Question

Suppose you are a member of company X's board of directors and chairperson of the company's compensation committee. What factors should your committee consider when setting the CEO's compensation? Should the compensation consists of a dollar salary, stock options that depend on the firm's performance, or a mix of the two? If "performance" is to be considered, how should it be measured? Think of both theoretical and practical (i.e., measurment) considerations. If you were also a vice president of Company X, might your actions be different than if you were the CEO of some other company?

Answer 1

Assessing CEO compensation is an art. Interpreting the numbers isn't terribly straightforward. Yet investors should get a sense of how compensation programs can create incentives - or disincentives - for top managers to work in the interests of shareholders.

While everyone can support the idea of paying for performance, it implies that CEOs take on risk. CEOs' fortunes should rise and fall with companies' fortunes. When you are looking at a company's compensation program, check to see how much stake executives have in delivering the goods for investors. Let's take a look at how different forms of compensation put a CEO's reward at risk if performance is poor.

Companies trumpet stock options as one way to link executives' financial interests with shareholders' interests.

But options can also have flaws as compensation. In fact, with options, risk can get badly skewed. When shares go up in value, executives can make a fortune from options. But when they fall, investors lose out while executives are no worse off. Indeed, some companies let executives swap old option shares for new, lower-priced shares when the company's shares fall in value.

Committees must evaluate several factors when making decisions on CEO compensation. This article outlines six key considerations. While most decisions on salary increases, actual bonus payouts, new equity awards, and target compensation for the year are made shortly following year end, Compensation Committees should be taking action through the year to ensure a defensible position for all significant decisions.

Key Considerations

1) Company Performance

Top of the list is the company’s financial and stock price performance over the last year. Performance should be measured against the business plan and pre-established goals set for incentive purposes. A fulsome review of performance, however, doesn’t stop there. How well has the company responded to unanticipated events? In hindsight, how rigorous were the goals for incentives? How has the economic/political/governance environment impacted the company’s ability to achieve those goals? How has the company performed against other important strategic initiatives? How has the company performed relative to industry peers or broader indices? These questions should be considered throughout the year to set the stage for informed compensation decisions, protected by the business judgment rule.

2) Individual Performance

Company performance alone doesn’t always tell the full story of the CEO’s performance. Who personally drove those results? Was it the CEO? Was it the executive group (or individuals within that group)? Was it the team as a whole? The CEO should have documented performance objectives, including succession and development plans, separate and apart from expected financial results. Progress against these goals should be reviewed with the CEO during the year to make sure they are still meaningful and that there are no surprises at year end. If the board has performance concerns, a surprise action on CEO compensation at year end can be disruptive and counterproductive.team, in addition to the CEO, throughout the year to anticipate the need for differentiation, and potential consequences. Are incentive plans tracking to pay the CEO (and/or corporate staff) significantly more than one or more of the divisions? Does that outcome make sense based on the individual performance assessments? If not, expectations may need to be managed and/or corrective action taken before the Board finds itself in an awkward situation at the end of the year.

While Compensation Committees (and the full board) are in the best position to determine CEO compensation, they do not operate in a vacuum. These days there are multiple external parties who may try to second guess their decisions.