MarksonHRC Perspectives

What Do Private Companies Need to Know About Equity Compensation?

2011-01-18T13:44:00.002-05:00

When non-public client companies come to us for help in developing employee equity plans, it’s typically for one of two reasons: (1) Rapid growth has a young company’s owner(s) now concerned about maintaining morale and motivating key employees, who have started to wonder about the company’s end-game and want to share in its success, or (2) the owner of an established company is seeking a creative way to retain key executives over the long term, with a minimal outlay of cash up front. In both cases, equity compensation seems like a good possible solution, but the first question we’re asked is whether or not a private company can make that solution work without a public market for its shares.

The answer is yes. In fact, designing and implementing such a plan is not as complicated as one might think. And far from being available to only public companies, equity compensation is a retention and motivational tool that can be used by S-Corps or C-Corps and even by partnerships and sole proprietorships.

After learning that equity compensation is a viable option, most clients then want answers to the following key questions:

Do we need to register an equity offering with the SEC or State? Generally, no. Under "Rule 701" of the Securities Act of 1933, securities used for employee compensation purposes are broadly exempted from registration requirements at the federal level, and most states (including Georgia) have conforming exemptions. Large offerings—such as transfers of more than 15% ownership in a single year, which most private companies will not exceed—are not exempt. And offerings of more than $5 million will require disclosure of company finances and risks.

Should we use actual common stock or phantom (notional) shares? Employees can be granted the same financial benefits of ownership through either issuance of common stock or a share in the equity value and dividends. Real shares must be used when designing a plan that avoids some of the tax complexities of being a "deferred compensation plan" under IRC Section 409A (see below). And some employees may simply consider real shares more attractive. Ownership of real shares, however, gives them voting rights and, depending on the state of incorporation, may also include minority shareholder rights to attend annual meetings, review financial statements, and sell shares to any buyer under the same terms as those of majority holders.

Note: Partnerships and sole proprietorships have no common stock but can still share "equity" with non-partners using notional shares.

How do we value the shares (whether real or notional)? Shares can be valued using any reasonable and consistent method: for example, periodic assessments of market value, net-book-value appreciation, or via a formula. To avoid some of the complexities of having what is defined as a "deferred compensation" plan under IRC Section 409A, the use of a market-value approach is generally advisable, although not a requirement.

Do we have liquidity obligations?Because private companies have no external liquid market for their shares, they have to make sure they will have the cash on hand to repurchase any equity compensation awards. This can be accomplished by restricting the timing of liquidation, forecasting and modeling various distribution scenarios, and/or, most commonly, by ensuring a strong correlation between share value and the cash available in the business.

What are the tax issues associated with an equity grant? IRC Sections 83 and 409A are the key sections dealing with the taxation of most equity offerings. Generally, employees can be taxed (and employers become eligible for deductions) when their right to property or cash is no longer subject to a significant risk of forfeiture. The determination of when this occurs varies, depending on (a) whether the award settlement is in the form of cash or real equity, (b) when an employee is vested, and (c) whether or not the equity plan is defined as a "deferred compensation" plan under 409A. For example, employees who exercise options granted by a stock-option plan that is not defined as "deferred compensation" will be subject to taxation at exercise, assuming they have vested rights to option gains at the exercise date.

How many shares should we give out? Reasonably well-established private companies most often give out +-10% of their equity value. But we have seen numbers ranging from 5% to 25%, depending on the owner's comfort with giving away ownership as compensation and, most importantly, on the value employees place on share ownership. An owner may think he has the greatest company in the world and a solid balance sheet, but unless his employees believe strongly in him and in the company’s future prospects, offering them equity—whatever the percentage—is not going to accomplish much in terms of engagement or retention.

Can I require employees to forfeit their shares if they leave the company before a specified retirement age? Yes. But consider this: The purpose of giving out equity is to encourage retention and motivate performance. If employees understand that shares given can just as readily be taken away at owner discretion—by firing or forcing the employee to resign, for example—those shares will hold no real value for them. A better solution is to require some years of service, or even company performance level, to become "vested" in the share value.
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Granting equity to employees is the most effective way to motivate them, retain them over the long term, and align their pay with company performance. While equity grants such as stock options, performance shares, and restricted shares are most often used by public companies, there is no reason why they cannot be used just as effectively by private companies.

Six Shortcuts to Guide Your "Say-on-Pay" Vote

2011-01-18T13:29:00.003-05:00

As proxies start to trickle in from companies in which I own shares, my perspective shifts from that of a disinterested advisor on executive-pay practices to one of a thrifty owner reviewing the pay and performance of my senior staff. This year, thanks to the say-on-pay provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), I can now do more than merely sound off on those pay practices. I can vote on them.

Among the provisions of the Dodd-Frank Act is its Section 951 requirement (adding Section 14A to the Securities Exchange Act of 1934) for a non-binding shareholders’ vote to approve the compensation of a company’s named executive officers—as described in the company’s Compensation Discussion and Analysis (CD&A) and related compensation tables—at least every three years. In addition, Dodd-Frank calls for a separate, non-binding shareholder vote, the results of which would influence how frequently in the future a company holds a say-on-pay vote: annually, or every two or three years.

Given my profession, it may surprise some to learn that in preparation for casting my proxy votes I have no intention of poring over the details of each company’s CD&A and pay tables. First of all, as an outside shareholder, I give the board and management the benefit of the doubt when it comes to pay. Their understanding of what the business needs and how their industry operates far exceeds any armchair analysis I might perform during the standard course of my occasionally checking out the stock price or skimming an annual report.

So what information do I consider for guidance in casting my proxy say-on-pay vote? To get a sense of each executive-pay program’s fundamental design and how well it’s being managed, I will look for any of six company practices, described below, that I consider red flags. If I find three or more, I will vote no. Otherwise I will probably support the proposed compensation plan.

Companies might find this six-point checklist helpful as they develop shareholder communications around executive compensation, and I offer it also as a time- and money-saving alternative to individuals and institutions who want to vote responsibly on pay without having to analyze CD&A details or purchase expensive ISS advisory reports.

Red-flag Pay-related Practices

1. Convoluted Writing. If a company cannot provide a clear written explanation of its pay practices, levels of compensation, bonuses, pay raises and long-term grants, those practices probably (or at best) make no sense. I am not suggesting that complex plans are bad plans. A company’s business goals and human-resource requirements might appropriately lead to a plan with a number of layers, triggers, offsets, etc. But whether complex or simple, all aspects of a company’s compensation plan should be based on logic that can be readily explained and implemented. Be wary of any proxy that provides nothing more than vague, "pay-for-performance" boilerplate terminology or, alternatively, one with complicated jargon and charts instead of straightforward explanations.

2. Perquisites and Special Benefits. Perquisites, even personal use of an airplane, represent relatively small dollars when compared to cash and equity compensation. And since the attraction they hold for some executives is disproportionate to their cost, special benefits can even have a “bigger-bang-for-your-buck” justification. Nonetheless, in my mind perquisites are like the canary in the coal mine. Given the strong trend away from perquisites in executive pay practices, the presence of a particularly broad or rich perquisite package suggests to me a management team that might not have its priorities in order or is tone deaf to changes in external tunes. I suspect the leadership qualities of an executive who insists upon using the company jet for personal travel rather than buying a first-class ticket—or, for that matter, paying for a home security system or an enhanced medical plan—with his own sizable paycheck.

3. No Off-target Years. Patterns of awarding bonuses for performance that is infrequently or never below "target" and/or customary approvals by the board of discretionary gross-ups are warnings of poor pay practices such as setting goals too conservatively and weak board oversight.

4. The “Better-than-Average” Strategy. Bonuses and equity programs targeted at the competitive median or 50th percentile already have the flexibility to pay larger than median payouts as long as performance and/or results are also above the median. But pay programs targeted above the 50th percentile, usually justified as “needed to attract the best” or "we are better than the median", effectively confer above-average pay for average or less-than-average performance. That’s not a policy to support.

5. Evergreen Employment Agreements. Although employment agreements are often required to hire new senior executives, guaranteeing employment to a long-term executive has little or no business rationale. On the contrary, the endorsement of any such agreement can indicate a board that is either inattentive or unwilling to stand up to management—a bad sign no matter which is the case.

6. Frequent Base-pay Increases. Once a senior executive's base pay has reached a competitive level, the only circumstances under which I might expect to see significant increases would be the infrequent—and clearly explained—occurrences of a change in the competitive structure of the industry, an expansion of the scope of his/her job, or demonstration of a manifest leap in the skills that individual brings to the company. Rather than base-pay increases, raises at the senior level should be awarded primarily in the form of bonuses and/or equity.

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The question begged by the say-on-pay vote—and one that vote cannot fully address—is how competent the board and management are to fulfill their responsibilities with respect to an issue as important as compensation. If my proxy analysis were to uncover pay practices that I believed warranted a negative vote, I would probably choose also to vote against incumbent board members. Or, better yet, sell my shares and reinvest in a better-run company.

Dodd-Frank Wall Street Reform & Executive Compensation

2010-07-31T21:47:00.022-04:00

According to its introduction, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”) signed into law by the President recently was created with the following intent:

to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end `too big to fail', to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.

The ambitious sweep of this “war-to-end-all-wars” sort of statement is not uncommon in major pieces of legislation. But based on historical precedent, we can be confident the Act will produce any number of unintended consequences and, although less likely, be pleasantly surprised if it succeeds in accomplishing even one of its stated objectives.

Presumably, the “other purposes” are executive compensation and governance provisions, which are referenced in only nine of the Act’s 200+ sections. Of those nine, two contain provisions that may in fact have a positive effect, whereas most of the remainder merely elaborate on requirements that already exist or have been superseded by trends and practices.

What follow are summaries and effective dates of the Act’s major executive pay and governance provisions with our italicized comments. If no date is indicated, the provision is effective upon publication of SEC rules.

Say-on-Pay. The highest-profile provision of the Act requires companies to give shareholders a non-binding vote at least every three years to “approve the compensation of executives” and every six years to approve whether compensation is approved every one, two or three years. Companies must also offer to shareholders a non-binding vote on any extra executive compensation related to a transaction: so-called golden parachute arrangements. The say-on-pay votes must take place beginning with annual shareholder meetings held on or after January 21, 2011.

This provision, along with the enhanced disclosure requirements around the relationship between executive pay and corporate performance (see below), may have the salutary effect of encouraging companies and their boards to think through more comprehensively than is often the case the relationship between pay and individual performance and between pay and corporate results. It may also encourage companies to put a higher priority on clearly explaining compensation policies to shareholders and to their executive teams(!). I mention the executive team because, while intentions are usually sound, executive pay programs are often so complex that the intended recipients—never mind shareholders—barely understand them.

Compensation Clawbacks. Included in the Act is a requirement that executives return to the company any paid compensation based on company results that are subsequently found to be erroneously reported.

Sarbanes-Oxley already requires clawbacks (albeit more limited than those contemplated by the Act).

Executive Pay at Financial Institutions. The Act requires enhanced regulatory reporting of executive pay policies at financial institutions. Effective after rules are published by 4/21/2011.

Financial institutions that accepted TARP money already have a special and somewhat restrictive compensation reporting and limitations regime.

Compensation Committee Independence. Members of Compensation Committees must all be independent and must consider a number of specified factors to determine the independence of potential legal and consulting advisers before choosing them. Effective July 21, 2011.

Existing exchange listing regulations and IRC requirements on the tax deductibility of executive pay in excess of $1 million (IRC Section 162(m)) have already led most Compensation Committees to be composed entirely of independent members.

Existing SEC rules already require disclosure of any significant compensation consultant relationship with management.

Pay-for-Performance. Enhanced disclosure is required of pay-for-performance policies, and companies must also disclose the ratio of the CEO’s pay over the median pay for all other employees.

While companies are already required to disclose the relationship between performance and pay in their proxies, the implications of this provision, which requires SEC rules to be effective, are for more structure—perhaps analytical in nature—around the communication to shareholders of the pay-for-performance relationship. Leaving aside what many will perceive as an unnecessary mandate, this provision, like the Say-on-Pay provision noted above, will have the beneficial result of encouraging companies to tighten up their thinking on how pay programs relate to company profitability and ultimately shareholder returns.

As for requiring disclosure of the relationship between CEO pay and the median corporate compensation, similar ratios have been used by executive-pay critics to demonstrate the excessiveness of CEO compensation, especially when comparing the U.S. to other developed countries. The impact of disclosing this ratio remains to be seen, but other than making it easier for these critics to gather data come proxy season, we anticipate it to be minimal.

Corporate Governance. Companies must disclose their reasoning as to why the CEO and Board Chair are, or are not, the same person and provide shareholders with proxy access to make Board nominations.

SEC guidelines on proxy disclosure already require discussion around the issue of whether or not the CEO and Board Chair roles are combined and what qualification criteria are used to select Board members. This provision simply further encourages companies to be more definitive in their explanation of why the proposed Board slate is best for the Company.

Enough with the Teamwork!

2010-05-26T09:36:00.011-04:00

The axiom, although unproven, that teamwork is what drives business success has become the widespread premise for many corporate directives. Business leaders exhort their employees to exhibit more of it. Companies task self-directed teams with their important business initiatives. And new-product development is based on the concepts generated by brainstorming teams. To support all these team-based efforts, a popular incentive practice is to evenly—or mostly evenly—distribute a common incentive pool among "team" members. Attempts to build more team-based compensation incentives have begun to appear for even that so-called bastion of pure individual capitalism: the direct sales force.

Because of its conventionally accepted value, teamwork—like such other workplace principles as diversity, employee engagement, and an ownership culture—is so strongly ingrained in business language that it rarely invites critical scrutiny. But before putting together a team-based compensation program, it’s important to explore precisely how and when teams create value. In our experience, compensation programs too often err in spreading the wealth evenly, whether it be raises or bonuses. While the stated rationale behind the design of these programs is usually the belief that teamwork drives results, or that the organization wants to encourage collegiality, the real reasons are often emotional and sometimes administrative.

In a recently published paper entitled "Idea Generation and the Quality of the Best Idea", Wharton professors Christian Terwiesch and Karl Ulrich argue that not only are individual contributions a more effective way to develop new products and innovative processes than through teams, but that group dynamics actually stifle creativity. In gathering evidence for this claim, they studied the ideas developed by two common “brainstorming” approaches: 1) a group working together as a team to develop ideas and 2) a scenario in which individuals work first alone and then together. What Terwiesch and Ulrich found was that groups employing the latter approach are able to generate more and better ideas, and can better discern their best ideas compared to teams that rely purely on group work. Their evidence also demonstrated as counterproductive the frequently recommended brainstorming technique of building on each other’s ideas; teams using this method neither create more ideas, nor are the ideas built on previous ones any better.

Is it possible that in the effort to encourage teamwork by designing compensation programs that spread the wealth we actually undermine the power of individual creativity, energy and initiative? Certainly, some practical issues favor a spread-the-wealth approach. Isolating individual performance, particularly if the evaluation is based on subjective criteria, costs more in terms of management time, increases legal risks, and is emotionally difficult for both giver and receiver of the evaluation. Furthermore, a strong current in corporate culture and social trends also seems to be encouraging a mentality of the collective over the individual. Who wants to vote against teamwork?

Before throwing out team-based incentives like so much bathwater, though, I think it’s important to preserve recognition of the baby in that bathwater: that in a complex business world it takes a team of individuals working in a coordinated fashion to accomplish almost anything of value. But scratch a team deep enough and you will find that it's individuals, not teams, who actually do work and create value. Certainly, team meetings are helpful in socializing and—notwithstanding the Wharton Study findings—even developing new ideas, and team skills are needed to create complex products and processes. But individual team leaders ensure that priorities are set and that individual contributions are brought to bear in a coordinated and effective manner. And, individuals must still contribute their own spark to team-based goals. In our experience, businesses err less on team-based incentive compensation as a concept than on spreading it too evenly in the interests of teamwork.

If you strongly believe in team-based compensation for a certain job or group of jobs, ask yourself exactly what you expect the team, working as a team, to do to create value and why you want to pay everyone the same. What you will probably find is that what you call teamwork is really a number of individuals successfully performing a task in a coordinated way. Then stop to consider whether you like team-based compensation because it is easier for the administrative, legal and emotional reasons cited above or whether you really believe you cannot sort out individual contributions from what the team is doing as a whole.

Ironically, when rewarding team performance, you are much more likely to create non-collegial behavior as, invariably, individuals who contribute more to the team feel they have been underpaid. We have found that, despite the difficulty and expense, rewarding individual performance results in more collegiality and greater productivity than sharing rewards.

So how does a business leader effectively balance the incentives for individual creativity, initiative and energy with ensuring that individuals contribute those same things to help other members of the team? Or the transparency and individual accountability that comes from individually-based incentive plans with the administrative ease of equally sharing team-based results?

Some general guidelines for incentive design that may be helpful.

First, unless you are using annual bonuses to manage your fixed costs, cut down on the number of jobs eligible for any type of incentive pay to only those that fit into one of the following categories:

The job has shifting priorities from year-to-year that need to be emphasized through the bonus plan.
The job requires the incumbent to set priorities and goals for subordinates.
The incumbent has significant discretion as to how his or her job is performed.

Second, when incentive compensation is paid, emphasize and isolate individual contributions to the extent possible, even if you evaluate individual contribution as a contribution to a team effort.

If the individual contribution can be identified numerically, base the reward on numerical contribution.
If the individual contribution can be identified subjectively, base the reward on a subjective evaluation but clearly enumerate the subjective factors.
If an individual is part of a team that is tasked with producing results, identify a team leader whose role is to divide up the incentive payments based on identified numerical or subjective factors.

Overall, identify jobs that should be rewarded with incentives, explore your assumptions about teamwork, isolate individual contribution whenever possible, and watch the positive change in employee performance.

Competitive Equity Compensation: The New Rules Will not Help

2009-12-21T16:30:00.007-05:00

The SEC recently finalized new disclosure rules affecting a number of governance and executive pay issues as of February 2010. Among other requirements, the new rules attempt to provide more meaningful disclosure about equity awards granted to Named Executive Officers by requiring the value of equity awards at the date of grant to be included in the Summary Compensation Table; currently, the Summary Compensation Table shows the accounting expense under FAS 123(R).

With a sense of resignation we can, with some certainty, make three predictions about the new requirements. They will (1) require modest incremental administrative work on the part of companies and their advisors; (2) do nothing to reduce the controversy among shareholders, institutional investors and shareholder watchdog groups on the size of executive compensation; and (3) lead to requests for expanded and/or different disclosure around executive pay starting almost immediately.

In addition to being observers of the evolution of the corporate proxy statement, we can safely make these predictions because developing appropriate and competitive equity compensation is inherently problematic for at least two reasons and those reasons will not be fixed by different or additional disclosure. Identifying competitive equity compensation requires the consideration of a variety of competitive groups, valuation methodologies and time periods.

The true value of an equity grant is uncertain and is apparent only when and if it is converted to cash. The calculation of a present or current value must, by necessity, be based on a number of assumptions as to future stock price movements, timing of any option exercise and prevailing interest rates. Companies often place restrictions on the conversion of stock to cash, such as continued employment for a period of years or the achievement of company performance goals. This requires additional assumptions as to future length of employment and company performance. For private companies, the calculation is further muddied by the lack of a transparent, liquid market for the equity.

Competitive data is often skewed by the irregularity of the timing and size of equity grants. Some companies grant large amounts of equity periodically and other grant smaller amounts each year. There is typically no delineation of what a "target" award is, as is the case with annual bonuses. Equity awards often vary significantly from year to year without regard to individual or company performance based on the prevailing stock price, value of prior grants, and shareholder dilution concerns.

Because of the problems with arriving at competitive benchmarks for equity compensation, boards are often presented with conflicting and ever changing data around the appropriate average grant to offer.

Consider as examples, three widely used measures of equity compensation: 1) Present Value at Grant, 2) FAS 123(R) expense value and 3) percentage of ownership. To get a sense of how these measures look in practice, we analyzed 15 Fortune 500 companies with approximately the same revenue ($4.5 billion).

The following chart shows the median equity compensation for the CEO using Grant and Expense Value and percentage of shares transferred (after converting options to full-share equivalents).

                         Value at         FAS 123(R)    Ownership
                         Grant ($k)     Value ($k)      Transferred

Current Year            2,671          3,082               0.11%

Year – 1                   5,849          2,415               0.10%

Year – 2                   2,544          1,268               0.70%

Notice that none of the measures provide any sense of consistency. A board looking at these numbers will have a hard time trying to make sense of what the appropriate “target” annual award for their CEO should be. The percentage of ownership transferred appears to show the least volatility but, in fact, the median value hides a lot of variation as companies with smaller market capitalizations are transferring a greater percentage than companies with larger capitalizations. That is, the trend is to deliver a somewhat competitive annual pay rather than a share of ownership.

All three values have their strengths and weaknesses. The grant value is a good indicator of current practice but does not reflect that companies often vary their grants significantly from year to year or make one large grant with a vesting requirement and no grants for several years thereafter. The accounting value is a smoothed value of prior grant practices but does not necessarily reflect current practice. Ownership transferred is independent of stock price and provides a good measure of the cost to shareholders of executive pay in terms of dilution but provides no indication of the value received by an executive.

So, where does that leave us? First, accounting expense will no longer be reported. We felt it was a good measure of target equity grants when the competitive community was 10 or fewer, as it already smoothed over the volatility in historic grant practices. For private companies or smaller-cap public companies, we find the percentage of ownership transferred to be a particularly important and meaningful measure of executive pay as there is either no liquid and transparent share value and/or the share value is subject to wide fluctuations. Also, these companies are the most likely to grant awards at non-periodic intervals. For other companies a three-year average of Value at Grant provides a reasonably consistent and robust target equity award.

Because of the vagaries of grant practices and valuation methodologies inherent with equity compensation, boards and shareholders will never have a straightforward and always-consistent method for determining a competitive pay value - no matter what the SEC requires as disclosure.

Improving Your Bonus Program

2009-12-14T23:15:00.010-05:00

Fourth quarter is when two of the more stressful, emotion-laden annual activities in white-collar America occur: bonus allocations for the year ending and goal-setting for the upcoming one. In most companies, the bonus program is so complex and opaque that employees do not know what they will have been working for in 2009 until they receive their bonus checks from deus ex machina.

Occurring usually at the same time, the process of setting bonus goals for 2010 is the annual kabuki show wherein shareholders and senior executives push an aspirational view of performance against the employee’s “poor me” world view.

If you recognize your company in the above scenario, it's probably too late to do much about 2009, but you might consider the following suggestions to help improve your bonus plan process for 2010.

1. Clarify what the bonus program is intended to do, communicate it to employees and shareholders, and stick to it. Sounds obvious and simple, but the problem with bonus programs is the frequent disparity between what they are designed to reward and what they need to reward. Compensation committees and management make up for the disconnect with special deals and black-box calculations. This is what causes shareholders to complain about bonuses for non-performance and employees to become overly stressed and cynical come bonus time. Not even the best bonus plans eliminate this problem altogether, but they do minimize it.

Take for example, the common bonus plan that pays on broad-based financial measures such as EBITDA, revenue or EPS. A nice simple approach that funds itself and keeps shareholders happy as bonuses are highly correlated with financial performance. In years with poor financial results, however, boards scramble to justify off-formula bonuses to the high-performing executives they need to keep motivated and on board. In fact, some of the strongest performances turned in by executive teams is during periods of great financial turmoil and distress.

Or consider a bonus plan that is based on the achievement of objectives more readily identifiable with individual effort such as implementing a new plant safety program, hiring a new CFO with SOX experience, or rolling out a new product. In good years or bad, it is hard to argue with this type of plan, which can pay out strongly in a bad year and poorly in a good year, all depending on individual performance. Such plans have the advantage of allowing boards to incent desired behaviors, focus the executive team on changing priorities, and reward outstanding performance (as opposed to results). Among the downsides are shareholder optics when strong bonuses are paid during financial downturns and the risk that the incented performance is not actually driving shareholder results. Boards often compensate for this by applying black-box adjustments to take into account the company’s financial results. But again cynicism and confusion can result.

Alternatively, companies that try to combine the results and performance approaches meet with equally disruptive results. It has been our observation that companies that use a bonus plan that pays out 50% based on individual objectives and 50% based on financial results, for example, wind up creating the problems inherent in both approaches.

A strategy that we have seen work is to create a bonus pool based purely on financial results – sometimes a rolling average of financial results - and to allocate that pool on the basis of individual performance and contributions towards creating that pool. This keeps shareholders happy and maintains the possibility that employees can earn a good bonus in a year with poor overall results. It also forces management discipline around allocating bonus dollars in the most effective way (often disproportionately towards the highest performers).

2. Assess your organization’s administrative capabilities before creating a new bonus plan. A theoretically correct bonus design is useless if your organization cannot effectively implement and administer it. For example, a bonus program based primarily on one or two financial results such as revenue growth or EBITDA can be managed by one person and a spreadsheet. A bonus program designed to drive certain employee behaviors or actions that is based on the assignment and measurement of individual employee objectives is going to require a lot more. People managers need to be trained and have the time to develop such measurements, assess them and communicate them to employees. Software needs to be developed or purchased that can keep track of everything.

3. Model payouts and review design to ensure that you are not creating any unintended consequences. Some of the questions to ask include:

Are bonus payments reasonably correlated with any cash flow on which they are supposed to be based? An example of what might be a poor practice in this category would be bonus payments tied to deal completion or sales orders booked rather than to deal success or customer payments

Is the bonus fixed in the employment agreement or otherwise not particularly variable in practice. If so, is it part of an overall compensation program that has too much fixed compensation in the form of base, bonus and retirement benefits?

Are bonus payments based on the same measures year after year? (This can result in a lack of freshness in management approaches.)

Could shareholders be unpleasantly surprised by a disparity between their gains compared to bonus payouts? Such might be the case, for example, if the financial results required to achieve an extraordinary bonus payout are not particularly extraordinary. As a good rule of thumb, results that double a target payout or create a zero payout should each be achieved every five years or so.

Incorporate these three actions into the development of your 2010 bonus plan and your organization will have a stronger, more supportable program - and maybe less stress - a year from now.

Executive Perquisites are Alive and Well

2009-08-24T10:17:00.003-04:00

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

2009-08-04T23:18:00.001-04:00

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

2009-05-08T17:18:00.000-04:00

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

2009-04-27T12:49:00.000-04:00

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

2009-03-19T14:17:00.000-04:00

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

2009-01-20T21:25:00.000-05:00

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

2009-01-20T12:12:00.000-05:00

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.

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
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.
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
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.

Rethinking the Annual Bonus

2008-12-08T20:37:00.000-05:00

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?

2008-11-20T10:19:00.000-05:00

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.

Strategic Human Resources (Do not Read This if Your Business is Going Great)

2008-11-07T22:20:00.000-05:00

Bad times have a way of bringing out our most conservative instincts. Like a turtle facing a raccoon, the natural instinct of business leaders is to pull into a shell and wait out the danger.

But some of the business leaders I have talked to recently take a contrary perspective. They see a downturn as an opportunity to think ahead and gain a long term competitive advantage. As one CFO of a mid-size manufacturing company said to me, "the time to buy stocks is when they are beaten down and a recovery seems most improbable".

So why not think about the people-related opportunities afforded by the downturn. If not now when? After all, when times are good, you are busy with day-to-day stuff like meeting customer demands, stopping your best employees from walking across the street for more money and otherwise figuring out what to do with all the revenue rolling in.

Here are the people practices up for rethinking that some of the more aggressive business leaders are talking about.

They start with a big number. These leaders do not start their planning with a sober, conservative assessment of where their business will be in two or three years. Instead, they begin with positive, some would say aspirational business goals usually stated in terms of key financial metrics such as revenue, profit margin or market share. One said to me, "if you goal is to hang on, that's probably the best you will do".

They then move on to a sense of how many and what kinds of employees (along with capital) they will need to reach those goals.

They are not a sentimental group. Starting at the top jobs, these leaders are identifying the "A" level skills, experience and qualifications needed to achieve the stated business goals. If there is not a match with the incumbent, change is quick to come. That means firing the incumbent, moving the incumbent to a better fit or working to bring the incumbent up to speed (but only if it can be done in a time-frame of months not years).

They are aggressively poaching talent. These business leaders are taking advantage of the economic fear and indecision of their competitors to hire the best talent away from them - usually at a bargain price.

They use brutal honesty and openness to engage the workforce
These leaders are sharing the burden by educating the workforce about the business and engaging them in the shared goals. They are honest about the tough times and challenges as a way of making their bright vision that much more compelling. They provide forums for collaboration, feedback and idea sharing. This is typically done using 'lunch and learns', e-mail, and employee forums. I expect that the future will see more use of some of the newer web-based approaches to collaboration such as blogs and wiki-type software.

They use compensation to support the plan
They see this as a great time to lock in talent with long-term equity and cash compensation that is generous but that pays off only if aggressive goals are met.

Leaders are taking this opportunity to differentiate sharply in compensation among those who are truly strategic contributors to the business and those who are purely doing their jobs.

While it is too soon to tell if there will be a wide-spread rethinking of the amounts and approaches to granting equity compensation, there should be some changes in common practices. For example, the heads-I-win-tails-you-lose approaches have come up so obviously and awfully short in the finance/banking industries.

I will address this issue in more detail in a future post, but for starters owners and boards need to find alternative approaches to compensating their top talent besides granting huge amounts of options, SARS and restricted stock to executives as a way of purportedly aligning executive interests with those of owners. This approach is often ineffective and counterproductive. Investors are risking their capital when they take a stake in a business. Executives rewarded with large equity grants are playing with house money. Their incentive is to take big risks for a big payoff as they cannot lose their "investment".

They are positive These strategic business leaders are all realists,yet they are optimistic. They just choose to focus more on the opportunity as opposed to risk.

_____________________________________________________

The market is down, your customers are afraid to buy and your employees watch you for any sign that they are next on the list. Now may just be the time to be a strategic optimist.

Sales Compensation During Tough Times

2008-10-21T16:51:00.000-04:00

In reviewing a sales compensation program with a CEO recently, he described his salesforce as cockroaches: "I try to wipe them out but they always seem to survive and come back stronger than ever".

Leaving aside the precise accuracy of the simile, there is no doubt that CEOs and CFOs running their fingers down a list of major expenses will often zoom in on sales compensation as a particular irritant. Costs can run as high as 40% of revenue in some businesses. And, whether stated explicitly or not, leadership often convinces itself that the company's products/services are so unique that it does not need a lot of high-end sales talk to convince customers to buy them. Even in good times, there is the temptation to reduce incentive payouts to the sales force. With revenue and margins under particular pressure today, the target is even more inviting.

But, if you fall into this category, resist the temptation to go scorched earth on your sales force. Bad times can create great opportunities to grow market share as existing customer/supplier relationship come under financial stress and reconsideration. And while there are a myriad of strategic and tactical issues to consider when looking at how the sales force is managed and compensated - and the two are somewhat intertwined - I see the following as key issues to focus on.

Open up your wallet. Be prepared to pay your good sales people a lot. Admittedly, you might not want to hear this. But, your sales force is the sharp end of the spear and your front-line in the efforts to grow revenue. An effectively designed sales compensation program is a means of growing the pie not of dividing it up. Sure, the shareholders might take home a smaller slice in the end, but it will be from a much bigger pie (this is making me kind of hungry).

The key word here is, of course, "good". The problem with many sales compensation programs is not that they pay out loads of money to their best performers but they pay out too much for not-so-good results.

Look at how often sales people meet their targets. If the percentage is consistently over 75% your targets are too generous. Also, analyze the relationship between compensation and sales volume. If the relationship is not highly correlated, the odds are you are paying out too much for mediocre performance.

Build in extra-large incentives for adding new customers. I have heard about the 80/20 rule to death. Yes, in most cases, 20% of your customers create 80% of your revenue and more than 80% of your profitability. So the smart money focuses most of its attention on retaining and growing revenue from that 20%. The conventional wisdom is that the easiest and least expensive way to grow revenue is to sell to existing clients who evidence a propensity to buy. This is the siren song: sweet, logical, cheap and quick.

But, if you are not adding new customers your business will die. Focusing revenue growth efforts on existing customers gradually erodes the customer trust in the relationship as your sales force is inevitably put in the position of trying to sell anything in the pipeline as opposed to picking and choosing what makes most sense for the customer. Also, under the best of circumstances, you will loose customers each year. The pipeline needs to be replenished. Some of the new, seemingly marginal customers of today will turn into the Fortune-500 companies of tomorrow. Unfortunately, you can't figure out who the winners will be a head of time. Finally, new customers excite the workforce by adding "wins" and bringing in new learning and growth opportunities.

All that being said, bringing in new customers is the hardest sales job of all. The investment of time is great, the outcome uncertain and often the revenue is tiny up-front. A business needs to invest in incenting the salesforce to bring in the new customers the same way it invests in new products - with the idea of losses in the short-term and gains and a healthy business over the long-term.

Simplify. Make sure your sales force's compensation program and performance management is not weighted down with accumulated goals, hanger-ons and responsibilities. Only those people who actually deal with customers and significantly influence the buying decision should receive a sales compensation incentive. Sounds kind of obvious but it is amazing how many roles pile into the sales incentive plan including sales support staff, sales management and technical advisers.

Ensure that your sales force has clearly defined and relatively simple responsibilities. For example, in most cases, a sales individual should have responsibility for either selling new customers or growing revenue from existing accounts but not both. They should not have the added responsibilities of mentoring, managing people or providing significant post-sales support.

Finally, make sure your incentive compensation program is simple enough that your typical sales employee can calculate their commissions in their head as they walk into a sales meeting. If your sales compensation program takes up more than a page it is probably too complicated. For example, it should usually not include more than one or two multipliers for certain types of sales (e.g., new customers, new products) or more than two commission rates.

Tough times can mean some great opportunities to grow market share. This is when existing, long-term customer/supplier relationship are under stress and most likely to break. So, when it comes to your sales force now is the time spend the money, incent for new customers and simplify.

Investment Banks and Pension Liabilities

2008-10-17T11:29:00.000-04:00

Every once in a while I am forced to modify a strongly held belief in the face of the withering fire of facts and events. The collapse of financial institutions such as Lehman, Bear Sterns, Merrill and AIG has caused me to reconsider my general faith in the investment banking community's ability to manage risk. More particularly, from the perspective of the employee benefits world, I have reconsidered my view that these financial institutions could provide a solution to help corporate america get defined benefit pension plans off of their financial statements.

It was not too long ago, that I believed that folks who ran ran Investment Banks were better than the rest of us. They were smarter, more creative and they dressed a bit better. They certainly got paid more and they seemed innovative enough to come up with a solution to one of the most pressing issues facing Companies with defined benefit pension plans: how to get rid of them (i.e., get them off of the balance sheet) in a financially efficient way.

For those not into defined benefit pension plans some brief background might help. Defined benefit pension plans provide guaranteed income at retirement as opposed to defined contribution 401(k)-type plans which only guarantee a contribution or match. The long-term liabilities inherent in defined benefit plans are backed by a federal insurance company - the Pension Benefit Guaranty Corporation. The trend away from defined benefit plans has become very pronounced over the past five years for a number of reasons but the balance sheet and income statement volatility caused by these Plans has been a major factor.

However, while many companies have "frozen" their plans by stopping future benefit accruals past the freeze date, they have not been able to get the liabilities accrued prior to the freeze date off of their financial statements. This is because, under the extensive regulatory scheme surrounding defined benefit plans, there are only recognized methods, barring bankruptcy, that companies can terminate them and both approaches have significant financial drawbacks: purchase annuities from an established AAA-type insurance company for all accrued benefits, or convince employees to take a lump sum buy-out.

Buying annuities from insurance companies is very expensive because insurance companies must, by law, invest the proceeds from such a purchase very conservatively, they need to earn a profit and they are culturally risk averse. Paying out lump sums to employees is just as expensive because of laws requiring the use of conservative actuarial assumptions in calculating such lump sums.

Enter the investment banks. Why not hand off the pension plans to these guys. They can manage the investments much more aggressively than an insurance company and with their risk management skills can do so without putting pension benefits in jeopardy. Even after building in their profit, they can take over a pension plan at a much more attractive price than an insurance company or by paying participant lump sums.

This was a win-win for corporate sponsors of defined benefit plans looking to get rid of them and for investment banks looking to get their hands on huge pools of additional assets with which to practice their financial engineering skills.

Amazingly enough, I could have written the last paragraph with a straight face six months ago. In fact, this was a business investment banks wanted to get into and were lobbying the government to allow this third avenue for transferring pension risk.

In September, the IRS formally closed the door on this approach with Revenue Ruling 2008-45 saying that pension buyouts as described above would violate the IRC's "exclusive benefit" rule. Without going through the technical aspects of this ruling suffice it to say that the IRS believed that divorcing pension assets/liabilities from any link with employees would not lead to the ideal management of these plans. And given that the federal government, through the pension benefit guaranty corporation, would assume all unfunded liabilities of plans unable to pay benefits, they have a large stake in insuring that pension plans are managed prudently.

The Administration has followed up with proposed guidelines for future legislation that would allow these types of transactions. In order to protect their insurance liability, the guidelines include a heavy dose of regulation around the companies doing the buying and the underlying fundamentals of the transaction.

Several months of watching investment banks get crushed have made the Revenue Ruling and the Administration's guidelines moot if not downright amusing. No one believes that investment banks are particularly clever at managing investment risks anymore. No doubt about it but purchasing annuities from insurance companies is a very expensive proposition. After all, you are basically investing your money into long-term corporate bonds. But handing off a plan to a place like Lehman, Morgan or Goldman? No way. As they have demonstrated, they are great at taking long-term risks to maximize short-term revenue. What do they care about benefit payments 40 years down the road when their are bonuses to be paid six months from now.

Nothing against these companies or large bonuses but it is now clear that the incentives at these firms are completely misaligned for managing a long-term liability like pensions.

If the Federal Government is on the hook for pension promises not kept by the original plan sponsors or the third-parties who might take them over, they are absolutely right to require a great deal of regulation of these "deposits" including segregated accounts and restrictions on investments. But with that type of regulation, the investment houses will be acting more like insurance companies and providing insurance company returns on investments. Which leads back to insurance company prices. Which leads back to what's the point of making any changes to the whole structure anyway. The regulatory structure is already in place for managing long-term liabilities through established insurance companies. Why more-or-less duplicate the structure by regulating investment banks in the area of pension liabilities?

I have come around. If companies want to get the pension liabilities off of their books, they need to pay the appropriate (read: risk asverse) price. Either go the lump sum route or purchase annuities via the already highly-regulated insurance companies.

Lehman

2008-10-10T16:38:00.000-04:00

I admit that I have written on at least two other occasions (see my posts on Citi and Bear Stearns) about how the separation of executive pay at financial institutions and any measurement of financial risk has contributed to the disaster on Wall Street. But given that my retirement account has lost about 25% in the past week and that decline can be attributed to poor risk management on the part of banks and investment houses, I think I can take the liberty of repeating myself - although it is hard typing out here on a ledge.

So, excuse me as I join Congress and pile on Richard Fuld of Lehman Brothers. I am also going to pile on Lehman's Board for letting things get so out of control.

There are many businesses where financial risk could reasonably be left off a list of key criteria for managing executive compensation. A pharmaceutical is focused on getting effective drugs through the pipeline and into customer's hands. An Oil Company is interested in finding as much oil as it can and getting it safely to market. But if you are in the investment banking business, the riskiness of investments has to be a major factor in measuring performance whether it be of a mid-level trader or the CEO.

If you want to pump up earnings, or return on equity, get your hands on as much borrowed money as you can, at say 5%, and invest it at 8%. Pretty simple formula for getting rich right? Buy low and sell high. Retail banks do it all the time. They collect deposits, pay a smidgen of interest and try to loan it out in a prudent way for mortgages and business loans.

This formula was particularly easy to follow over the past 5 years with easy, cheap credit for loans and a huge pool of securitized commercial and home mortgage loans to invest in with very attractive interest rates.

So back to Lehman Brothers. If you look at their last 10-K, you will see some serious language around the factors that could significantly impact shareholder value. "Financial Risk" appears often in this verbiage recognizing that when you trade financial securities, act as a market-maker and otherwise develop and sell financial products to clients, the risk that markets might move against you is a pretty big deal.

But when we turn to the proxy, there is only one weak, generic mention of risk (executives are tied to corporate risk via equity-related grants) when it comes to executive compensation. The cash and stock incentives are based on areas such as earnings and return on equity. Some of the other areas mentioned for executive performance include: "Strengthening the Company's brand and Improving employee programs".

If Lehman did not go bankrupt within six month's of the Proxy's publication, I like to think the executives would get a "not meeting expectations" in the Brand area.

All these areas are worthwhile. And for non-financial institutions, earnings growth and return on equity would probably be good places to start as measures for executive performance. But for a company like Lehman which can leverage itself to the hilt, take great risks and pump up its earnings and return on equity without breaking too much of a sweat with lots of easy credit going around, these measures will create what they incent - lots of suboptimal risk-taking and an eventual crash.

Okay, I am approaching this after-the-fact. But I cannot understand why a sophisticated Board of a financial institution that's primary job is to effectively manage risk would not make this a key area of executive compensation. Why not simple things, like risk adjusted earnings or an adjustment for leverage?

So Fuld and the rest of the Lehman crew collected some pretty good paychecks over the years (a signficant portion of which was in cash) while the going was good and left the wreckage to bankruptcy. At least in Lehman's case, the primary losers were only clients, equity holders and the poor employees who loaned money to Lehman through deferred compensation plans. With AIG, we are all picking up the tab.

Private versus Public Compensation

2008-08-25T20:06:00.000-04:00

Recently, I had a discussion with a mid-size ($100 million), private financial services firm about setting up a long-term incentive program. From a purely intellectual perspective, working with smaller to mid-size firms is refreshing. The issues they face are usually immediate and there is little process and procedure that stands in the way of action. For better or worse, a consultant can see the impact of his or her advice very quickly. There is also something to be learned from noting the differences between the compensation approaches of private and public companies.

Take equity. While both public and private companies hand out on average about 15% of ownership to employees, the variance among private companies is much wider, with both 0% and 100% (ESOP) being common. Public companies will rarely grant employees ownership of less than 5% or more than 25%. Conversely, with the exception of ESOPs, private companies share ownership with a much narrower group and are much more likely to maintain ownership stakes to the CEO and a few key employees. Public companies will often spread the wealth to a broad group of employees with the CEO and top leadership group rarely getting more than 25% of the equity granted.

On the cash compensation side, private companies will generally pay less than public companies. As one owner famously said to me (famous to me, at least), we are like a family here and everybody knows that you don't pay your family to help out.

Or Perks. Senior management of private companies are far less likely to have access to benefits such as private planes, first class travel, security systems, financial planning, enhanced life insurance, etc.

Why these differences? On the margins, there may be governance and technical issues. Among many such issues, private companies do not have to publicly disclose compensation and they do not have a liquid, transparent market for their equity. S-Corporations have to be concerned with creating so many owners they loose their S status.

I think these are mere technical issues to be overcome and do not fully explain the differences in public and private compensation mix and magnitude. After all, companies whatever their ownership structure, have to attract and retain talent, so how can private companies get away with paying less and granting equity to a much smaller class of employees?

Private companies generally see equity as something you grant to those employees who are essential to producing retained earnings over a long-period of time. If you can contribute to the growth of equity value, you can get a share of it. This usually means a small class of employees. Public companies are more likely to use broad equity grants to support an ownership culture or for morale or public-relations purposes. Even after FAS 123, management of public companies often see equity as a low-cost way to compensate employees. Not so, with Private companies. The owners see equity grants as the most expensive way to compensate their employees. This last point, I think sums up the reason for the differences.

Yes, all companies need to pay competitively to attract and retain talent. But there is a broad range of compensation terms that are mutually acceptable to owners and employees. At one extreme of the agreeable compensation spectrum, call it the "I have a cheap employer" point, employers have squeezed the maximum value out of employees and at the other extreme, call it the "I am practically self-employed" point, employees have squeezed the maximum value out of their employers. An example of the latter is when a sales employee who pretty much owns their client base has a commission base so high that the only thing left over for shareholders is a small 'management' fee. An example of the former is an employee who claims they will work for practically nothing for the experience.

Because the owners of private companies feel the impact of higher wages or equity grants so directly (every dollar I pay to my employees is one less for me), they are more likely to push the negotiations towards the minimum employee pay scenario. Management of public companies also have an incentive to maintain costs but the impact on their personal compensation is much more diffuse and indirect.

I believe private companies can learn something from public companies around thinking more long-term when it comes to compensation. Sometimes the approach that maximizes profit right now by squeezing employees to the maximum is not the way to produce growth over the long-term. I also believe that public companies can learn something from private companies when it comes to equity. True ownership should not be so cavalierly handed out and should be restricted to those who truly are expected to contribute to ownership value.

Reflections on Retirement

2008-08-12T12:54:00.000-04:00

Maybe it is because I am on vacation in a resort-type setting but retirement has been on my mind. Not my retirement but the concept of retirement. While hanging out at the pool with a cocktail or playing tennis at 10:00am, it is hard not to imagine what it would be like to do this full time. I suspect my imagination is contrary to the typical view of retirement which is shaped so much by the culture of Corporate America, heavy marketing on the part of investment houses and government policy.

Consider Corporate America. Working in any company, from the CEO on down, requires subsuming some of our individuality to the interests of the organization. Partly as consequence of this stressful repression of individuality, many in Corporate America work for what they view as freedom: retirement. The nirvana that, when the magical age is reached, means the financial freedom and time for the full expression of individuality. The benefits department doesn't help. They constantly prod us to save more for retirement through the 401(k) plan. They often provide us with retirement planning software and access to investment advisers that all encourage a mindset around saving for this retirement event.

Financial firms, which have an interest in getting their hands on our money, reinforce the retirement event view. In their commercials, they promise that if you follow their advice, invest in their products and regularly sock away money, you too can wile away hours viewing your wine collection, throwing your grandchildren up in the air and walking on the beach with your well-preserved spouse.

Our societal norms encourage the concept of working until a specified point and then - not working. We have laws against age discrimination but our employment system invariably creates older workers who cost more than their ability to produce. Performance management programs and pay systems (in practice, not in principle) encourage promotions and pay increases that start to outweigh productivity gains by the time an individual hits the late 40's and early 50's. Defined benefit plans with their back loaded costs are three to four times more expensive for an employee in their 50's than those in the 30's; our approach to underwriting health costs results in higher costs for older employers and vacation and time off with pay for sickness almost always increase with an employee's service (age).

Our Social Security system which defines retirement as age 65-67 (depending on when you were born) reinforces the work-until-you-RETIRE mindset. When Social security was enacted in the 1930's, the life expectancy at birth for a male was in the low to mid 60's range. You retired from work, got a couple of years of social security benefits and then died. Now, with life expectancies in the 80 range, people feel entitled to get a life annuity for 15 to 20 years after they stop working.

I started rethinking my view on the merits of a classical retirement some years ago. I struck up a conversation with a fellow golfer at Hilton Head Island. He described his success as an oil executive that allowed him to retire at 50 to a beautiful property right on the golf course we were playing on and that allowed him the time and money to play every day. Being new to the area, I asked him which were the best courses to play on the Island. His reply has stuck with me ever since: "I don't know. I live right next to this course, so I've never seen the need to play on any course other than this one". That lifeless response scared me off of the life-of-leisure picture of retirement when I was in my early 30's. Setting and working to achieve goals, whether they be to make more money for ourselves or to help others to achieve their goals is one of life's great pleasures. Working towards a goal of no goals seems like a recipe for disappointment.

My view is also shaped by observing the most financially successful self-made individuals - people like Warren Buffet, Carl Icahn, Donald Trump, Bill Gates and Mark Cuban. I do not get the impression that they are working towards the goal of not working - kicking back and playing some golf and watching the world go by. They are creating new challenges for themselves long after they found financial security.

Even if your goal is a classical retirement, I do not believe we have the ability to financially plan for a 20 to 30 year retirement period that commences 20 or more years in the future with any sense of confidence. In "The Black Swan: The Impact of the Highly Improbable", Nassim Nicholas Taleb makes the point that we are so biased in forecasting future events by the past that we completely under-estimate how events are shaped by the improbable or rare events. The carefully laid financial plan, with indexed mutual funds, life insurance and a generation skipping will can be thrown to pieces by a paralyzing car accident, a close relative in need, or, on the positive side by a windfall inheritance. While rare events are by their nature - rare, over a long period of time, a rare event of one kind or another is likely to occur.

So am I saying that we should all throw up our hands and stop saving for an event that will not give us much satisfaction anyway. Partly. As a society and as individuals, I think we would benefit by moving the needle away from the retirement event concept. A prudent person will put aside money for a rainy day and to improve their flexibility to set non-financial goals in the future. But we should all understand that our financial plans will never materialize as anticipated and in any event, a period of leisure without work will ultimately be disappointing. As a society, we should not be encouraging those individuals with the most experience, expertise and judgement to drop out of the workforce.

A modest proposal

2008-07-11T18:03:00.000-04:00

An issue that comes up more frequently in the Board room these days is what to do about incentive compensation for key talent.

The value of equity compensation granted in the last several years is so underwater as to be in complete darkness. Similarly, the company performance upon which cash bonuses are based is often barely approaching threshold levels for 2008. Executives are threatening that, without some sort of special retention compensation or changes to their bonus targets, they may walk. Boards are rightfully concerned.

A purist of the "that's the way the cookie crumbles" school of business will reasonably argue that there should be no change to the compensation approach just because business conditions are poor and the stock market is down. Everyone was happy with the model in 2005 and 2006 when times were good, so why shouldn't incentive compensation drop when times aren't so good?

The practical businessman of the "in the long run, we are all dead" school of business will just as reasonably argue that, like it or not, human capital is mobile and if our top executives are not paid at least equal to what they could get paid by say, walking across the street, that is what they will do.

Both arguments are persuasive. It leads me to wonder if the whole concept of "incentive" compensation and "pay for results" is flawed. We like to pretend that by loading executives up with equity and bonuses tied to company performance that their interests will be better aligned with shareholders - that they will behave as owners.

But the fact is, executives are not owners, they are employees. They are not putting up the risk capital that owners do and probably should not be rewarded in the same way. On the other hand, employees need to get paid in good times or bad.

Is it time to rethink the whole deal? Maybe the issue of changing goals in the middle of a performance year or repricing options would not be as emotional if we called compensation tied to company or stock results "profit sharing". Doesn't that term better describe what is really going on? In the long-term, companies need to grow and make money in order to pay the lucrative bonuses and stock option grants that executives expect and often deserve. So profit sharing will pay off big in good times.

If times are bad, little or no profit sharing gets paid but we would no longer say the lack of payouts is due to lack of "performance". It is merely due to lack of results recognizing that a significant portion of stock price and company results are out of the control of individuals - even CEOs.

I would not do away with incentive compensation all-together, in fact, it would still be a significant portion of an executive's pay but it would be solely tied to things the executive can really influence or control. This might include actions such as completing an acquisition, cutting expenses, grooming a successor or developing a new product.

Clearly the above suggestion goes against the tide of basing compensation on results and away from action-based incentives and profit sharing. While much of this is purely semantical - I do not expect it would change the overall magnitude of an executive's pay, I think the change in nomenclature and approach will improve performance and reduce the Board room angst when times get tough.

Don't fire me or else....

2008-07-01T14:56:00.000-04:00

Cari Tuna had a story in the The Wall Street Journal yesterday on how more companies are making employee retention metrics a component of their bonus goals ("Keeping Workers Earns a Bonus In Some Offices"). The article cited a Hay Survey that

suggests that the practice is gaining popularity. In the 2007 survey of 182 organizations, 8.2% of respondents said they use turnover as a performance measure in executive-incentive plans, more than three times the 2.3% who responded similarly in 2005.

While this is generally a welcome trend, tying management bonuses to retention can create unintended negative consequences. Also, I do not mean to be a nitpicker but the trend is not a result of employer recognition that turnover is expensive or that employee performance drives business performance as a Hay consultant in the article says. I cannot believe that business leaders only became enlightened about the importance of employees to their operation in the past few years. Instead, employees simply have become more willing to leave their employers for a better financial deal and/or work environment and companies are increasingly being forced to respond.

Turnover is often a big finger-pointing exercise. Executives blame it on the poor management practices of first-line supervisors, supervisors blame it on the demands made by executives and they both blame it on HR. The unfortunate truth, for those who like to think that there are programmatic fixes to HR problems or that just a bit more CEO vision is needed to raise employee morale, is that most of what drives employee attraction, retention and engagement cannot be controlled in the short-term. A growing and profitable business creates large pay increases, promotion and development opportunities and an overall positive mood in any company. What are often cited as great HR and management practices around work environment more often go along for the ride than actually drive change.

Being realistic about management's limited impact on turnover is important to setting goals that do not create skepticism. It also important not to send the wrong message about retention. Managers and supervisors often need to make difficult and sometimes harsh people decisions and to implement tough performance management standards. These do not come naturally to most people but need to be encouraged and supported. Without the right context, adding turnover metrics to bonus goals can completely demotivate and disempower managers.

Does that mean companies should throw up their hands and not try to improve management practices in the hopes of improving various people metrics? No, I think there a few things companies can do that can have a positive impact in the annual cycle around a typical short-term incentive program:

Make certain behaviors that might impact turnover "threshold" behaviors required to receive any bonus or potentially to remain employed. For example, all employees should be honest in big things and small and treat their colleagues and outside business partners with respect and integrity.

Recruiting is an area that can be driven very quickly to the positive if enough emphasis is placed on it throughout the organization. And by emphasis, I mean time and money.

Create emphasis on actions that might reduce turnover regardless of business performance such as ensuring that all employees have performance plans, career development discussions and reasonably customized goals.

Ditto for actions that might positively drive employee engagement such as, implementing business literacy and spot bonus programs and identifying special projects and job assignments for select employees.

You will notice that much of the above list is extremely labor intensive and, with the exception of setting recruiting goals, behavior rather than results oriented. It takes a lot of time to develop and discuss career plans with employees or to develop goals that are unique to each individual. This is the hard work of employee management that often gets sidelined as HR's responsibility or the "soft stuff". But if a company really wants to get serious about retention, these are exactly the areas senior management needs to emphasize.

Leaders with Halos

2008-06-13T15:39:00.000-04:00

I recently finished Phil Rosenzweig's "The Halo Effect". This is a thoughtful book about how much of what passes for academic research into the the underlying drivers of business success is nothing more than the reflected light of historical achievement.

Rosenzweig rips into such books as "In Search of Excellence" and "Good to Great" as nothing more than anecdotes, disguised as rigorous academic research, about business that were successful when these books were written. While not a comfortable message, he gives sheer luck its rightful, prominent place, along with strategy choices and strong execution, in drivers of business success.

Rosenzweig believes that there is no instruction manual for aspiring business leaders to follow. Business is too unpredictable. A leader who makes the "right" strategy choices and execution approaches will more than likely create business success. However, there is no way of knowing a head of time, what those choices should be nor is there a particular decision methodology that will more often than not lead to success.

This got me thinking from an investor's perspective. If looking at the historical performance of a company is not necessarily a valid indicator of leadership's ability to create future success, is there a way to evaluate the quality of a firm's management? Certainly, if you are a wall street analyst who is able to attend management briefings or someone who has the time for management-led earnings conference calls, you can make an informed judgement about the individuals leading a company. But if you do not fall into these categories, is there any way to make an informed judgement about a company's management?

Perhaps I have spent too much time reviewing company proxies, but I think there are some important clues to the quality of management contained in them. My list includes:

Is there more than one director or officer with the same last name. Nothing wrong with giving your son a job, but does it have to be as President, CFO, or Director?
Does the Board include too many of the usual suspects? If I see too many ex-Presidents or Directors who are on multiple boards, I wonder whether this is a company looking for publicity or brand names to build confidence among less discerning investors rather than seriously looking for the diversity of experiences and views that a strong Board needs.
Does the company provide a lot of perks to its top executives? I see nothing wrong with perks for those lower in the organization. Since most of us don't go around telling everyone about our big raise, Perks can be a nice, public way of recognizing achievement. Everyone can see our big office, special parking place and blackberry. At the most senior level, however, everyone does know how much we make - its all public. Good management is confident enough to avoid the ego gratifications of perks that have no strong business rationale.
Does the Company endorse "Say-on-Pay" type proposals? I want a strong Board. If they do not have the confidence to set compensation without shareholder confirmation, I would have doubts about their ability to make all the other decisions necessary to run a company.
Is the Compensation Discussion and Analysis three pages or less? Great. Compensation should not be that complex and it should not take more than two or three pages to explain it.
Is there a lot in the proxy around severance benefits and employment agreements? Other than as a recruiting tool to induce an executive to take a risky move, there is rarely a good case for an employment agreement and for a severance plan any richer than that provided to the broad-based employee group.
Similarly, are retirement benefits excessive? Executives should not be focused on attaining rich retirement benefits. That seems to be something more appropriate for the stick-it-out-until-death attitude of postal workers.

There are plenty of notable and reasonable exceptions to the rules noted above. The same strong ego that aspires to perks and friends on the board can often be what it takes to drive a business forward. I would look to my proxy list, but in the end, I would not want to invest in a company whose CEO has a halo.

A little more tension in the Boardroom?

2008-04-17T12:24:00.000-04:00

The issue of whether compensation consultants are providing independent advice to their corporate clients has garnered a good deal of attention lately. Two recent studies reach conclusions that should give Board Compensation Committees some pause when hiring a consultant but also, indirectly, highlight the much more general and illusive issue of "professional independence".

Henry Waxman's House Committee on Oversight issued a report in late 2007 that found that:

There appears to be a correlation between the extent of a consultant’s conflict of interest and the level of CEO pay. In 2006, the median CEO salary of the Fortune 250 companies that hired compensation consultants with the largest conflicts of interest was 67% higher than the median CEO salary of the companies that did not use conflicted consultants. Over the period between 2002 and 2006, the Fortune 250 companies that hired compensation consultants with the largest conflicts increased CEO pay over twice as fast as the companies that did not use conflicted consultants.

"The Role and Effect of Compensation Consultants on CEO Pay", A study by two Wharton Professors, Mary Ellen Carter and Brian Cadman, had related but somewhat different conclusions. They found that a) executives get paid more when compensation consultants are involved but b) the pay is still as equally sensitive to pay-for-performance variability as those companies who do not use a compensation consultant and c) there is some, but not conclusive evidence that "conflicts of interest" among compensation consultants influences the magnitude of executive compensation.

The Waxman report defines a "conflict of interest" as when a consulting firm that provides executive compensation advice receives a significant amount of revenue from the same client for non-executive compensation consulting services. A not-atypical example would be a consulting firm that provides executive compensation consulting services to the Compensation Committee for 100k a year and is also hired by the company's management to provide $10 million a year in administration, brokerage and actuarial services on behalf of the employee benefits program.

The Wharton study defines conflicts similarly but did not have access to the same consulting firm revenue as the subpoena-empowered congressional committee.

As a consultant that often provides executive compensation advice, I would like to be able to punch holes in the data but in this case it is not lying. The data clearly shows that, after adjusting for other factors, companies that hire compensation consultants pay more to their executives than those that do not use consultants. I am also persuaded by the data from the Waxman committee that the more money companies pay to the firms that provide their executive compensation consulting services, whether for compensation or other consulting services, the higher their executives are paid. While the Wharton study does not firmly conclude this, they also did not have access to the detailed consulting firm revenue data as the Waxman Committee and were forced to rely purely on proxy data.

This is a serious issue that needs to be faced up to. But it is not a new issue nor does it begin and end with compensation consulting. Every professional, whether they be consultants, lawyers, accountants, brokers, or actuaries, that provides advice to a corporate client faces the uncomfortable fact numerous times throughout their careers that the folks who pay their bills (i.e., company management) might, at times, have a different agenda than their ultimate client - the shareholders. After all, even if you are a compensation consultant that does not have a conflict of interest as defined by the Waxman Report, you do not want to be fired from your consulting job for providing advice that the CEO doesn't like.

The best professionals - compensation consultants among them, face this reality head-on. They acknowledge the possibility that they may provide advice that the check writer does not like, and they are always prepared to walk away from a job. The best consulting firms support this independence. And, in my experience, what might surprise Waxman, et al. is that the most financially successful consultants are those who are data driven, daily work to provide "objective" advice whether it is welcome or not and are always prepared for the consequences of their actions whether it means having their firm loose a lucrative benefits administration contract or losing their engagement.

I would also add, that in my experience, corporate management usually works just as diligently with the compensation committees to develop solutions that are fair to executives and shareholders alike. But by its nature, fair is often in the eye of the beholder and, in a healthy relationship, there should be some tension between what management wants to receive and what shareholders through the Board wants to pay.

Maybe we need a little more tension in the board room. With respect to compensation consultants, I see Boards and management already swiftly moving in the direction of requiring independence from other revenue streams. But beyond that, we professionals need to continuously monitor our corporate relationships and remind ourselves of who is ultimately paying our bills.

Don't Blame the SEC

2008-03-31T12:59:00.000-04:00

Recently, the WSJ had an article by Phred Dvorak on the complexity of the recent proxy disclosures on Executive Compensation : "(New Math) x (SEC Rules) + Proxy=Confusion". The article cited examples of comically complex compensation formulas. The proxy for Novel

tosses around such terms as "assigned weighted quantitative performance objective achievement percentage," and describes a two-step process for calculating executive bonuses: First: "Bonus Funding Percentage x Weighted Quantitative Performance Objectives Achievement x Qualitative Performance Factor = Performance Factor." Then: "Performance Factor x Target Bonus Percentage x Base Salary = recommended Bonus Amount."

Anyone who works on executive pay issues is painfully aware of the convoluted language in proxies; we have to wade through hundreds of them annually. Overly complex descriptions of company compensation programs is not a new issue. In 1992, the SEC started requiring the tables currently found in proxies describing, in quantitative terms, every element of executive compensation. The idea was that since the previously required narratives were practically unreadable, the tables would at least give an investor some idea of the magnitude of the compensation numbers.

Maybe some of the good government-types thought that the new executive compensation rules published by the SEC in late 2006 were going to simplify things. According to the rules, companies are to use plain English to provide investors with a clear idea as to how executive compensation is set. The fact that the SEC has to devote a page or two of its regulations to define what they mean by plain English is a clue that, perhaps, the natural inclination of preparers of financial information is not always towards illuminating the investor on company affairs.

I give the companies a bye on the sheer amount of information they have thrown into the proxies related to executive compensation. My unscientific survey shows that companies take an average of twelve single-space pages to explain its executive compensation approach, philosophy and pay practices. And why not. From a company's perspective, there is no incentive for providing a concise version. The SEC is never going to bring a company up on charges of violating its rules by disclosing too much information. But there is a real risk of leaving something out that is deemed material now that the CD&A is considered part of a company's formal financial reports and subject to CEO/CFO Sarbanes-Oxley Certification.

What concerns me is not the length of the descriptions but the complexity of many of the compensation programs I have reviewed. I can see two reasons for this, neither of which shines a positive light on management:

The Plans are, in fact, so complex that an experienced compensation professional has to read them multiple times to understand what they pay out and under what circumstances. If that is the case, can the executives themselves understand what they are supposedly being incented to do?
Management purposely obscures its executive compensation plan through lengthy and convoluted proxy language because it is embarrassed by its practices.

Based on my experience, the first rationale is the primary reason for complex language. Despite all the compensation consultants hired by management and despite the fact that some of the brightest people I have ever met run large public companies, executive compensation programs are often a mess; poorly thought out, communicated and executed.

Beyond complexity, the major flaw I see in executive compensation design is too much emphasis on short-term profit sharing. Many, if not, most annual incentive plans primarily reward a measure related to corporate- or division-wide profitability. But, at the executive level, profits are created over a period of time by making the right decisions and through actions aligned with a strategic plan. And that period of time does not always coincide nicely with the annual accounting cycle. Short-term incentive plans are best designed to reward actions and behaviors that can be monitored in an annual period. Not results.

In the end, results are all that count but they are best left to rewarding over a three to five year period through stock option, grants of restricted stock and performance unit plans.

We cannot blame the SEC for poor executive compensation design. Yes, if it makes all the lawyers feel better, throw the kitchen sink into your proxy. But an effective compensation program is simple to understand and will reward short-term what can be measured short-term and long-term what can be measured long-term.

It's spring - time to grill your CEOs

2008-03-07T15:46:00.000-05:00

Proxies are trickling in for the 2007 calender year and the economy is showing weakness. It is time for the "executive-compensation-is-out-of-control ritual" performed periodically by Congress, the press and assorted shareholder "representatives". Not that we should expect too much subtlety and depth of analysis from these sources but there are some learning's to be had in pointing out the real distinctions among three executive compensation stories recently prominent in the news that otherwise might be lumped together.

The WSJ and NYT have articles today on Congress's investigations into the compensation received by three executives in the banking and mortgage industries: Stanley O'Neal of Merrill Lynch, Charles Prince III of Citigroup and Angelo Mozilo of Countrywide Financial. The gist of Congress's inquiry is why they received such large compensation in 2007 in light of the terrible performance of the companies they led.

Another article in the WSJ added a twist on Mozilo's case. Apparently, two outside compensation consultants hired by Countrywide recommended lower pay packages for Mr. Mozilo. They were fired and a third consultant hired that supported what Mr. Mozil was seeking. The appearance was that the consultant was acting more as an advocate for Mr. Mozilo than an impartial advisor.

I have commented previously on the cases of Mr. O'Neil and Mr. Prince. In their case compensation packages seemed designed with asymmetric rewards between management and shareholders. That is, a heads I win, tales you lose sort of proposition in which management is improperly incented to take large risks with shareholder money. If the risks pay off, management takes home a lot of cash which is what O'Neill and Prince did for some years including deferred compensation and pension amounts in 2007. When the luck runs out and the bubble bursts as it did with mortgage-backed securities, shareholders are left with the loss and the manager, at worst loses his or her job, as these guys ultimately did. The problem is not what O'Neill and Prince received in 2007 when things went bad, but rather how richly they were compensated in the preceeding years when things were going great.

The case of Mazilo is a somewhat different cautionary tale. He may also have had a compensation package poorly designed with asymmetric rewards. The more interesting part of his story, however, is that Mazilo was one of those executives who builds their company to such an extent that they, and the Board, cannot seem to separate the CEO's personal interests from shareholder interests (to be fair, Mazilo is also a large shareholder). The compensation consultant in question fell into a similar trap of not being able to separate his role as an independent compensation consultant to the company as opposed to an advocate for Mr. Mazilo. Without excusing the consultant, I can sympathize with the difficulties of balancing conflicting agendas and demands among individuals who, in theory, all work for the same shareholder "client". Members of the compensation committee and the Board should be in front of Congress not Mazilo.

Finally, we come to the situation that Michael Corkery describes in today's WSJ of how the Boards of Toll Brothers, KBH and Washington Mutual are finding ways to grant sizable bonuses to their CEOs even as the profits and share prices of these companies are hammered by the drop in home prices and the slowing economy.

Admittedly, it does not look good when the bonus formulas for top executives are modified after the fact to ensure that annual "incentive" compensation does not drop too much which is the case with the executives cited in the WSJ article. But, let us not throw too many stones here. While CEO pay is public, anyone who is involved with setting employee compensation knows that this sort of thing happens all the time in Corporate America at non-executive levels. It is commonly called "management".

The theorists can talk about "pay-for-performance" or "pay for results" but the truth is, firms need to compensate individuals not just for what they did last year, but also for a reasonable expectation of what they will be bringing to the company in future years. If companies unthinkingly held short-term incentives to a rigid formula they may lose some of their future best performers who will get their raise or bonus from a new employer. Sounds mercenary and petty? Yes, but mercenaries and sensitive individuals can also be valuable employees.

In the real world, management (and boards) must constantly calculate at what point to stand firm on principle and when to be flexible in the long-term interests of the firm. This goes double for CEOs whose departure (or demotivation) can have the most serious consequences for an organization. I believe these are exactly the calculations made by the Boards of Toll Brothers, KB Homes and Washington Mutual made.

The magnitude and structure of executive compensation, corporate governance and consulting independence among public companies are all topics that will continue to be scrutinized by the public. The stories of greed, personal failings and corporate intrigue are just too interesting. I believe, however, our reaction to these stories too quickly jumps to "less" rather than an appreciation of the more subtle ways that we can improve the compensation practices of the organizations we advise or work for.

A Presidents Day Tribute to Compensation

2008-02-18T17:01:00.000-05:00

It is Presidents Day or, as we used to call it when I was growing up, the Monday between George Washington and Abraham Lincoln's birthday. I thought it might be interesting to take a look at pay for world leaders. Notice, I did not say an instructive look at pay. Like everything else that gets churned through the political process, the pay for Chief Country Officers (CCO) does not seem to be based on any set of consistent underlying principals.

It is hard finding out what CCOs make. Apparantly, there is nothing like a Mercer sponsored survey of CCO compensation. If you look hard enough you can find out the pay and perks for the world's democracies. But, it is impossible to find it out what people like Robert Mugabe (Zimbabwe) or Kim Yong Il (North Korea) make. I'm guessing they are paid well above the 99th percentile of CCO compensation as there is no oversight by what we would term "independent" directors.

It is well known that the US president ($400k) makes far less than what a CEO of a Fortune 500 company makes - even if we don't count the free room & board, personal use of a 747 and top-of-the-line home security system. This relationship between public and private compensation at the top level applies throughout the democratic world. In a December 2007 Forbes article on the subject, Steve McGookin, notes that Gordon Brown, the current UK Prime Minister ($375,000) makes less than 10% of a typical large-company UK CEO and this percentage, while on the low side, is not unusual in Western Europe. The same article notes that President Sarkozy of France, for example only makes about $350k.

A major determinent of CEO compensation is company size. This is not the case in the CCO world. Take for example, the prime minister of Ireland. Bertie Ahern makes $434,000 managing a country with a GDP of 187.5 billion. Compare that with Germany's Chancellor, Angela Merkel who makes $318,000 managing a country with a GDP of $2.8 trillion or the Prime Minister of Japan (GDP of $4.3 trillion) who makes about $355,000.

The prime minister of Nepal (GDP of 30.7 billion) and Vladimir Putin of Russia (GDP of $2.1 trillion) make $3,600 and $81,000, respectively which are, I guess, the the exceptions that prove the non-rules.

How about pay-for-performance? A Wikipedia article on Presidents shows that William Taft would be by far the highest paid US President. His $75,000 annual salary back in the early 20th century would be equivalent to over $1.7 million in 2007 dollars. Just prior to the 100% increase in presidential salary in 2001, Bill Clinton would be among the lowest paid Presidents. His $200,000 salary in 2000 would be worth about $260,000 in 2007 dollars. George Washington's $25,000 salary in 1789 would be worth $566,000 today.

No comment on the politics. With honor to anyone who takes on, or tries to take on, the CCO responsibility, happy Presidents Day.

Fantasy Strategic Workfore Planning

2008-02-05T16:08:00.000-05:00

A recently published paper from the Boston College Center for Retirement Research on the subject of the "aging workforce" got me thinking about the more general business topic of strategic workforce planning (SWP) and whether or not it has any value.

In "Population Aging, Labor Demand, and the Structure of Wages", Margarita Sapozhnikov and Robert Triest hypothosize that as the workforce ages the relative market value of experience will decline. That is, the wages of older experienced employees will decline as a percentage of wages paid to younger employees. The argument makes intuitive sense, as the supply of older versus younger employees increases, the relative wage advantage will decrease. The researchers test their hypothesis based on historical labor and wage data and find support for it.

What I like about this research is that it rightly assumes that in a free market, the labor market will find a way to reach an equilibrium between supply and demand. Contrast that with much of what is out there on SWP. It assumes that the "war for talent" is a zero sum game with a limited supply and eventual shortages. In reality, there will be no shortage of labor. It may get more expensive but talent will always be available.

I differentiate between two types of SWP. There is the very worthwhile exercise that HR often leads of determining an organization's labor needs in the next year or two and putting together a recruiting or retention plan to help close any anticipated gaps. This kind of SWP is short on process and long on developing short-term actionable steps.

Contrast that process with fantasy SWP or FSWP. In FSWP, a business projects out its need for various types of labor 5-20 years. It also projects out what its internal labor supply will be to support that demand based on assumptions as to retirement and terminations. In theory, it is a great way of identifying longer-term gaps in the workforce assuming business as usual with respect to hiring and retention. All the big-name HR consulting firms provide this type of SWP.

In practice, there are killer problems with this approach. For starters, no one has shown any ability to accurately project business conditions two years down the road - forget 5 or 20 years. Years ago, big business did away with its strategic planning departments for just this reason. While it sounds good ("we are being strategic and thinking long term") to think about workforce demands beyond a year or two is a waste of time.

How about the supply of labor? A business can make assumptions as to future retirements and even terminations and those assumptions may even turn out to be reasonably accurate. But so what? Even if you could make a reasonable guestimate of future labor gaps or surpluses would you really be able to make use of the information today?

If, for example, you were to predict an overall surplus, you might lower your hiring rates and not do too much to retain talent. But is there any real business upside to this approach. After all, if all your assumptions turn out to be true and you indeed have too much talent in the future, you can downsize the surplus. Not an ideal scenario, but from a business perspective, better than to stop hiring today or not make any effort to retain employees in the expectation that you won't need them five or ten years from now. Think of the lost business opportunity if your projection turns out incorrect.

How about if you project a deficit? You can step up your hiring and retention programs which means spending more money on labor in the expectation that you will need them down the road. A more practical approach might be to hire them in the future if you need them.

The objection to this latter approach might be that it is more cost-effective to begin developing the work force of the future now rather than to try and hire into the gaps when they are needed.
Maybe. However, as you are always going to end up paying the current market rate for labor whether you develop it internally or hire it from the outside, why overpay the market now.

All that being said, there may be some current value to understanding the workforce of the future but it goes beyond the HR concerns of hiring, retaining and firing. And any actions you take on that understanding involve a whole lot of risk.

If, you believe in the forecast of overall labor "shortages" and the declining relative value of experience, a reasonable business decision right now would be to make capital investments in plant and automation - the more complex the better and avoid spending a lot of extra money on talent retention.

There is another possibility which would make the above approach a poor long-term decision. As the babyboomer population ages past historical retirement age and wages (and potentially prices) begin to rise, the supply of labor increases to somewhat offset the increase. The extra supply comes from increased immigration, employees delaying retirement, retirees coming back into the workforce and one-worker families deciding to become two-worker families. All of these due to the incentives of higher wages and the disincentives of higher costs.

My view: hold off on the FSWP and bet on equilibrium.

Recession?

2008-01-23T13:57:00.000-05:00

My neck is hurting from watching the market go up and down over the past several months. Actually, it has been mostly down and my wallet is hurting more than my neck. The newspapers are filled with news of bank troubles and layoffs and arcana around the Federal Reserve's interest rate machinations. There is almost a gleeful tone to the coverage. Maybe they sell more newspapers during bad times? The President and Congress are contemplating a short-term stimulus package that may put up to $300 cash in the hands of consumers which probably is great news for Circuit City and Best Buy but will do nothing to create sustained wealth.

Does all this mean a recession and mass layoffs? For what its worth (and this blog is free), I do not think so.

The economy is much more flexible and transparent than it was even just 15 years ago when we had the last real recession; and, even that one was mild by historical standards.

We are increasingly a service-based, knowledge economy. Variable compensation in the form of incentive pay, stock options, bonuses in lieu of base pay increases all have made wages much less 'sticky' than in the past. This makes it easier for companies to reduce their variable costs without resorting to layoffs.

Globalization of business and advances in information technology make it less likely that the economy develops sustained disconnects. Business is constantly and rapidly adjusting to keep inventory, prices, costs and demand in balance and therefore avoiding the massive short-term adjustments such as layoffs that were required in the past. We all complain about the pace of change in business these days. Another way to look at it is that we change a little bit every day so that we do not have to change a lot all at once.

Finally, the underlying economics of the global and US economy are strong. Wealth is created by productivity and growth comes from increases in productivity. Productivity is, in turn, driven by investment, education and the accumulation of experience. All the rest - interest rates, stimulus packages, even the daily vagaries of the stock market are all short-term noise.

Ignoring the noise and economic static and looking at the world things have never looked brighter. India, China and Southeast Asia are growing market economies. Russia and Eastern Europe have much greater economic upside than downside. The better off these countries and regions do, the better we all do.

My advice? If you are an employer, put away your severance plans, you will not be needing them. If you are an investor, this is a great buying opportunity both with equities and hard assets. If you are an employee, expect a smaller paycheck in 2008 but the demand for your services will remain strong. And, no matter where you fall, sit back and put in your earplugs. The noise might get deafening.

Is health care too cheap for employees?

2008-01-02T22:37:00.000-05:00

It is the start of the year, open enrollment is over and HR staff throughout the land are promising themselves once again to spend some time reflecting on strategic issues and not to get distracted by putting out fires and administrative tactics.

How about some big picture thinking on health care? It is certainly a high profile financial issue. According to a recent Towers Perrin Survey on the subject, the average cost to cover a family is expected to be about $14,000 in 2008. Seems like an outrageous amount, right? Also, everyone knows that if employers provide incentives to improve primary/preventive health care they will recoup the savings through lower long-term health care spending and that better employee health means greater employee productivity and engagement?

In the spirit of starting off the year in a strategic state of mind, I want to bring to your attention some contrary thinking on the subject.

John Graham of the Wall Street Journal in "Debunking the Health Care Myth" raises an original point on the subject of national spending on health care. The topic is invariably framed by noting that health care takes up around 16% of U.S. GDP and if its cost continues to grow at the same rate as in the recent past, it will soon take up the entire economy. Further, our expensive, inefficient, health care system puts at us a competitive disadvantage internationally.

Mr. Graham frames the issues somewhat differently.

But what about the share of Gross Domestic Product (GDP) spent on health
care, a metric of health system performance and value that some consider
definitive? The United States leads the pack in this regard, spending far more
on health than other countries. Surely this puts the U.S. at a competitive
disadvantage, doesn't it?

No: It's the other way around. America's high productivity gives us the ability to spend more on health care, especially the latest treatments and technologies, than other developed nations that labor under forms of socialized health care.

Robert L. Ohsfeldt and John R. Schneider of the American Enterprise Institute have determined that health spending increases at a constant rate of about 8% for every $1,000 increase in GDP per capita. For example, if GDP rises from $30,000 per capita to $31,000, health spending increases by $232. But if GDP per capita rises from $40,000 to $41,000, health spending increases by $500.

Thus, because Americans earn so much more than people in other countries, it naturally follows that we spend more on health care. Consider four countries whose
health-care systems are often held up as admirable alternatives: Canada, Germany, France and Great Britain. Certainly, the U.S. spends significantly more on health care than those countries do, but these nations also earn significantly less income per person.

Look at it this way: Even after paying for our health care, Americans have far more money left over than their neighbors to spend on other goods and services. It works out to about $8,000 more than the average German or Frenchman, and about 4,000 more than the average Canadian or Briton.

Put another way, after providing for basic food, shelter and clothing, is there some higher priority than health? As the economy grows more productive and richer over time, it is only natural that a larger share of our wealth will be spent on the one item that we cannot get enough of - health.

If you figure that the average employee is picking up 20% of total costs or about $250/month, there is a good chance that the employee complaining about the latest increase in required premiums or deductibles is spending more on his car payment than on health insurance.

A web site I came across from a group called "Health as Human Capital Foundation" contains blogs, articles and original research on the topic of health care in the context of overall efforts to improve employee productivity, well-being and engagement.

In one of the published papers: "Benefits, Rewards and Importance of Health", the authors, Wendy Lynch, et., al. address what would seem to be a settled issue: To what extent does an employee's health impact their job performance? In response to a broad 2007 survey of employees about their health and other aspects of their employment relationship, only 28% of surveyed employees strongly agree that staying healthy is important for them to be successful in their careers; 38% moderately agree and 29% disagree or are neutral.

Further, the authors note that only 10% or less of employees voluntarily participate in wellness programs and that participation is only significantly increased when there is a financial incentive (lower deductible or contribution) for employees to try and improve their health (e.g., smoking cessation and education programs).

This raises the question: how much should employers care about their employees health if a) it may not make much of a difference in job performance and b) employees themselves don't seem to be willing to make the effort to participate in wellness programs and prevention education unless they are paid to do so?

I have heard clients discuss another, related economic reality when they analyze "investing" in the well-being of their workforce. When it comes to health, prevention costs are front-loaded but the benefits of prevention through improved health and presumably lower health care spending are long-term. Given the increased mobility of the workforce why should an employer make investments to, for example, get employees to eat healthy and exercise, when the diabetes won't hit for 20 years.

Getting down to the tactical level, what does all of the above imply in terms of employer practices? Perhaps a smaller role for employers in softly encouraging their employees to improve their own health? Perhaps strong economic incentives for employees to manage their own health coupled with disincentives, to the extent legal, for unhealthy behaviors? Maybe we should be doing away with the voluntary "education" programs and pushing for even more aggressive cost sharing arrangements with employees.

This is much like the "consumerism" approach to health care that is a modest trend among employers. While I believe that the tools are not yet out there for employees to adequately take charge of the financial aspects of their health care, the economic incentives associated with high deductable health plans, coupled with health savings accounts seem to encourage employees to become more educated about prevention and long-term health.

Maybe its time for some tough love among employers. Stop encouraging employees to think of health prevention as something that benefits employers through improved productivity and lower health care costs and start encouraging them to think of improved health as something that they are responsible for as they will be the primary beneficiaries.

Alex Rodriguez and the Savior Syndrome

2007-12-17T09:58:00.000-05:00

Last night I watched Alex Rodriguez being interviewed on 60 minutes. Alex was there to talk about his great achievements in baseball and categorically deny ever having taken performance enhancing drugs. I believe him. But what I found most interesting about the interview and what is germane to the HR world was Rodriguez's failure to "come through" in the post-season despite being the highest paid play in baseball. Further, none of the three teams he has played on over his 10+ years of MLB play has even reached the world series. The New York fans have been vocal about his failures, his teammates have been disquieting quiet on the subject and it is a source of great regret to Rodriguez himself.

Substitute any major hire - particularly at the CEO level for Rodriguez, your company for the Yankees, shareholders for the New York Fans and employees for teammates and you have the makings of the "savior syndrome".

It is common to see businesses make the same hiring mistake as made by the two teams that have hired Alex Rodriguez subsequent to his first: the Rangers and the Yankees. Both teams made Alex by far the highest paid play in baseball with the understanding that he was going to bring their teams a world series championship.

But the team failures that have followed Rodriguez around the league like a bad cold often happen when an organization hires, usually from the outside, a high-paid, high-profile new hire with the expectation that he/she is going to "save" the company/division/location. Think Nardelli of Home Depot, and Fiorina from HP. Think of the new high-paid sales or marketing guy your organization brought in to finally 'help the top line grow'.

Bringing in a Savior creates problems. The enormous pressure on the new hire to quickly show results can lead to poor decision making. A more suttle and dangerous effect is the impact a Savior has on the motivation and morale of the rest of the organization. If everyone feels that the new hire is there to save the organization by making the tough personnel decisions, bringing in new clients, and otherwise doing the hard, dirty work of building a business, the impact on the organization can be demotivating and debilitating. There are too many leaders waiting for their leader to give orders. Compound that with the organizational schadenfreude of watching the the big-money guy fail, and you have laid out the foundation for failure.

Look at the impact of the Rodriguez on his teams. Personally, he has performed as advertised. His teams however actually seem to do better after he has left them.

My advice when bringing on an outside senior level hire is to lay the groundwork within the organization in terms of reasonable expectations. The senior team cannot sit back and watch the new guy show them how its done or even worse watch with quiet enjoyment as he fails.

While difficult to do in practice, it would be ideal to convince the high-level new hire that it is in everyone's interest to have her/her compensation in line with reasonable (conservative) short-term expectations of performance that escalates over time with results. As opposed to the more common scenario where a large hiring premium is built into base, incentives and and sign-on bonus.

The hard truth is that, even during the holiday season, businesses are rarely going to find a savior.

A deathly serious compensation Issue

2007-12-03T18:44:00.000-05:00

I believe pay-for-performance compensation systems stink but are still better than all the other approaches to rewarding employees. However, as a frequent flyer, a recent article in the Washington Post entitled "Pay System Causing Turbulence at the FAA" caused me some pause in my ideological certitude.

The article described discontent among air traffic controllers over the 10-year old "Core" pay-for-performance approach. Tim O'Hara, a 24-year FAA employee in a letter to the FAA wrote :

...The problems with the pay system.....are both myriad and a significant depressant on the morale of the FAA workforce. Significant corrections need to be made...

The article goes on to say that:

The core system has drawn criticism from some employees at the top of their pay scale, or pay band, for their job category. Because they have hit their pay ceiling, the employees receive their performance-based pay raises as a lump sum rather than as part of their base pay. More than 9,500 employees fall into this category, O'Hara estimated. Under the system's rules, the lump sum does not count toward retirement, a sore point for many of the employees.....

Okay. Maybe its just me, but I would make it a priority to keep Tim and his colleagues in the tower happy? I really do not want a bunch of depressed air traffic controllers distracted by thoughts of their compensation bumping up against their pay-band maximum directing my flight.

Also, if you are thinking about a job in the Federal Government note this:

The FAA ranked 204th out of 222 agencies in a "best places to work" index compiled this year by the nonprofit Partnership for Public Service and American University's Institute for Public Policy Implementation.

Let me get this straight. Sitting in a dark room, for hours at time, at government scale, under intense pressure to make sure that little blinking lights don't 'bump' into each other is only the 204 worst goverenment agency job out of 222. What in god's name are the other 18.

Memo to the President: Keep these guys happy. Please. I have a vacation coming up.

HR software or how to waste a lot of money real fast

2007-11-30T16:34:00.000-05:00

An article entitled "HR in a Box" in the WSJ the other day described the difficulties faced by small to mid-size companies in finding cost-effective system solutions to HR issues such as recruiting and performance management. It also reminded me of two major traps I have seen companies - large and small - fall into when purchasing software solutions to address HR processes.

.... Managing human resources is a common struggle for companies like StarCite. Small companies generally have few -- if any -- people dedicated to the job. And as the companies grow, their ad hoc systems -- often based on Excel spreadsheets and emails -- quickly become obsolete. Now a growing crop of software products aim to help growing businesses get their human-resources functions up to speed. Small-business people who use the products say they have a number of big advantages.
The software typically doesn't require complicated installation or database management. Many of the vendors offer a monthly subscription model, making them useful for commitment-phobes worried about cost. And not only do the products help manage standard housekeeping chores like annual reviews, they help companies better identify and reward top employees -- which keeps them from defecting to outfits with deeper pockets. A generally tight labor market "puts a premium on small and midsized businesses to come up with other ways of satisfying their work force -- to make sure high-performance individuals have a career plan,"
says Robert Anderson, vice president of small and medium-size business applications at research company Gartner Inc. in Atlanta....

No doubt about it. Mid-size companies - say between 25 and 2000 - employees have it rough when it comes to system support. Small companies can find good-enough solutions using Professional Service Organizations. PSOs can be expensive and outsourcing employment is not an ideal way to manage your people. But, when you are in start-up mode and focusing 100% of your energies on growing the business, you can afford to ignore sky-high per-capita administrative costs.

Once a company hits the higher end of the size-range, it can start thinking about realizing economies of scale in administration and move towards thoughtful insourcing and outsourcing to cost-effective vendors. Mid-size companies that find PSOs too expensive and are not big enough to spread technology solutions across a large employee/revenue base are mostly out-of-luck.

All that said, focusing on the costs of administration and finding the right technological solutions to assist in managing HR is Trap Number One. Human Resource functions such as recruiting, firing, performance management, compensation administration and career development require judgement and experience. Yes, technology can help smooth the processes but all the software in the world cannot replace the judgement needed to evaluate candidates for hire, figure out the best way to get dead-wood out of the organization or otherwise help create a high-performance culture.

HR processes do not necessarily need to be performed by HR professionals. In fact, in smaller companies, the CEO is likely to be the senior HR executive. Further, even in large companies, line management should be performing most HR functions with the advice of HR professionals. No matter what the title of the individuals performing HR, software without judgement, training and inclination to use it is worthless.

Recommendation for small and midsize companies: Unless the business case is obvious and the payback is almost immediate, stay away from expensive software and stick to the spreadsheets, e-mails and other organic HR processes that you already have in place. Hire HR expertise if you need it - even if only part-time.

And, on the subject of the inclination to use software, Trap Number Two is purchasing software without a change-management plan for getting individuals to utilize it. HR software will be utilized for two reasons. First, it obviously helps the professionals on the ground tasked with using it achieve recognized results such as hiring needed staff, improving employee benefit administration service or reducing lawsuits. The second reason the software will be used is because leadership has mandated it be used and enforces the mandate with serious penalties (e.g., you will be fired if you don't use it).

HR software that fits the first category needs only minimal change-management support. The word will quickly get around that the new software will help you get raises, promotions and other glory.

Software that fits the second category requires some serious thought and planning about changing behaviors. For starters, management has to be honest with itself about why it is purchasing the software. Often the stated reason is to "help"those expected to use it. However, if the real reason is because it allows the organization to better understand what is going on at the ground level or to standardize processes (both good reasons) the software can seem like a waste of time to those who are expected to use it. For example, software that helps the VP of HR keep track of the hiring pipeline requires input from individual recruiters as to offers, declines, and referrals. However, an individual recruiter may not find the software particularly useful in his/her job which merely requires keeping track of his or her own pipeline.

Recommendation for all companies: be honest with yourself and your staff about the purpose of the software in particular at what level in the organization will value be created. Prepare a change management plan accordingly.

There is a lot of great human resource-related software out there. Some of it is even cost-effective for smaller companies. If you follow these two recommendations before considering a purchase, however, you will have a good chance of avoiding the two biggest money traps.

The OTOH Quotient

2007-11-14T15:25:00.000-05:00

The most challenging and rewarding aspect of providing advice in the area of human resources is that there are rarely pat answers and most "solutions" have a high risk of creating unintended consequences. I was reminded of this the other day working with a client on structuring an offer for a high-potential mid-level executive. On the one hand, the client needed the new blood and the hire offered the potential of jump-starting growth. On the other hand, paying what was needed to bring the new hire on board might put at risk the the fragile fabric of team work and collegiality that made this firm historically successful.

On the one hand....On the other hand. Call it Tevye syndrome after the protagonist in Fiddler on the Roof who dealt with life's major decisions by contemplating his hands as he carefully weighed the alternatives. An organizational consultant might create a nice chart showing the "OTOH-OTOH" set of solutions.

What are the compensation issues with the highest OTOH quotient? That is, what are the issues where an approach creates significant opportunity for organizational improvement but also has a high risk of blowing things up. In no particular order, I list my choices below.

We need to bring in new talent. OTOH, we want this candidate - he/she can help us grow. On the other hand, what kind of message does this send to other high performing individuals at a similar level (and they all feel that they are high performing) who are invariably paid less than the new hire? Are they underpaid? Should they be looking to switch jobs for a big bump up in pay?
Sharply differentiate pay in a high performance organization. OTOH, we need to differentiate compensation and pay increases to reward and motivate our strongest performers without busting our compensation budget. OTOH, most of our workforce does not consist of superstars and we need teamwork for success. Providing a lot of 0% and 1% pay increases can be pretty demotivating after a while.
We never counter-offer. OTOH, we need to retain our strongest performers and have told all our employees we provide competitive compensation. If one of our top performers threatens to leave for a competitor offering significantly more compensation, we may have to come up with a counter offer to keep him/her and demonstrate competitive pay. OTOH, what does that tell the rest of our employees - you need to interview and threaten to quit to get paid competitively?
Goals need to be transparent and not retroactive. OTOH, employees need to understand how their performance will be measured - preferably on paper - and they need to feel that they have a chance to exceed their goals (e.g, don't find out about them at the end of the year). OTOH, we need to have flexibility during the year around performance metrics. Goals set at the beginning of the year are not necessarily going to be valid throughout the year as priorities change. But changing goals and metrics mid-stream creates a high demotivational risk.
We pay for performance. OTOH, we want to compensate for results. Without results, we have no business and no pay. OTOH, results do not always appear during a performance year and they are often due to somewhat subtle team dynamics. Also, even the strongest performers may have an off year. Do we reduce their pay with the risk that they see an opportunity somewhere else or do we pay for anticipated performance? After all, if we are purely compensating for past performance we run the risk of killing our business based on policy. As the old Jerry Seinfeld joke goes when the satisfied restaurant diner peruses the check after a huge meal. "I'm not hungry, why am I paying for all this food?"

What is the key to dealing with these issues. Be flexible. Rules like "we pay for performance" and "we don't make counter-offers", need to be constantly evaluated in light of changing conditions and circumstances. Collect as much data as possible, understand the pros and cons. If you can get it right over 50% of the time, that's not too bad. It's a tough job and if I was a rich man......

Playing with Other People's Money at Merrill, Citi and Bear Stearns

2007-11-06T20:55:00.000-05:00

What if someone gave you a million dollars to bet in Vegas and let you keep 50% of whatever you earned. Would you try to slowly build your revenue through conservative by-the-strategy black jack where you would have a very low probability of losing money but also a very small probability of winning anything substantial? Or, would you take a risky red bet on the wheel where you had a 52% chance of loosing it all but also almost a 48% chance of taking home half-a million? With nothing to lose and everything to gain, my guess is most people would go for broke.

When I read about the executive shake-ups at Merrill Lynch, Citigroup and Bear Stearns, I thought about the Vegas analogy. In each case, you have executives who have been able to play the 'heads I win, tails you lose' game with shareholder equity.

I never could get too fired up over the "excessive" executive compensation issue. If compensation is negotiated at an arms-length with a reasonably independent board, then CEOs have every right to whatever they can get. That is, I have the same feelings about the size of the pay package for Merrill Lynch's Stanley O'Neill, Citigroup's Charles Prince and Bear Stern's James Cayne as I do about the pay for Alex Rodriguez and Brittney Spears. Would I pay them what they were able to get from the Yanks and Zomba recording, respectively? No. But, do they have a right to get everything they are able to despite what many would argue is poor performance? Absolutely.

It is not the amount of pay that Messrs. O'Neill, Prince and Cayne were able to extract from their employers that should be a cause for concern. Instead, the problem with their pay was that performance targets seem to ignore risk and almost guaranteed the kind of billion-dollar hits to shareholder equity that recently occurred. Why not take a leveraged flyer on mortgages? The earnings were great while they lasted and the pay rewards were commensurate. When things went bad as they started to over the summer, the shareholders were left holding the bag.

Many compensation consultants believe in the premise that loading up executives with equity best aligns them with shareholder interests. I do not think so. Unless executives are taking cash and voluntarily purchasing equity or options, their interests will never be fully aligned with those of shareholders. Being given lots of equity only creates an incentive for risky behavior.

Portfolio Management 101 would say that you cannot judge the returns of an investment without also considering the riskiness of that investment. Higher returns generally equate to higher risks. But, in reviewing the proxies of Merrill, Citi and Bear Sterns, there is no mention of this basic premise in judging the performance or compensation of their CEOs. In fact, all three seemed to get pretty good reviews from their board.

Consider the ML Board's evaluation of Mr. O'Neill for 2006:

The Committee considered performance against the CEO objectives determined at the beginning of the year and noted that all financial targets were met or exceeded and all strategic and leadership objectives were met with distinction.
This review included consideration of numerous objectives but focused in particular on the following achievements [net revenue increases, pre-tax earnings growth, return on equity and various non-financial measures].

Or the Bear Stearn's review of Mr. Cayne's performance:

The Compensation Committee believes that the Company performed well during the 2006 fiscal year on both a relative basis, vis-à-vis industry competitors and on a year-over-year basis. The Company’s performance as measured by profit margins remained strong and earnings per share increased over the prior year. In addition, return on common equity was among the highest of the Company’s key competitors. The compensation paid to the Company’s executive officers for fiscal 2006 reflects the strength of this performance.

While the Citigroup Board seems to have been more discreet about revealings its performance evaluation of Charles Prince, there is no mention in the proxy's discussion of compensation around the importance of risk or risk-adjusted returns and he got a 10%+ increase in his bonus from 2005 to 2006.

Without a risk measurement of some type in the compensation reward formulas, there is little incentive for executives to not throw the dice Vegas style. And nobody should be surprised if they do. Public boards and management, particularly of financial services organizations, need to provide pay metrics around 'value-at-risk', and goals for risk-adjusted earnings growth and/or return on equity to ensure that executive incentives are more closely tied with shareholder expectations. Otherwise, shareholders will just need to continue to prey for the ball to drop on red.

Reflections on IRS Notice 2007-86: Tough Love Needed

2007-10-26T14:21:00.000-04:00

After the IRS released Notice 2007-86 less than two weeks after Notice 2007-78, both extending transition "relief" for complying with IRC Section 409A, I got to thinking about the insidious harm that ongoing extensions like this have on the benefit's community.

The IRS, through its own inefficiencies and misguided desire to be seen as sensitive to the concerns of business, is enabling all of us who work on employee benefit issues - benefit managers, consultants, lawyers, etc., - to acquire the habits of the the US government: ponderous, rule-smitten and somewhat whiny.

After all, where else in the business world can you routinely get away with not complying with an order from your boss (in this case Congress), until he/she comes back to you with extremely detailed guidance on how to comply with the order and then be further allowed to have several extensions to the original deadline before following through? Probably not too many places outside of the post-office and your local division of motor vehicles.

Take the most recent example. In late October of 2004, President Bush signed the American Jobs Creation Act of 2004. Included in that Act was IRC Section 409A which tightened up the rules around which "service providers" (employees to the rest of us) could defer compensation from "service recipients (i.e., employers) on a tax-deferred basis. The law's requirements are relatively straightforward and only applied to compensation deferred after the effective date. Further, almost immediately after enactment, the IRS published Notice 2005-1 that allowed for good faith compliance until more detailed guidance was published.

Also, almost immediately, the benefits community began expressing concern that there was lack of sufficient guidance to comply with the law and that, in any event, more time was needed to deal with the law's complexities.

Proposed regulations were published in October 2005 - a year after the law was passed. Not bad for the IRS. The proposed regulations provided for transition relief in complying with 409A until December 31, 2006 - a good year after the publication of the regulations and over two years after the passage of the Act. It would seem like plenty of time to comply.

But, as 2006 came to a close, the benefits community complained again about the complexity, lack of time, lack of guidance, etc., etc., In response, the IRS published Notice 2006-79 that extended the transition relief through December 31, 2007.

Final regulations were published in April 2007 without a lot of changes from the proposed regulations. There would seem to be plenty of guidance and time at this point to comply with 409A by any reasonable measure. But again, as 2008 grew closer, the pleas for extensions grew louder and more frequent and the IRS complied with a further extension through 2007-78 (not quite enough relief) followed within two weeks by 2007-86 (finally enough relief). Together these two Notices delayed full compliance through the end of 2008 - a good four years after the law was enacted and a good two-plus years after the proposed regulations pretty much laid out the details of compliance.

The grandaddy of extensions is around IRC Section 401(a)(4). It was passed in the Tax Reform Act of 1986 (signed in October 1986) and prohibited discrimination in tax-qualified retirement programs.

It was not until five years later in September of 1991 that the IRS produced regulations on the Act. And, these regulations were not even effective until 1994 a good seven years after the Act was passed. In between there were numerous notices, clarifications, rulings, etc clarifying the act. In between reams of paper were spent on compliance-related issues. In fact, the regulations and associated guidance continued to get updated and corrected at least through 2004.

These are just two examples of what seems to be an IRS habit of providing extensions and transitions around new laws. The rub is that we all go right along with the delays and even encourage it. The more time we have to review, revise and consult, the more time we have to review, revise, consult and notice problems that may impact one company in a thousand. Maybe we and our clients would be better off if forced to take action under strict deadlines and sometimes without total certainty.

Message to the IRS: do us and our clients a favor and put us out of our misery quickly and decisively. Write the law. Write the guidance. Make it stick. We need some tough love.

Diversity is good and other HR Insights

2007-10-19T12:26:00.000-04:00

I read a lot of Human Resource-related literature in the course of my business. Maybe too much. The HR profession produces a startling amount of unstartling conclusions along the lines of Emil Faber's "knowledge is good" or contains research that would not pass a sixth grade peer review panel.

Let me be more precise. Much of what purports to be ground breaking surveys, "thought leadership" or original research can characterized as stating the obvious or stating the obvious with lots of diagrams and numbers. When some remarkable or interesting conclusion is arrived at, it is often backed up with little or faulty research.

I am not saying this is always the case. There is unique, inspiring, well-written and well-written literature on HR subjects. I am saying that HR seems to produce more of our share of, how shall I say it, Junk.

What brought this topic to the top of my mind was a recent study by Catalyst summarized in Workforce Week:

Firms With More Women on Boards Perform Better Than Those That Don’t

During the span of a study [2001-2004], Fortune 500 companies with the highest percentage of women on their boards saw equity returns 53 percent higher than companies with the fewest number of women on their boards.

This one caught my eye. I do not have any problem accepting that greater diversity on a corporate board is going to help provide broader strategic perspectives and ultimately better decision making and corporate performance. But, a 53% increase in equity returns resulting from more women on the Board! Such a dramatic result just seems to good to be true, particularly for something as tenuous in causation as the the number of woman on a Board. The variables of corporate performance are too complex and numerous to isolate the individual impact of the sex of board members; and over only a four year period of study?

Scratch a little deeper and there are issues that give you pause with this study. Catalyst describes itself as "the leading nonprofit corporate membership research and advisory organization working globally with businesses and the professions to build inclusive environments and expand opportunities for women and business". It is always nice to have research that matches up perfectly with your mission.

Another issue is that the study looked at corporate performance from 2001 through 2004. Why not include the most recent publicly available data? Why not go back before 2001? Why not look at the most commonly used general measure of corporate performance: total shareholder return? I do not know the answer to these questions. What I am saying is that the research appears to be gamed to produce a specific result.

But I cannot just pick on Catalyst. Look at any HR web site or randomly peruse HR books or articles and you will find platitudes disguised as original research or faulty research.

Take employee engagement. Would it surprise anyone to know that an engaged workforce is going to perform better than an unengaged workforce? Yet, how much HR material is devoted to demonstrating this point or quantifying it? As if the effect of improved engagement, like the number of women on a board, can be measured against all the other complex and changing variables of corporate performance. How about minor things like, product quality, location, marketing, capital allocation, patents and sheer luck.

Towers Perrin, Mercer, Wyatt and Gallup among others have published extensive studies purporting to show the relationship between engagement and firm results. They have also published studies showing what drives engagement.

Watson Wyatt states that:

Engagement is a leading indicator of financial performance. Companies that increase their engagement levels can expect to significantly improve their subsequent financial performance.

Despite the conventional wisdom that immediate supervisors play a key role in driving retention and engagement, strong senior leaders who communicate effectively and frequently are a far more important factor.

Towers Perrin's study says:

The top drivers of engagement are different still. Here, the single most important element is whether employees perceive that their senior leaders are genuinely interested in their well-being. The number two element is whether employees feel they have been able to improve their skills and capabilities over the past year.

Mercer's Study says:

By analyzing key drivers, we can understand the issues that are the primary drivers of employee engagement. Most important is the need for employees to feel hope for the future of their organization, their place in it, and their potential to expand their skill and realize their goals. They need to feel emotionally connected to an organization that has a good reputation. They need to feel they are able to perform a significant job well.

Gallup says:

Investors, Take Note: Engagement Boosts Earnings...Companies with higher employee engagement levels enjoy greater growth in earnings per share

When deciding where to put their money, do investors take into account the engagement level of a company's employees? If not, it's time they did. Gallup research has found that higher workplace engagement predicts higher earnings per share among publicly traded businesses. Read our report of these groundbreaking findings.

So, what can we conclude from all this study of engagement: More of it is better and there are varying factors which can improve it.

Is HR unique among business disciplines in producing junk research? No. But we seem to produce more than our share.

Collecting 401(k) Plan Fees: A nice gig if you can get it.

2007-10-11T16:13:00.000-04:00

The topic of 401(k) fees is front and center these days and if you are in the business of choosing or managing a 401(k) plan for a company, you should take note. In my experience, small to mid-size companies and their employees are particularly hurt by several industry fee practices.

Representative Miller has sponsored HR 3185 which would require substantially more disclosure around 401(k) fees. His Education and Labor Committee has recently held hearings on the subject. The Department of Labor is also moving forward on a number of softer, regulatory, approaches to enhancing fee disclosures including requiring more fee information on the Form 5500, developing standardized fee disclosure worksheets and publishing more education on the subject via its web-site and brochures.

I guess this is wonderful news. The fact that 401(k) plans have supplanted traditional defined benefit retirement plans as the principal employer-based retirement savings vehicle has finally reached Washington and, after years of over regulating defined benefit plans, it has turned its friendly gaze to defined contribution 401(k) plans. Tellingly, the reaction from the 401(k) industry to this attention has been voluminous and vociferous. I've linked a couple of good examples of supporting /opposing testimony before Miller's Committee.

Of course, the issue at the bottom of all the high minded talk of transparency (everyone is for), fiduciary responsibility (all for), and participant disclosure (ditto) is money. And, in the end, notwithstanding all the jargon, this is not a particularly complex issue.

Let's start with the basic premise that there is a cost to running a 401(k) plan. These include record keeping, loan processing, employee communications, investment management and insurance "wrap" fees associated with products like variable annuities that are offered in some plans.

The fees come from one of two sources: employers pay them directly or employees pay them through reduced investment earnings or direct charges to their 401(k) accounts. When employees pay the fees they are more obliquely referred to as "Plan" payments.

You will see a lot of talk about about "bundled" and "unbundled" approaches to paying fees but the issue at the heart of the controversy over fees are the payments that are deducted from participant accounts through reduced investment earnings or through "wrap" fees which are also deducted from participant accounts.

These fees are not particularly transparent and they are usually charged as a percentage of assets under management. They are disclosed in investment prospectuses but that is about it. They do not show up on 5500s or participant statements. A good fiduciary will look at these fees in total when choosing its fund options but he/she will have trouble finding out how much of that money goes towards various plan services such as administration, investment management, employee education etc.

Similarly, plan participants, when choosing among investment options offered within the plan, will have a hard time figuring out how much of their contributions and earnings are related to the underlying investment and how much is going to pay for plan administrative and investment management services.

This is a particularly important issue for a plan fiduciary and plan sponsor in being able to effectively manage the services provided by the Plan or to compare vendor costs. If you choose a third party administrator, they may have a portion of their costs defrayed by payments deducted from the investment earnings in the funds offered in the plan. If you choose one company, such as Fidelity to manage your 401(k) plan, the same issue applies: How much is going to pay for administration and how much is going to pay for investment management?

Not surprisingly, those who make their money primarily by managing investments (e.g., Vanguard and Fidelity) like the system the way it is. They control how fees deducted from participant accounts are spent. Those companies that make their money through administration want more transparency. They rightly feel that if plan sponsors can control how much of plan money is spent on administration versus investment fees, they will allocate more money to administration and will be less likely to choose an investment house like Fidelity to administer their plans.

Another transparency issue that fiduciaries, as far as I can tell, have not really focused on and that is not being addressed by regulation or legislation (as it shouldn't be) is the industry practice of collecting its fees as a percentage of plan assets. Fees generally go up every year, even if services stay the same, without any negotiation with the fiduciaries or notice to plan participants.

No matter what regulations the DOL publishes or what legislation Congress passes, companies and their employees are footing the bills for a variety of 401(k) plan services. Good fiduciary practice is to understand and control how that money is spent.

Between the lack of transparency and automatic fee increases, being a 401(k) money manager is a good gig if you can get it.

Who has a better executive retirement plan: ExxonMobil or Wal-Mart?

2007-10-03T18:00:00.000-04:00

Over the past several years, with increasing frequency, clients are asking for competitive assessments of their executive retirement programs. This greater focus on executive retirement benefits is in part driven by the new proxy rules and in part by the general trend towards more oversight of executive compensation.

On to the title question. The answer is somewhat involved, so we'll give the short answer first and you can read on for more. ExxonMobil's executive retirement program is more valuable than Wal-Marts - but not by nearly as much as you would think through a review of their respective proxies.

Usually, a client wants to understand not just the relative value of their executive retirement program but the value of that program in the context of overall executive compensation. So far, so good. Retirement benefits are often a significant component of an executive's total rewards and their design can have a meaningful impact on executive attraction/retention.

What makes these competitive assessments so tricky is that the interpretation of the retirement dollars shown in the proxy is not always clear and there are a number of reasonable approaches to coming up with an apples-to-apples comparison across companies.

Consider three of the more significant issues that need to be addressed to arrive at a meaningful competitive analysis.

How do you compare the value of a traditional defined benefit (DB) pension plan with a deferred compensation or defined contribution plan (DC)?
How do you adjust for differing executive demographics (e.g., age, service) and compensation when comparing plans?
Should investment earnings be included in the value of a DC plan? If so, all earnings or just "above-market" rates on company contributions?

Take, as an example, a relative assessment of the retirement programs provided to the CEOs of the top two Fortune 500 companies, Wal-Mart and ExxonMobil, based on the 2006 proxy disclosures.

Wal-Mart provides a 4%-of-pay DC contribution and an enhanced DC plan with matching contribution levels that increase with an executive's service. The summary compensation table (SCT) in the proxy shows a company contribution of about $0.3 million to CEO H. Lee Scott's account. However, this is only for above-market rate earnings credited to the accumulated DC balance. After picking through the SCT footnotes you will arrive at a 2006 company contribution to the Plan of about $0.6 million. Ideally, this amount should be further adjusted to smooth out the back-loaded nature of Wal-Mart's enhanced DC plan. As a rough estimate, this would mean adding another $0.1 million to the accrual for a total of $0.7 million.

At first glance, Rex Tillerson of ExxonMobil seems to have a much larger retirement benefit than Mr. Scott. The SCT shows a $4.1 million defined benefit accrual in 2006. However, the proxy methodology for showing a DB plan accrual assigns most of the value in the latter stages of an executive's career - which is where Mr. Tillerson resides. Converting his DB accrual into a DC equivalent produces an annual 15%-of-compensation contribution over an executive's career. In 2006 this would be about $0.6 million. Add in the $0.1 million DC contribution and you get a total 2006 retirement plan accrual of $0.7 million. A big difference and equal in value to Mr. Lee's 2006 accrual.

But one final adjustment is needed for a competitive analysis of Wal-Mart's program. How much would H. Scott Lee's retirement benefit be worth if he participated in the ExxonMobil Plans. Afterall, Mr. Lee's pension bearing compensation is $1.3 million higher in 2006 than Mr. Tillerson's ($5.6 million versus $4.3 million). As a rough approximation, the adjustment would be to apply the 15% ExxonMobil DB factor to Mr. Scott's 2006 base and incentive compensation for the DB plan and add in the ExxonMobil 6%-of-base-pay DC contribution. The total is about $0.9 million.

While this analysis is greatly simplified, it is reasonable and shows two significant results. First, the $4.1 million DB amount shown in the SCT for ExxonMobil greatly overstates the annual value earned under the plan and second, that even after adjusting for this factor and the difference in compensation between Mr. Lee and Mr. Tillerson, the ExxonMobil retirement program is still more valuable (30%=$0.9/$0.7) than Wal-Mart's.

Finially, any difference in retirement value should be considered in the context of all other compensation. In Mr Lee's case, retirement benefits are about 2% of his overall 2006 compensation as shown in the SCT. In Mr. Tillerson's case his retirement benefits are a much more significant 30% of total compensation.

The GM/UAW Deal

2007-09-26T22:22:00.000-04:00

GM and the UAW arrived at a preliminary labor agreement yesterday. The terms of the agreement released to the public are purposely sketchy as it awaits communication and approval by the UAW membership. Based on what I have read, little of substance is changing. The union continues to bleed the pay, benefits and work rules it won over the years - just slowly enough to eventually kill it but not quickly enough to provide GM with the radical changes it needs to save itself.

Take, the cornerstone of the proposed deal: the implementation of a Voluntary Employee Benefit Association (VEBA). The VEBA would assume responsibility for the administration and financing of the union's retiree medical plan. The NYT describes the deal as follows:

The contract’s main feature — a health care trust called a voluntary employee benefit association, or VEBA — means that G.M. will no longer have to carry the debt it will owe for employee and retiree health care benefits on its books. Earlier this year, G.M.’s chief executive, Rick Wagoner, referred to those obligations as “very large and frankly formidable.”
That debt is estimated at $55 billion for the next 80 years. So G.M. will establish the trust with about 70 percent of that amount, making an upfront payment of cash, stock and other assets. The difference is expected to come from gains on investments by the trust.
In return, the union won guarantees that medical benefits for hourly workers and retirees and their families will remain in place for the next two years. G.M. will also invest money in its American plants, and will maintain its current union work force of 73,000, according to Ron Gettelfinger,

What is really happening with the retiree medical benefits? GM is transferring the liabilities for retiree medical benefits to a trust and then promising to fund those liabilities over time. There is an accounting benefit in that GM's balance sheet looks better without all the liability and it also appears as if they have been able to cap their future exposure to health care cost increases. GM has exchanged its open ended promise of retiree medical benefits to one that is more predictable. Potentially a good change for GM shareholders, but one that will not impact GM's cash flow for the foreseeable future (until either the cap kicks in or the VEBA trustees actually elect to reduce retiree benefits).

It looks like GM has gained a superficial concession from the Union. On the bright side for GM it has provided the Union with its own superficial concessions: an increase in the number of UAW members through a conversion of a lot of part-time employees to a lesser number of full-time employees and vague promises of investments in US plants.

The VEBA itself is basically a financing mechanism. A savings account. It does nothing to improve the lot of UAW members, improve the quality of GM cars or decrease health care costs.
The whole strike thing seems anachronistic. A bunch of guys walking around in a circle with placards yelling tired slogans of union brotherhood while fevered negotiations go on inside a conference room. This is not 1970. GM is right in the thick of the global economy and has little or no control over the pricing of its vehicles. GM and the other members of the "big 3" are no longer a monopoly that can pass on the costs of any labor agreement to consumers.

What is happening to employer-provided retiree medical benefits in the real world where unions do not have the traditional strength that they appear to have in the auto industry? They are going away. Companies are overwhelmingly either freezing these plans to new hires, reducing benefits significantly or terminating the plans altogether. I am not saying this is a good trend but it is a trend in reaction to competitive pressures.

Given that the unions and GM have so little power and that consumers obviously care less and less about whether there are GM cars to buy makes the negotiations closer to a civil war reenactment than a business negotiation. It would be kind of funny if the lives of the employees and suppliers were not so subject to disruption and insecurity.

Another dance around the basic issues of competitiveness and quality avoided by management and union alike - whew a close call.

Why Doesn't everyone work for Google?

2007-09-19T15:47:00.000-04:00

When I have a particularly bad day at office, I think back to an early potential career path teaching economics and wonder why I did not go into academia. Seems like nice working conditions - interesting colleagues, tree-lined pathways, lifetime tenured employment, no P&L to worry about.

It is similarly nice to be reminded why I decided to go into the practice of business rather than teach it. One such reminder was a study by Peter Cappelli, director of Wharton's Center for Human Resources, and Monika Hamori, a management professor at Instituto de Empresa Business School in Spain, "Are Franchises Bad Employers?"

A summary of the study was published in Knowledge@Wharton. But, I can save you the trouble of reading it. The short answer to the question they pose is: No. The longer answer is that franchises appear to offer a rewards package (pay, benefits, training) to their employees that is sufficient to attract the workforce they need. Not a big surprise. They wouldn't be in business very long if they didn't.

In analyzing data from a national employment survey designed by Cappelli, they found that franchises paid their employees better than comparably-sized independent operators in the same industry and offered more training. Indeed, when it came to training, franchises beat their independent competitors on two different measures: They not only trained a higher percentage of their workers, but they also provided more hours of instruction per employee, on average. They were also more likely to have a formal training policy and to use practices that required employee involvement -- like work-related meetings and Total Quality Management. Meetings may often be dull but, in many workplaces, they offer a genuine opportunity for employee input.

...Franchises don't trump non-franchise operators on every measure. They have greater turnover, and in their non-managerial ranks, they employ less experienced, less educated workers. They also have a higher percentage of part-timers. "A fair assessment might be that franchise jobs offer more [than non-franchise ones] to lower-quality workers," the two researchers write. The average McDonald's employee isn't weighing a job making Quarter Pounders versus one writing software for Microsoft. He's comparing it with one at the local Greasy Grill. And in that contest, McDonald's wins.

Cappelli and Hamori then raised the questions as to why, if franchises invest more in their employees through pay and training, their turnover is higher than in non-franchises? And, if pay and training are higher and turnover is higher than how do the franchises stay competitive?

As someone who has conducted field research over the years at institutions such as Arby's, McDonald's, Burger King and KFC, I think I can answer these questions. The franchises are much more capital intensive than their non-franchise counterparts and consequently are much more efficient. They also have gigantic marketing/branding advantages. Four or five individuals can churn out an amazing number of hamburgers and cokes during lunch at a McDonald's compared to a diner where you have a guy flipping burgers on a big grill and a waitress providing table services.

On the other hand, because they are so much more more efficient and capital intensive and because there are so many more employees per manager/owner, I suspect franchises cannot provide the same degree of management (or customer) touch as the non-franchises - ergo the higher turnover.

Putting my own academic hat on, if businesses did not provide a different mix of rewards, require different skills and experiences, and have limits to their growth and employee requirements, we would all be working at Google and nobody would be working to clean the rest stops on I95.

That's not to say that everything is always in equilibrium. HR executives and business leaders should, and typically are, constantly evaluating whether the workforce they are attracting and retaining is the workforce required to execute on the business strategy. And if it isn't they look to rejigger their total rewards package, recruiting strategy, leadership training, etc.

Deaccumulation of Assets

2007-09-11T17:26:00.000-04:00

It is 9/11 and I must admit it is somewhat difficult to focus on work. In fact, about everything I do on this day reminds me of 9/11. It was such an ordinary day at the office. Getting coffee, sitting at my desk, making and taking phone calls and reading and writing e-mails.

For better or worse, life has mostly gotten back to normal. For most of us, the only big change pre- and post-9/11 is the strip-down at the airport security lines. Given the wars in Iraq and Afghanistan, we are very fortunate to be able to focus on business.

With that said....in the retirement practice area, there is growing attention being paid to the "deaccumulation" phase of retirement. That is consultant-speak for how retirees draw down their assets to provide income. It is becoming a higher-profile issue as the large baby boomer cohort retires and defined contribution plans become the predominant form of employer-based capital accumulation.

I may be somewhat cynical, and am certainly not on top of all the research, but notwithstanding how important this issue is to the financial well-being of retirees, the big mutual fund houses have payed little attention to it. After all, it involves losing assets rather than just accumulating them. One recent and notable exception to this is an article I just came across from a financial advisor at Russell - Richard Fullmer: " Modern Portfolio Deaccumulation: A New Strategy for Managing Retirement Income"

I cannot due complete justice to Mr. Fullmer's point, but essentially he is saying that traditional portfolio optimization strategies do not work during the retirement deaccumulation stage. These strategies either need to be too conservative to avoid any probability of outliving assets or they require sacrificing a retiree's income based on the year-to-year vagaries of the market - again to ensure a low probability of outliving resources. Alternatively, the strategy of purchasing a fixed annuity at retirement has not been attractive to large numbers because of the perceived sacrifice of too much liquidity or because of the perceived lack of transparency in the annuity marketplace.

As an alternative deaccumulation strategy, Mr. Fullmer suggests optimizing a portfolio around a time horizon - say 20 years - over which the retiree would have a high probability of being able to purchase an annuity. Instead of a risk of financial ruin or a lower standard of living if investment performance is worse than expected, the worst case outcome is purchasing an annuity earlier than anticipated. The portfolio would ideally be reviewed each year and potentially modified in light of the time horizon and investment performance.

This innovative approach allows the retiree to retain significant upside on portfolio returns while still being able to minimize the risk of outliving assets or reducing retirement income due to poor returns.

Mr. Fullmer does seem to leave out one significant risk. Annuity purchase prices are heavily influenced by prevailing interest rates, so the purchase price can change significantly year-to-year along with the portfolio itself.

I like the thinking behind this and look to see both more such research on this critical piece of the retirement puzzle and more competitiveness and transparancy come into the annuity space.

Transparency Part II

2007-09-04T13:59:00.001-04:00

Fees charged by 401(k) administrators and investment funds are getting a lot of attention these days and that is a good thing. 401(k) "defined contribution" plans have become the predominant employer-based retirement savings vehicle for employees and fees charged to the Plan directly reduce an employee's retirement income.

The latest entry into the discussion is Representative George Miller. He has recently proposed "The 401(k) Fair Disclosure for Retirement Security Act of 2007" (like most pieces of legislation, it certainly is hard to oppose something with such a well-crafted title). The bill would require disclosure of fees charged to participants in clear and simple language and disclosure of all conflicts of interest to employers who sponsor 401(k) plans.

The issue of fees was not such a big deal as long as the primary employer-sponsored retirement savings vehicle was the traditional defined benefit pension plan. Since employers pay all expenses associated with these plans, employees just don't have an interest in the issue. And, as employers are in a pretty good position to monitor and negotiate expenses, they are able to ensure a pretty competitive product anyway.

Under a defined contribution plan such as a 401(k) plan, plan expenses may be paid by the employer or they might be paid by the employee in the form of reduced investment returns in their accounts. According to a survey by the Profit Sharing/401(k) Council of America, about two-thirds of Plans charge employees for investment management fees and about one-third charge employees for other administrative fees.

The fees charged to employee accounts can vary significantly depending on a variety of factors including the deals their employer has struck with the vendor(s), the types of investments and loan/distribution activity. But one academic study by Alica Munnell, et al... at Boston College's Center for Retirement Research attribute the 100 basis point difference between returns in defined benefit and defined contribution plans to higher investment management and administrative costs associated with defined contribution plans.

100 basis points can be substantial over time. For example, an employee who invests $5,000/year and earns 7.5% over 25 years will accumulate about $316,000 assuming 0.5% in expenses. If the expenses are an additional 1% per year, the accumulation drops by over $40,000 to $274,000. That's a 13% reduction.

Whatever the merits of proposed legislation, the increased spotlight on 401(k) fees can only help to increase the competitive pressure to reduce them. This is especially important in that employers should, but probably do not, monitor these fees as carefully as they would if they were not typically passing them on to employees.

The Uninsured

2007-08-30T10:31:00.000-04:00

The census bureau published its annual report yesterday on "Income, poverty and health insurance coverage in the US: 2006". .

There are any number of interesting facts that are contained in the full report. But for people interested in health care benefits, there are a few worth highlighting.

The one that received all the publicity was that the rate of individuals in the US without Health Care Insurance in 2006 was 15.8% up from 15.3% in 2005. What got somewhat less publicity was the statement by the census bureau that

Health insurance coverage is likely to be under reported on the Current Population Survey(CPS). While under reporting affects most, if not all, surveys, under reporting of health insurance coverage on the Annual Social and Economic Supplement (ASEC) appears to be a larger problem than in other national surveys that ask about insurance.

Check the actual report for causes of the under reporting. Also, I could not find out the potential magnitude of the under reporting.

That being said, the trend in the rate of uninsured s clearly up. It was 12.9% in 1987. Put another way, the percentage of health-insured has dropped from 87.1% of the US population to 84.2% since 1987.

Notwithstanding the press reports, is this increase in the rate of uninsured that surprising? Health insurance costs have risen over two times the rate of inflation over since the late 1980's (2006 Kaiser/HRET health care survey). Take any product that has had such an increase in real price and I'm guessing less of it will be purchased - even one as critical as insurance. Gasoline is another product that is critical and the demand for it also responds to price increases.

Actually, when you consider how much health care costs have gone up, it may be surprising that even more employers/individuals have stopped purchasing insurance.

All this raises an interesting question that I have not seen addressed very often. Is it bad that almost 16% of our population is not insured for health? Consider that of that group, 40% are between the ages of 18 through 34, 50% work full-time and 38% earned in excess of $50,000 (20% over 75,000). It is probably fair to say that a significant number of the uninsured were uninsured by choice to the extent that they could purchase health insurance but made a conscious decision to spend their money elsewhere.

An individually-purchased, comprehensive health insurance policy for a family might cost anywhere from $400 to $1000 per month depending on deductibles, coverage, etc. Now, there are admittedly all sorts of underwriting issues for those required to purchase insurance in the individual market, in particular pre-existing condition exclusions. But, the numbers strongly indicate that a significant number of the uninsured are uninsured by choice.

Transparency

2007-08-27T15:26:00.000-04:00

Workforce Magazine recently cited action by the New York State Attorney General to get underneath the hood of how insurance companies rank the quality and efficiency of doctors. Insurers provide information in these areas to, in theory, help their customers be more informed consumers which will in turn help control health care costs and improve quality.

The New York Attorney General’s Office is seeking information about programs used by Aetna Inc. and a Cigna Corp. unit to rank doctors based on quality and cost-effectiveness.

In letters sent to the two insurers on Thursday, August 16, Attorney General Andrew M. Cuomo expressed concern that the physician rating programs of Hartford, Connecticut-based Aetna and Philadelphia-based Cigna carry “a significant risk of causing consumer confusion, if not deception.”

The attorney general expressed similar concerns in a letter sent to a unit of Minnetonka, Minnesota-based UnitedHealth Group Inc. last month.

The programs—Aetna’s Aexcel and Cigna Care Network—are designed to encourage consumers to choose specialists based on quality and efficiency metrics and may be used by employers offering financial inducements such as lower co-payments and deductibles to promote cost-effective doctors, according to the letters.

This goes right to the heart of whether Consumer Directed Health Plans (CDHPs)work to improve quality and reduce health care costs. CDHPs provide information about the cost and quality of health care providers and drug alternatives and use high deductibles and, often, tax-favored health care savings accounts, to incent employees to shop for the most cost/benefit effective health care available.

The premise of CDHPs is that individuals actually have the means to purchase health insurance in the same way they purchase a car. Leaving aside, that health care purchases carry somewhat more weight than a car purchase, can an individual get their hands on the information they need to be an educated consumer?

While there seem to be many information resources for individuals to educate themselves about health care issues and provider quality, shopping for price is another matter. First, it does not seem practical to shop for a cost-effective surgery when there are so many disparate and independent providers that produce a surgery (e.g., surgeon, anesthesiologist, hospital) or for an emergency room visit. Second, I know of no resources that provide information on costs even if you had the knowledge and time to research a complex medical procedure.

The New York State action, makes you wonder if even the quality information is so reliabile - at least information provided by those institutions with some sort of vested interest in your provider choice.

This adds to the fair amount of disquieting information about CDHPs. One piece that seems to have gotten a lot of publicity is a survey produced in late 2006 by the Commonweath Fund and EBRI that provides a fair amount of evidence that CDHPs actually incent the deferral of needed care through high deductibles.

CDHPs may be helpful to employers in remaining competitive by reducing health care costs. But, unless there is signficant development in the marketplace for health care information, it would seem to me that their main benefit is to shift costs from employer to employee. That is not necessarily a bad goal. Cost shifting can provide a good platform for bringing employees into the difficult cost choices employers must make to remain competitive and create a greater line of site with the business. What a CDHP does not seem able to do at this point is to actually improve health care or incent more cost-efficient purchasing.

The Big Exchange

2007-08-08T16:56:00.000-04:00

Corporate America is in the process of making an historic transition of risk and financial responsibility to its employees as Companies move, or consider moving, from traditional comprehensive medical plans to “consumer-driven” health plans (“CDHPs”) and from defined benefit to defined contribution pension plans.

CDHPs are a catch-all category for employer-provided medical plans with high deductibles (e.g., $3,000), various forms of information about the cost and quality of providers, savings accounts with acronyms like HRA and HSA and other features that are, in theory, supposed to incent employees to manage their own health care more effectively than under traditional comprehensive medical plans.

Defined benefit pension plans are those that guarantee an annuity to an employee at retirement payable for their lifetime. The company is responsible for all investment risk and the risk that the employee has a longer-than-average life span. Under a defined contribution plan, employees are responsible for investing their own retirement savings and the risk that they outlive their savings.

The transfer of responsibility and risk to employees is driven by a desire to reduce costs, remain competitive and, in the case of CDHPs, a belief that they can result in improvements in employee health.

Nothing wrong with that, except that for a number of structural, actuarial and regulatory reasons, employees are not able to adequately prepare themselves for the additional financial risk and responsibility being transferred. There is also some evidence that CDHPs may actually result in higher long-term health care costs to employers.

Human Resource Professionals probably cannot impact these trends, but they can help ensure that their companies make such a transition in a way that minimizes the negative impact to employees and even use it positively to reinforce corporate business messages and line-of-sight.

This is clearly a very broad issue which I have just summarized. In follow-ups, I will address particular aspects of the problem and explore various options.

Creating Something New

2007-08-08T14:04:00.000-04:00

After almost 25 years of working for others as an actuary, corporate compensation and benefits manager and finally a principal with Towers Perrin, I started my own advisory firm to help clients design, implement and administer their employee compensation and benefit programs - MarksonHRC.

The idea of MarksonHRC is to provide first class, advice and service at a reasonable cost, integrated across the broad array of expertise required to develop solutions in the C&B area. The premise of MarksonHRC is that value can be created through the strategic management of deep expertise without regard to physical location or firm label.

MarksonHRC also addresses gaps in the advice and service that I have consistently heard clients say they receive in this area. These gaps range from advice mixed in with product commissions to services provided by inexperienced associates to impractical ideas.

So, with the above in mind, this blog will revolve around the admittedly very broad arena of employee compensation and benefits. What are the trends and competitive practices?, Pros and cons of different approaches, interesting and innovative ideas, articles and resources and even what's changing in the regulatory environment.