Director Pay: The Gathering Storm
from
September/October 2006
by Julie Connelly
When it comes to their own pay, board members have decided to cool it. The boards of 350 large companies surveyed by Mercer Human Resource Consulting gave themselves a median raise of a scant 6.1% last year, to $164,637. That’s a paltry increase, considering the 50% hike directors of big companies rolled up over the previous four years. Not that they’re overpaid—hardly anyone thinks they are, not even such governance sentinels as the Corporate Library. No, the reason board members were smart to keep the lid on last year is that their bosses, the shareholders, are really,
really
upset with one particular aspect of their spending habits—namely, the lavish packages they bestow upon their CEOs. You don’t have to be Peter Drucker to know that when the boss is unhappy, your job security wobbles.
Some shareholders are so angry that they’re meting out punishment. This year the Catholic Funds, a Milwaukee-based mutual fund outfit, sponsored resolutions at six companies—AT&T, Cendant, Exxon Mobil, Honeywell, Merrill Lynch, and Wells Fargo—that would allow shareholders to vote annually on board pay. “We believe that directors who recommend excessive CEO packages should be held accountable,” said the resolutions. “One way to do this is to allow shareholders to vote on directors’ compensation.” Support for the resolutions was comparatively weak; about 9% of Merrill’s shareholders liked the idea, for example.
Even a majority vote would not have obligated any of these companies to put the issue on next year’s ballot, but the signal was clear. Shareholders are getting impatient and focusing on members of compensation committees. Some comp committee members have garnered so many “withhold” votes at annual meetings that it is becoming a subject of gallows humor among them. At the cocktail party before a regional meeting of the National Association of Corporate Directors, edgy board members ribbed one another about who would get the fewest votes at the next round of annual meetings.
Meanwhile, shareholders are sharpening a far more effective instrument to express their views––majority voting for directors. An estimated 140 resolutions this year called for directors to be elected by majority instead of plurality vote, up from 89 in 2005. (At present it’s possible for a director to be elected with even a single-digit percentage of the votes, as long as no rival gets more.) Most of these resolutions aren’t binding either, but it’s easy to see what shareholders are pushing for. Why try to cut big-spending directors’ pay when they can throw the bums out instead?
Is the message getting through to board members? “I think there’s a sense of urgency among them,” says Robert Felton, the leading consultant of McKinsey & Co.’s board governance practice and director emeritus of the consulting firm. “The genie is out of the bottle.” Adds Donald B. Rice, chairman and CEO of Agensys Inc., a biotech company in Santa Monica, California, who sits on the compensation committees at Amgen and Wells Fargo: “All board members have a heightened awareness of pressure from shareholders generating votes on these things. We’re not just sitting there scratching our heads. We’re trying to make a judgment on what’s right.”
Other trends in director comp are pretty much what they have been for the last several years, according to the 2005
Mercer 350 Director Compensation Survey and Trends
report. Meeting fees are being deemphasized; options are giving way to grants of restricted stock; and boards are increasingly insisting that directors make substantial investments in company shares and hang on to them. The changes are welcomed by Diane Lerner, senior compensation consultant at Watson Wyatt. “This isn’t an area where you want too many bells and whistles,” she says. “You want to pay directors fairly so they can focus on what they’re doing, and you don’t want too much complexity in the package.” But under the placid surface, there is some thrashing around that could affect compensation in the years ahead. First, interest in paying directors for performance has spiked as a result of Coca-Cola Co.’s announcement that from now on it will tie board members’ entire pay package to whether the company meets a three-year target for earnings growth.
Next, the new Securities and Exchange Commission regulation calls for complete disclosure of the pay packages not only of CEOs and various other executive officers but also of individual directors. This probably won’t affect board pay much, but some directors could be embarrassed when the dollar values of their perks stand revealed.
The structure of board members’ wages is undergoing an interesting modification. Directors’ comp arrives in two chunks. The first, typically between 40% and 50% of the whole, is the total annual compensation retainers for board and committee service and fees for attending meetings. Last year this piece rose 6.7%, to a median $80,000. While annual cash retainers were up 12.5% and committee-chair retainers surged 25%, board and committee meeting fees remained flat, at $1,500, and are slowly being phased out in favor of larger retainers. Some 61% of the 350 big companies surveyed by Mercer paid directors to attend each board meeting, down from 64% in 2004; 63% paid committee meeting fees, versus 65% in 2004. Showing up is starting to be recognized as part of the job. As Dan Dalton, a management professor at Indiana University’s Kelley School of Business, puts it: “A thousand dollars for a meeting? That’s stupid. You hire me to be a college professor—should I get a bonus for each class?”
The second pay chunk, making up 50% to 60% of a director’s total package, is what Mercer calls the total long-term incentive grant value. This is the aggregate value of all options, stock grants, and restricted stock grants or units that the director receives for the year. Incentive pay increased 5.9% to a median $89,684 last year on the boards Mercer surveyed—significantly less than the 30.7% hike in 2004. (See the chart on pages 46 and 47 for how the cash-stock split breaks down in various industries.) Because the number of shares granted remained pretty constant, the increase came from stock-price appreciation. Stock options declined in prevalence; 53% of companies offered them in 2005, down from 59% in 2004. Instead, restricted stock is on the upswing, offered by 41% of companies versus 39% in 2004.
No matter what shape it takes, the equity component of director pay has more strings attached than it used to, in the form of ownership requirements and holding periods. Some 47% of companies now have ownership guidelines for their directors, whereas only 25% did four years ago. Board members at these companies are generally expected to own shares worth three to five times their cash retainers within five years of joining the board. If they own more than that, they are presumably free to dispose of the excess as they wish—but not necessarily on their own timetable. Watson Wyatt’s Diane Lerner says, “There are increasing requirements that directors not sell their shares while they are on the board.” And when pay goes up, so must the director’s investment in the company. For example, this year the DuPont board increased directors’ cash retainer from $50,000 to $85,000 and raised its guidelines for the amount of stock a director must own from $250,000 to $400,000.
Directors in general come under not-so-subtle pressure to convert their cash retainers into equity or defer them into some kind of equity account. The insurance company Chubb notes in this year’s proxy, “Our Board has adopted guidelines suggesting that eligible non-employee directors voluntarily defer 50% of all stipends into a market value account.” Until last March, General Motors required non-employee board members to defer $140,000 of their annual $200,000 pay in restricted stock units. Directors have now halved their pay to $100,000—and must defer all of it.
Deferrals combined with ownership guidelines and mandatory holding periods can create hardships for what James Reda, managing director of his own compensation consulting firm in New York City, calls the “smart-but-not-rich director,” often a university professor. If such people spend what little spare time they have moonlighting on a board, they need to be paid for it now. “Most boards allow you to take your fees half in cash and half in stock, but they do forget that not every director is a CEO who has amassed great wealth,” says Julie Daum, who runs the board recruiting practice at the Spencer Stuart search firm. “If you don’t get paid that much and then you have to own so much stock by year five, it can be difficult.” Adds Peter Oppermann, a principal in Mercer Human Resource Consulting’s human capital advisory service business, “You don’t want to make pay so long-term that people can’t afford to serve.”
Pushing directors to own more and more stock in their companies tethers their finances to those of shareholders, of course. But directors could wind up tethered to management instead if other companies fall into line with the decision by Coke’s board members to pay themselves all or nothing depending on whether the company meets an annual target of 8% earnings growth compounded over the next three years.
One hesitates to dispute the wisdom of such a high-powered group—the board includes Herbert Allen, CEO of the Allen & Co. private investment firm; Cathleen Black, president of Hearst Magazines; Barry Diller, chairman and CEO of IAC/InterActiveCorp; and, until April of this year, Warren Buffett, who is widely presumed to be one of the architects of the plan. But this kind of pay for performance pushes the envelope on conflict of interest.
John Wald, an associate professor of finance at the University of Texas at San Antonio, is the co-author of a paper positing that company performance is negatively correlated to excess compensation of directors; the Catholic Funds used his work as a basis for arguing that shareholders should vote on director pay. But Wald doesn’t see Coke’s plan as a way to deal with excess director compensation. Far from it. “It creates perverse incentives,” he says. “It encourages too much risk in order to get to the threshold. And if you are already at the threshold, there are incentives to coast rather than do anything to put the payout at risk.”
Among the minority of compensation experts who like the Coke idea is executive compensation consultant Brian T. Foley in White Plains, New York. “The plan does send a powerful message to shareholders that ‘we care about earnings,’” he says.
That’s just the problem. Should a board be so intently focused on earnings? Or is that management’s job? In 30 years as a director, business consultant Betsy Sanders of Sanders Partnership in Sutter Creek, California, has sat on the compensation committees of Wal-Mart, Washington Mutual, WellPoint Health Networks, and Wolverine World Wide. She complains that pay for performance has everyone peering through the wrong end of the telescope. “Today’s situation holds directors responsible for the quarterly and annual performance of the company. This keeps us focused on earnings without regard for revenue creation. But the lifeblood of a company is to enhance its revenue streams, and you need somebody to focus on the strategy for doing this,” she says. “I would expect my overall compensation to rise and fall with the shareholders’, but the job is bigger than being sure that earnings come in on the estimate.”
Only a handful of other companies link their director pay to performance. An example, perhaps illustrative of what could happen at Coke, is SPX Corp., a Charlotte, North Carolina, manufacturer of pumps, valves, and other industrial products. In 2005, SPX’s shareholders approved a board proposal that gave outside directors annual grants of 2,500 shares of phantom stock with a three-year vesting period based on whether SPX’s total shareholder return outperformed that of the S&P 500. In each of the three years when it did, a portion of the grant would vest and be payable immediately in cash to the board members. Then, as long as the company outperformed the S&P for the cumulative period, any unvested shares would vest. Any stock that did not vest within three years would be forfeited. Unfortunately for the board, SPX substantially underperformed the S&P in 2005, as it had in 2004. In 2006, SPX replaced the directors’ performance-based phantom-stock plan with incentive stock grants that “are discretionary, and therefore not determinable at this time,” according to this year’s proxy. SPX declines further comment.
Until now, figuring out how a director’s fees, retainers, stock options, and perks all add up has often been as difficult as calculating what a CEO really gets. But that’s going to change when the SEC’s new rules to amend disclosure requirements for executive and director compensation go into effect. Every component of a director’s or top executive’s pay will have to be presented in tabular form, with columns for the dollar value of all stock-based awards, the dollar value of any annual pension benefits along with any increase in their actuarial value, and the dollar value of perks worth more than $10,000. “Improved narrative disclosure,” as the SEC puts it, will describe the most important factors underlying the board’s decisions about how it compensates its members. “It’s one thing to pay me $5 million,” says Indiana University’s Dan Dalton. “It’s another to explain why you did it.”
No one is expecting to see a huge effect on director pay from all this disclosure, although it will be easier for directors to figure out whether they are being paid competitively—and to jack up the emoluments if they’re not—and for candidates who are being wooed for boards to do a little comparison-shopping. There will probably be some impact along the following lines: Say the audit chair is agitating to have her retainer raised from $15,000 to $30,000. That’s not an unseemly amount for this particular job at a complex company. But any inclination to double the annual retainer for the entire board will be stifled, because the dollar value will look way too large.
Says Concord, Massachusetts, pay consultant Thomas Wilson: “The value of full disclosure is that it will open everyone’s eyes to say, ‘What’s going on here?’” There could also be a chance of embarrassment when the dollar value of an individual director’s perks—and the gross-up for tax purposes—sticks right out there. Freebies like pensions, life insurance, and even charitable matching grants are being phased out, but the new disclosure might have a dampening effect on board members who are currently addicted to rides on the company plane or vacations at the corporate condo in Puerto Vallarta.
All this attention to compensation focuses the high beams on the activities of the board committee that oversees it all. The compensation committee is bidding fair to replace the audit committee as a board’s hottest seat. Says Mercer’s Peter Oppermann: “This is driven by the new rules on disclosure plus the need for the committee to look at all the pieces of executive compensation to make sure the whole package makes sense.” He says there will always be more work for the audit committee to do—just look in any proxy and see how many more times it meets in a year than the comp committee does—and so it will usually be paid more. But comp is a close second. (See the chart on page 48.) “A fairly large number of companies take the line that the compensation committee is exposed as much as the audit committee to shareholders’ concerns and litigation,” says Paul Hodgson, senior research associate at the Corporate Library.
And so we’re back with the angry shareholders again, taking out on directors their frustrations with runaway executive compensation. But that’s as it should be. The shareholders didn’t hire the CEOs; you did. And now you may have to put the brakes on the gravy train.
