Every company needs a captain to lead it, but how well does the executive compensation package reflect the contribution to the team?
With no cap on salaries or playbook to consult, executives can practically write their own employment and compensation contracts. But, as major players in the U.S. financial industry go under (or struggle for existence) and the heads of those companies pocket millions, executive compensation is coming under heavy scrutiny. Although the level of pay isn’t as high in Canada, the stakes are the same. Publicly traded companies will need to revamp their rule books and be clear on their strategies if they want to avoid controversy around how their executives are paid.
The Fundamentals
Although executive pay packages are highly customized, most include core elements such as a base salary, short-term incentives (often in the form of an annual bonus), long-term incentives (normally stock options and share units), retirement arrangements, benefits and perks. “For CEOs at big public companies, most of their compensation comes from longterm incentives,” says Ken Hugessen with Hugessen Consulting, adding that stock options often comprise most of the monetary value of executive pay. For example, data from Canadian Business show that Research In Motion chief executive officer Michael Lazaridis’s total compensation is $51.5 million. Without stock options, it is approximately $2.85 million—a significant difference.
But, according to industry experts, stock options aren’t being doled out as quickly or in the same quantities as they used to be. “Prior to the Enron scandal, everyone was handing out stock options left, right and centre, and stock options started getting a lot of bad press,” explains Robert Levasseur, senior consultant, executive compensation, with Watson Wyatt Worldwide. Now, more restricted share units (RSUs) and performance share units (PSUs) are entering the mix.
“With an option, if the stock price goes down, the recipient doesn’t get anything. With an RSU, it could initially be worth $10 but if the stock goes to $8, the person still gets $8,” explains Hugessen. However, with a PSU, individuals need to meet performance conditions. “You don’t get it for just fogging a mirror,” he says, adding that bigger companies usually do a fiftyfifty split of RSU/PSUs and stock options. “Stock options provide the opportunity to have the upside of what can be, in some cases, a hefty amount of stock. The payout is much less certain than [RSUs], but it is potentially much, much larger,” Hugessen explains. He adds that a base salary provides executives with security, which is something executives like. “The two things executives naturally seek are to limit risk and to increase opportunity. The trick of a good plan is to have a balance between the two.”
Game Highlights
$1.9 million a year for 23.6 years of service, $1.45 million a year for 10.3 years of service—these aren’t the details of professional sports contracts; these numbers are the annual amounts payable at retirement for Jeffery Lipton, CEO of Nova Chemicals Corp., and Gordon M. Nixon, CEO of the Royal Bank of Canada, respectively. While these numbers may seem jaw-dropping at first, their companies are two of the top 50 revenue generators on the Toronto Stock Exchange. Pensions like these are the norm for people in their positions.
Executives get the same pensions as other company employees, but they also often receive a supplemental employee retirement plan (SERP) to provide benefits in excess of the Canada Revenue Agency maximum. According to David Grace, a principal and actuary with Eckler Ltd., most companies that offer defined benefit plans offer a SERP to executives. However, those with defined contribution (DC) plans tend not to follow suit. “Most companies with DC plans don’t offer top-ups by means of a pension plan, but they may take it into account in terms of bonuses,” he explains.
But when you’re making millions, how important is a pension? For older executives, pensions can be a good retention device— especially for people who have been with a company for a long time. “Pensions are often designed to be worth far more if you stay than if you leave,” says Hugessen.
Grace agrees, adding that pensions can play a role in attracting executives as well. “Pensions are very important at the senior level, particularly for mid-career hires—people who are 45 to 50.” He says that it can be difficult to move a person from his or her current employer if an executive pension arrangement is in place—especially if the person is going to lose 20 years of top-up pension.
In cases where large organizations are trying to poach executives from other companies of similar size, the practice of buying back service is sometimes used— which can be a costly endeavour. “Buying back service can be a bit of a minefield,” Grace warns. “When you are hiring a senior person and offering to keep them whole or [offering] some kind of pension for prior service, you should know what the estimated cost is so that you can make an intelligent decision. The board or the compensation committee should also know what the number is.” He adds that although buying back service isn’t common practice in the grand scheme of things, it does happen regularly in sizable financial institutions.
In addition to generous salaries, hefty bonuses and great retirement arrangements, members of a company’s starting lineup get extra perks. Although these components don’t cost much compared to the rest of the compensation package, they hold a lot of value for executives. “You can’t believe how many times I’ve heard executives complain because they met the guy who did what they do, in another company, and they are driving a Lexus,” says Levasseur. “It’s about image.” Vehicles, club memberships and tax or financial planning are among the top perks that executives want. Plus, according to Levasseur, executive medicals that go above and beyond what one would get from the average doctor visit are an emerging trend.
Pay For Play
According to Statistics Canada, the median pre-tax family income in Canada is $63,600—minor-league compensation compared to what those on Bay Street make. It’s a fact that people have come to accept, and few debate the sums being banked by corporate MVPs unless the company isn’t doing well.
However, not to pay a CEO in a year when the company’s stock price has dropped and to give him or her a large bonus in a year when the stock price skyrockets is oversimplifying the issue. “If you don’t pay them in a bad year, that’s when someone else will snap them up in this competitive market. Even if the company is not doing well, there is a minimum it has to pay,” says Levasseur. “We call it pay for performance, but it’s more recognition for performance.”
That said, experts agree that executive pay and performance should be better linked. However, doing so is one of the biggest challenges of executive compensation, and it’s often a matter of perspective. “It depends on how you define performance— whether you have a long-term view or a short-term view,” Levasseur explains. “Linking pay and performance has always been, and will always be, a challenge with executive compensation. It’s really incumbent on management and the board— especially the compensation committee—to spend as much time as they can to develop plans that actually link pay and performance, however they want to define it.”
He says that consultants have seen compensation committees taking on a more active role in designing compensation programs. As this new behaviour matures, Levasseur expects that management and compensation committees will work as a team to develop compensation plans. “In the old days, management would present a compensation program to boards and it would be either approved or rejected. Now, there is much more of an active part being played by the compensation committee.”
Hugessen agrees that there is more collaboration than in the past on defining performance and the scope of pay. However, he points out that there are still some areas that require change—specifically, severances and change-of-control provisions (also known as pay-for-failure provisions). In the wake of the fiascos in the U.S., these items have come under review. “The problems emerge when people begin to soup up change-of-control provisions so that, in some cases, they become ridiculous,” Hugessen says. “I think these programs started in a useful way and continue to play a useful role, but in some instances, there are a number of features that need to be changed and the overall generosity restrained.”
South of the border, a trend of setting sunset provisions on severance arrangements has begun to emerge. Essentially, some companies have implemented severances that decline over time and amount to very little or are eliminated completely. The theory is that when an executive is hired, the risk of being terminated is higher initially than it is later on in his or her career with the company. If an executive is coming from a similar position in another location, he or she may be risking a lot financially, and a severance would protect against that risk. However, as the executive continues in the position, he or she should start to benefit from the pay package so there is less need for a severance. “There is talk of it in Canada, but I haven’t seen it yet,” says Levasseur. “It’s big with boards, but senior executives, especially CEOs, are not as enthusiastic about it. I think, over time, we will see some change in Canada, but I think it will be gradual.”
In addition to adjusted severance provisions, Hugessen thinks companies should eliminate single-trigger change-ofcontrol provisions. Parachute agreements (often called “golden parachutes”) allow executives to be financially protected if there is a chance of control in the company. Parachutes with single triggers allow executives to receive the full benefit (often, a severance, bonus and stock options) when a single inciting event occurs—for example, the executive quits or is fired. Hugessen argues that a more sensible alternative is to use double triggers so that two inciting events (a change of control and subsequent termination of employment, for example) need to occur before the executive gets the package. “There is no reason that a program should allow someone to walk out the door just because they don’t like the new owner of the company.” Although the types of changes are up to individual companies, there are regulatory changes coming that all public companies will have to abide by.
Levelling the Playing Field
In 2009, public companies will have to adhere to new disclosure rules for executive compensation. New rules recently went into effect in the U.S. Due to the fact that many Canadian companies are also listed in the U.S., Canadian regulators felt it was important that Canada not fall behind on requirements and, therefore, reviewed and amended the legislation. The new rules, which will require that all forms of compensation for executives be disclosed, will also require companies to explain the reasons behind each compensation element, how the company came to determine the dollar amount and how the amount—and the reason for it—fit into the company’s overall compensation strategy.
These changes should clear up some of the hows and whys of executive compensation and will provide more accountability. In the turbulent times that investors are enduring, such changes will surely be welcomed. The question is, How much impact will these new rules have on executive pay?
“I don’t think companies are going to make as many mistakes [that lead to] unintended results,” says Grace. He explains that the most common mistakes are including bonuses in the pension formula (or doing so without understanding the ramifications) and using vague agreements that leave room for interpretation. “[Companies] will have to be careful that they have their own plans and they stick by [them],” he says. “If the next Sidney Crosby comes along, they might not be able to afford him. They’ll have to accept that.”
Grace also advises against negotiating contracts in the heat of the moment. “It’s like making a trade at the trade deadline. I think, sometimes, people do things under pressure that they wouldn’t do normally.”
Post-game Strategy
In the end, negotiating executive pay packages needs to be a team sport—not a match for management, compensation committees or boards to take on alone. Andrew MacDougall, a partner at Osler, Hoskin & Harcourt LLP, suggests that sufficient due diligence be done before any contracts are signed. “That means looking at the executive’s tally sheet for compensation—including pensions and benefits—considering the amount that would go to them in various termination scenarios and complying with the minimal legal requirements and with best practices.”
However, while applying best practices and abiding by all laws may keep companies out of legal trouble, it doesn’t mean they will escape controversy. “The problem with executive compensation is that it is, and always will be, controversial,” MacDougall says. “Executives want to maximize their compensation, and the board of directors wants to maximize shareholder returns. There will always be a tension there.” So, while public companies may not be able to completely avoid controversy over compensation for their star lineups, with proper planning and thought, they can at least minimize the fumbles and unsportsmanlike conduct.
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