The Fuzzy Math on Executive Pay

By Jessica Marquez

Feb. 16, 2006

N o company would argue, at least not publicly, that the Securities and Exchange Commission proposal to require increased disclosure of executive compensation is a bad idea.

    But many executives and compensation experts are concerned that the proposal, which is in a 60-day comment period after being unveiled by SEC Chairman Christopher Cox on January 17, could create more questions than answers.

   One of the most controversial provisions in the proposal, expected to become a rule by year’s end, would require companies to disclose a total compensation number for the four highest-paid executive officers. Companies question whether this number would really be meaningful given that it includes projected values for stock options, retirement payouts and other compensation, such as severance pay.

    There are other pieces of the proposal, which comes in at 370 pages, that companies are expected to protest. One is a requirement to disclose perquisites in excess of $10,000, down from $50,000 currently. There is a mandate to disclose compensation of as many as three nonexecutive employees who are more highly paid than the lowest-paid named executive officer. Then there is the addition of the new “Compensation Discussion and Analysis” section, where companies would have to explain what kind of metrics they used to determine compensation.

    “This proposal is a move in the right direction, but it has just overreached in some areas,” says Jerry Carter, senior vice president of human resources at International Paper, a Memphis, Tennessee-based paper manufacturer with 82,000 employees globally. “In some areas it will just add cost, and not necessarily produce better companies.”

    Compensation experts predict that the proposals could increase the amount of time and money that companies devote to disclosing compensation by 50 percent to 100 percent for at least the first year.

    “These proposals are a radical revision of the existing framework,” says Mark Borges, a principal at Mercer Human Resource Consulting and former special counsel in the SEC’s division of corporate finance. “Next year’s proxies on executive pay are going to look pretty different.”

The numbers challenge
   The main concern that companies and experts have about coming up with a total compensation figure is that it will be misleading because it will require companies to put an exact dollar value on projected future benefits, such as retirement benefits.

    This seems like a fruitless exercise, particularly with change-of-control benefits, which may never take effect, says Allison McBride, director of executive compensation at International Paper. Gener- ally, International Paper’s compensation committee calculates its change-of-control figures once every three years, rather than once a year, because it is costly to bring in actuaries to figure them out.

    It might be more useful if the SEC required companies to set their own caps on change-of-control agreements rather than have to report figures every year, says Mims Maynard Zabri­skie, an attorney and partner in the Phila­delphia office of Morgan Lewis & Bockius.

    Also, by projecting values of benefits like pensions and severance, companies will end up reporting final compensation numbers that are much bigger than they are in reality.

    “People are worried about mixing many aspects of current compensation with prospective compensation,” says David Swinford, senior managing director of New York executive compensation consulting firm Pearl Meyer & Partners.

    This could result in higher executive compensation levels overall as companies see inflated numbers reported by one company and follow suit, says Charles Peck, principal researcher and program manager on compensation for the Conference Board.

    Since many companies rely on benchmarking studies of their industry to determine their executives’ compensation, this is a real concern, he says.

    Instead of benchmarking to their industries to determine executive pay, these companies need to make sure their compensation decisions are better aligned with executive and company performance, Peck says.

“This proposal is a move in the
right direction, but it has just overreached … In some areas it will just add cost, and not necessarily produce better companies.”
–Jerry Carter, International Paper

    Many companies and consultants are also concerned that the proposal’s requirement for companies to report the value of stock options at the time of grant as well as at the time of the filing could result in double counting by companies.

    “It’s a little tricky,” says Peggy Foran, senior vice president of corporate governance at Pfizer. “People just have to realize that often they want this to be simple, and it’s going to be a little more difficult now when you get into stock options and such.” Despite the complexities, Pfizer is planning to incorporate some of the proposal’s requirements in this year’s proxies, Foran says.

Perquisite problems
   Another benefit that companies might shift away from as a result of the proposal is offering perquisites. Many executives and experts argue that the SEC is going too far by lowering the threshold of perquisites that need to be disclosed from $50,000 to $10,000. “When you look at the total scope of executive pay, $10,000 is nothing,” says Robbi Fox, a consultant at Hewitt Associates.

    Experts expect that many companies will protest this requirement because it is too time-consuming to catalog. Further, only a few companies offer such extravagant perquisites.

    Then there is the issue of how to value the perks. “For corporate jets, many companies work out the value to the cost of first class, but that figure is really much less than the cost to the company,” says Bruce Ellig, who was head of human resources at Pfizer for 25 years and is the author of The Complete Guide to Executive Compensation.

    If this requirement is part of the final rule, many companies will have to evaluate how disclosing such perquisites may affect the corporate culture, attorney Zabriskie says.

It’s one thing to quietly shower extravagances on the people in the executive suite, but when it’s out in the open, there could be a bitter backlash. “It could create a culture where employees feel they can use the company dollars and time for their personal use,” she says. Call it the little guy’s perquisite.

    Companies shouldn’t just assume, however, that if this requirement comes to pass they will have to drop all perquisites. “Some perks are justified,” says Mark Reilly, a partner at 3C-Compensation Consulting Consortium in Chicago. “Many companies have corporate jets to save their executives time as they travel all over the world. Now they will just have to explain that.”

    Companies, however, do have to look at the perquisites they offer in light of their whole executive compensation packages, says Swinford at Pearl Meyer & Partners. “I think it’s going to be very hard to argue that an executive with a $750,000 salary who is making half a million dollars in other benefits needs $14,000 paid toward a club membership,” he says.

Other employees
Many executives and experts were surprised to see the section of the proposal that would require companies to disclose compensation of as many as three employees whose compensation was higher than the lowest-paid named executive. Although the proposal would only require that companies provide the titles, not the names, of these employees, companies are worried that by divulging this information they are highlighting their top performers to the competition.

    “These are not people who are in management,” says Carter at International Paper. “Most likely it would be a sales executive who had a great year and is reaping the rewards for it.”

I think it’s going to be very hard to argue that an executive with a $750,000 salary who is making half a million dollars in other benefits needs $14,000 paid toward a club membership.”–David Swinford,
Pearl Meyer & Partners

    This requirement could be particularly onerous for financial services companies, like investment banking firms, which could have many employees that make more in commissions than top executives, observers say.

    At many companies, the compensation committees don’t even handle the compensation of these employees because they are not management, says Ronald Mueller, a partner in the securities group at Gibson Dunn in Washington, D.C. It will mean hunting down that compensation information from elsewhere in the organization.

Discussion and analysis
   The proposal’s requirement of a discussion and analysis section that explains the performance metrics companies use to determine compensation has worried many employers. They view it as the SEC forcing them to give away competitive information.

    “The final rule will have to weigh a fine balance between giving people metrics and not disclosing proprietary information,” Mercer’s Borges says.

    It’s possible to do both, says Foran at Pfizer. “You can talk about certain metrics without getting too specific,” she says.

    This requirement might actually be a good performance management tool for executives. They’ll be better able to see that this amount of effort yields that amount of compensation, says Zabriskie, the attorney.

    Still, companies are worried that requiring them to discuss the thinking behind their compensation packages may open them up to more liability.

    “There is always the possibility that something you say or didn’t say could trigger litigation,” says Larry Ribstein, a law professor at the University of Illinois College of Law.

    Also, since this discussion section would be part of an SEC filing, it would require the signatures of the CEO and the CFO, who often are not involved with the compensation committee discussions. “This is definitely going to be an issue brought up in the comment period,” Hewitt’s Fox says.

    Regardless of their misgivings, organizations need to start reviewing their compensation packages and figuring out what they will need to do to comply with the new rules, experts say.

    “Companies need to start doing mock proxy statements and see how their plans will read under the proposed rules,” 3C’s Reilly says.

    This means companies that were going to give more stock options to executives next year or bigger severance pay may want to rethink that, or at least be prepared to explain why they did it, says Steven Hall, managing director of Steven Hall & Partners, a compensation consulting firm in New York.

    “The SEC has done companies a bit of a favor by doing this in the first few days of the new year,” he says. “Right now every company has been put on notice.”

Workforce Management, February 13, 2006, p. 1, 41-44Subscribe Now!

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