September/October 2008, Vol. 19, No. 5
Compensation Front and Center
Evolution, not revolution, is the best
approach to reforming executive pay
BY JEFF DIERMEIER, CFA
My recent participation in the Harvard Business School (HBS) executive
education program— “Compensation Committees: New Challenges, New
Solutions”—provided an opportunity to reflect on the role of compensation
and corporate governance from the board perspective in the for-profit world.
Say on Pay
This practice, already in place in the United Kingdom and Australia, gives
shareholders an advisory vote on compensation. In the Netherlands, these
votes are binding. Both the United Kingdom and Australia have had positive
experiences with say on pay. After a rocky start—shareowners of Glaxo
SmithKline rejected a plan in 2003—boards have tried to avoid problems by
improving their communications with large shareowners.
As a traditionalist, I view compensation as a critical role of
the board. It is sufficiently complex that many investors do not have the
training or perspective to add much to the equation. Of course, investors
should be able to communicate their views to management and the board. Also,
investors can abstain from voting for director nominations, particularly
those of the compensation committee, if they believe directors are failing
in this vital function—a blunt instrument, but it can capture attention.
Dialogue is a better avenue. Many believe the greatest benefit of say on pay
is to promote dialogue.
So far, say on pay has not won universal favor in the United
States, where plurality voting continues to impair shareowners’ ability to
send effective messages to company boards. Nevertheless, the issue has been
one of the most frequent proxy proposals of recent years, and that trend is
expected to continue into next year’s proxy season. This coincides with
views our members expressed in one of our surveys last year, which really
surprised me. Most who responded were sufficiently upset over what has
happened in executive compensation to want say on pay and for boards that
treat these votes to be more than merely advisory.
New U.S. SEC rules requiring disclosure in companies’
compensation discussion and analysis (CD&A) have focused boards on
compensation, which may prevent egregious abuses. This reform applies only
to the United States, where pay abuse is believed to be most excessive.
Pay for Performance
Where investors like to see the rubber hit the road is in those unfortunate
circumstances where performance is poor. They want to see reduced pay,
hopefully with an appropriate horizon. If you believe this is the critical
issue, I recommend looking at last year’s CD&A for Bank of America to see
how their cuts fell. Compensation committees everywhere are trying to match
pay with performance. U.S. companies have been required to do so since 1993
(or face tax consequences). As a result, most executive pay is heavily
JEFF DIERMEIER, CFA
President & CEO
Some may question the execution by boards generally and
compensation committees specifically.
The Fundamental Issue
A fundamental issue remains. Compensation estimates for the average U.S.
executive range from 180 times to more than 500 times that of the average
employee. This is an issue of fairness, morale, and motivation within the
One argument is that outstanding people merit outstanding pay.
(Proponents draw analogies to actors and sports figures.) But HBS professor
Jay Lorsch argues that there is not a functioning market for a Jack Welch.
Instead, pay packages are negotiated agreements, and the onus is on the
board chair or compensation committee to negotiate an appropriate deal. In
my mind, those negotiations should tie in to the company’s strategic plan
and performance measures should relate to discounted cash flows that
describe long-term value creation (which would include caps to prevent
unlimited upside). In this context, it appears that nonfinancial measures
reflecting a company’s fundamental drivers are underused in most executive
A related problem has been described by Warren Buffett as
“ratcheting.” If everyone wants the best and will pay in the top quartile,
can anyone be average? Candor about realistic performance is sorely needed.
In particular, boards should address a concept we know very well in the
investment world: the separation of alpha and beta. Our academic colleagues
need to bring this concept to bear on executive compensation.
Other common-sense tools and techniques are needed as well,
including systematic review of the ratio of CEO pay to top executive pay,
the share of total profits paid to management, and awards created by
financial results that are ultimately restated. Note that I am not against
great pay for great performance. I’m only suggesting that some context be
regularly provided for the pay granted at the time of the grant. The media
often get this wrong, but as an investor, you care most about the pay “when
granted,” including fairvalue estimates of securities or awards of
On the issue of succession or “insiders versus outsiders,” HBS professor
Joseph Bower argues that the best future leaders are insiders who are
outside the inner circle because they have a broader view of the company and
its markets and can avoid the tunnel vision of an inner circle. While many
firms use the “balanced scorecard” approach for business operations, rarely
do these tools make their way into executive compensation. This reinforces
my belief that executive compensation often lacks strategic intent. Finally,
the CD&A reform is in its first year. Early issues should be seen as startup
problems that hopefully will improve with time (and enforcement).
No one will ever be able to declare “the end of history” on
these issues. Instead, we should expect an evolutionary process leading to
better governance in general and compensation practices in particular.
2008 CFA Institute.