would put at least 10% to 20% of compensation at risk. Divide the target bonus into two categories. Base one portion of the target bonus on goals that meet three criteria:

the results of the goals are measurable;
the results are likely to vary from year-to-year;
the impact of the individual on results is measurable.

Call this the "Incentive Bonus". Call the remaining portion of the target bonus an "Allocated Bonus".

For some jobs, like a sales job, the Incentive Bonus will be all or a very significant element of the total bonus. For other jobs, such as those at the senior level or many staff jobs it is difficult to come up with goals that meet the Incentive Bonus criteria.

By definition, the Incentive Bonus is easy to define upfront and explain to an employee when paid out.

For all goals that do not meet the definition of Incentive Bonus - the Allocated Bonus - pay out the bonus based on an an allocated share of corporate-wide, division or team results depending on the employee's job level.

While the allocation methodology could be based on broad definitions of individual performance it should primarily be allocated based merely on job level. After all, if the individual contribution could be accurately measured, it would probably fall into the Incentive Bonus category.

Their are several benefits to this approach:

employees know upfront what their bonus will be based on;
the process is more mechanical and less emotionally loaded;
a significant portion of senior-level compensation remains variable;
there is a greater separation between ongoing performance or effort and annual results.

So how would this apply to the Thain bonus? It would clearly fall in the category of being an Allocated Bonus. It is impossible to quantifiably separate his individual performance in the areas of leadership, decision making, ability to motivate a team from from market factors when it comes to how well Merrill Lynch does. If the board directed upfront that his bonus was to be based on results such as EPS, profit or ROA, he would be entitled to zero bonus. Not based on his performance, hard work, dedication, etc but merely based on results.

Resurrecting Cash in Executive Pay?

The concept of paying cash to executives at retirement has fallen out-of-favor over the past 20 years, along with its broad-based counterpart - the defined benefit pension plan. But, this is an approach worth revisiting for companies concerned about retaining key talent and with the potential misalignment of financial incentives created by large equity grants.

Equity is a very popular form of executive compensation. Shareholder optics are great as executives do not make money unless the shareholders make money. Executives like equity because it offers the opportunity for a large paycheck if the business results are strong and/or the stock market broadly appreciates. Beyond the optics, however, equity compensation has significant hidden drawbacks for non-executive shareholders.

Large equity grants can create a misalignment of financial incentives between executives and non-executive shareholders. While executives have the opportunity to reap large rewards for making high risk/high reward bets but without the symmetrical risk of loss, non-executive shareholders have a different risk profile; they risk their entire investment on the same investments that executives find so tempting. See Lehman, Bear Sterns, AIG, et al for illustrations of this hazard.

Equity compensation is also an ineffective way to retain executives. When stock prices are falling, executives begin to attach little value to their equity grants and become more vulnerable to competitor entreaties. A competitor can easily make up for underwater options or otherwise provide large equity grants to compensate for a low stock price. An executive's current employer is trapped. They cannot revalue stock options or grant additional shares without appearing to contradict the original rationale of the pay-for-performance equity pay.

There is an approach that addresses these two issues. Replace a portion of equity compensation with a cash payment that increases in value based on service rather than performance. This approach provides a retention incentive even in a down stock market and reduces the misalignment of executive and shareholder risk profiles.

While the optics may be poor, the business rationale is strong under the right circumstances. The idea is not to motivate performance but to provide clear value to the executive for staying with the company through up and down markets and business cycles. Other incentive tools - short-term cash bonuses and variations of equity compensation can be used for employee motivation and business alignment.

There are tax, ERISA and security law issues to consider with a cash retention program but they allow for a great deal of flexibility in designing an approach around particular business and executive situations. As an example, a CEO who is 50 years old with a base salary of $750k might be provided with a benefit that is equal to four times this amount ($3.0 million)at termination of employment. The full payment is only made if the executive works until at least 60. Reduced payments might be added if the executive is terminated without cause prior to age 60 with increases for employment after age 60. The payment is made over five years subject to compliance with a non-compete agreement.

This approach would cost about $225,000 a year pre-tax for the 10 years following hire. The $225,000 could either replace an equal amount of equity which would typically leave plenty of compensation for incentive purposes or the $225,000 might be an add-on in exchange for the non-compete.

From the executive's perspective, they see a large payout waiting for them if they work until age 60 regardless of stock price or annual bonus. This incentive to stay with the current employer increases as the executive approaches age 60 and makes them less vulnerable to competing offers in a down stock market or in the event of poor short-term business results.

The retention incentive could be self-funded which allows the company to invest the deferred compensation in its business until the $3.0 million is due or it could purchase a tax-advantaged annuity to provide additional security.

Companies have a great deal invested in hiring and keeping key talent. A cash-based approach should be considered as a piece of an executive compensation program.