A Nation Under TARP AFLAC’s Ahead of the Game

Congress is considering rolling out to all public corporations the executive compensation restrictions that now apply only to companies receiving assistance under the Troubled Asset Relief Program. Current proposals include mandatory say-on-pay provisions, which give shareholders an advisory vote on executive pay.

But little will change at Aflac, the Columbus, Georgia-based insurer, where the board and the CEO have taken a series of pre-emptive measures that include many of the executive pay controls now captured in legislative proposals.

Three years ago, long before the executive pay controversy reached its current crescendo, Aflac became the first U.S. company to institute say on pay.

In February 2007, it implemented a clawback policy allowing Aflac to recover an executive’s compensation under certain circumstances. Then last November, CEO Daniel Amos gave up the severance pay provisions in his contract; and in February, with Aflac’s share price falling, he announced that he would forgo his 2008 bonus of $2.8 million.

Audrey Tillman, executive vice president of corporate services, who leads human resources at Aflac, is sanguine about the consequences of mandatory say on pay for all companies. “If an organization has true pay for performance, there’s no reason to be anxious about say on pay,” she says. It gives you a pulse about what shareholders think, and all HR executives should want to know that.”

Or maybe not. At many companies, say on pay will land in the laps of some extremely angry shareholders. Aflac launched say on pay at a time when its share price was rising and investor relations were strong. Its say-on-pay provision and the CEO’s self-policing actions have generated a flurry of positive press reports. Even with the pay changes in place, the CEO’s total compensation package remains very attractive and the company faces a far lower risk of losing its executive talent than most.

But most companies that now face the imminent prospect of instituting similar executive pay changes are not so well positioned. In fact, new legislative and regulatory restrictions are unfolding at the precise moment when executive pay plans have already lost much of their motivational and retention value. Boards and the HR executives who support them are struggling to restore that motivational and retention power with market forces and the regulatory environment clearly aligned against them.

The legislative wave
The American Recovery and Reinvestment Act of 2009, signed into law February 17, codified pay restrictions for the more than 400 companies receiving TARP funds.

“The TARP model for say on pay will become law this year,” says Steven Van Putten, Watson Wyatt Worldwide’s East region executive compensation director. “More frightening is that other TARP provisions will be applied to all companies.”

In addition to say on pay, TARP-like clawback provisions and severance pay restrictions are on the table. And the deep cuts in the tax deductions for executive compensation at TARP companies may soon affect all corporations.

“With TARP, we have a glimpse into the future of how government is prioritizing executive pay issues,” says Irv Becker, national practice leader for the executive compensation practice at Hay Group, Philadelphia. He believes that say-on-pay legislation is inevitable and that severance pay restrictions may follow. Mandatory clawback provisions are under consideration, but Becker believes that Congress may not act because so many companies are now adopting clawbacks in response to shareholder pressure.

Becker says the government is more likely to use the tax code rather than pay caps to suppress executive compensation. “The general direction is to use deductibility to inflict more pain,” he notes. “Government will push the burden back to compensation committees and shareholders.”

The American Recovery and Reinvestment Act cut the long-standing Internal Revenue Code 162(m) $1 million deduction for non-performance-based compensation to $500,000 for all compensation at TARP companies. Van Putten believes Congress may now apply the $500,000 limit to all companies and broaden the types of compensation brought under the deduction limit.

Becker believes the government may retain the $1 million deduction for non-TARP companies but apply it to all compensation, eliminating the distinction between performance-based and non-performance-based components.

TARP restrictions on severance are also likely to appear. “Historically, the government had only limited severance in a change-of-control situation, but for the first time, it has now broadened it beyond change in control for TARP companies, and may extend the limits to all companies,” Becker says. “Also, it may limit deductibility for severance, including severance unrelated to a change in control, which would be very significant.”

All of these possible changes could set off a scramble to adjust compensation and account for those adjustments in next year’s proxy statements. And if say on pay becomes law, those statements will draw even greater levels of scrutiny.

Aflac, which reported revenue of $16.6 billion for 2008, has already done the work. The company’s proxy statement provides 12 pages of tables detailing every aspect of executive compensation, supported by an additional 12 pages of compensation discussion and analysis, prepared by the finance function, the compensation committee and Mercer, Aflac’s compensation consulting firm.

Tillman attends the compensation committee meetings to assist and provide documentation. At the company’s May 2008 shareholder meeting, with say on pay in place, 93 percent of shareholders voted in favor of the company’s executive compensation practices.

Compensation experts note that the simple up-or-down advisory vote offers no information on which elements of the compensation package shareholders approve or disapprove of. A yes vote may make the board reluctant to institute the necessary changes going forward. Some governance experts are concerned that say on pay opens the door to shareholder intervention in a wide range of board decisions about issues that remain beyond the purview of most investors.

Tillman is undeterred. “Some shareholders can’t understand complex executive pay packages, and some will vote emotionally based on their own circumstances, but the large institutional shareholders can understand executive pay packages, and the board and the CEO should be aware of their perceptions,” she says. “We want to have our approach validated.”

Tillman met with Amos before he announced that he would refuse his 2008 bonus, but the company made no formal statement to employees. “They know our CEO and know that he is sensitive to sentiments around the country,” Tillman says.

Aflac has not instituted layoffs, but it cut the merit pool from its traditional annual 3.5 percent increase to 3 percent for 2009. “We have a very conservative philosophy on hiring and merit increases, and that’s paying off now,” Tillman says.

All employees receive a profit-sharing bonus that has paid out for 14 consecutive years. The company has not modified the traditional components for 2009, but is now reviewing targets.

Preserving motivation, retention
As of October 17, before the full effects of the crisis unfolded, 90.3 percent of Fortune 500 CEOs held underwater stock options, and the median year-to-date value of aggregate option holdings for Fortune 500 CEOs was down 63 percent, according to Equilar.

“The downturn has gutted stock prices, so equity programs no longer provide proper motivational and retention value at many companies,” Van Putten says. “In addition, there are new questions about how to set performance metrics and goals in an uncertain environment.”

With public and shareholder scrutiny and legislative actions focused on the components of executive compensation that are not performance based, HR executives will need to support boards that are now moving quickly to revise executive severance, perks and supplemental executive retirement plans. “This goes a long way to addressing critics,” Van Putten notes.

At the same time, boards and HR executives are working to redesign executive pay programs to restore the retention and motivational power of performance-based plans. “It’s all about increasing the probability that plans will pay out,” Van Putten says. “Otherwise, it’s too de-motivating. Every company is exploring how to handle the fact that equities are not performing. Some are considering exchanging underwater options, but this approach is not gaining traction at midsize and large companies because of the potential for shareholder criticism.”

If an option exchange is not feasible, the board can replenish shares in the program. “Boards will look to get new share plans approved to reload executives,” Van Putten says.

The payout problem is also drawing attention to performance metrics and goals. “Companies are revisiting earnings-based metrics and putting greater emphasis on cash flow or return on investment or return on capital, which say more about preserving the company’s value,” Van Putten notes. Another move under way entails increasing the line of sight by moving to division- or unit-based goals for annual incentives.

In addition to assisting the board with redesigning executive pay, HR executives must ensure that the modifications are aligned with broader changes in the workplace.

“HR executives can be sensitive about layoffs, morale and how executive pay is perceived internally,” Van Putten says. “Cuts should always start at the top. Begin by eliminating bonuses or paying them out in restricted stock. Eliminate salary increases at the top and then work your way down.”

With market forces slashing executive pay and legislative and regulatory actions for further reductions now pending, redesigning compensation to support its motivational and retention power is likely to be an ongoing process for many months to come.

Workforce Management, April 20, 2009, p. 1, 14-19 — Subscribe Now!