Executive pay has long been a key focus for shareholders, activists, directors, and the media—and there are no signs of that changing. Increased attention on income inequality, corporate social responsibility, and incentive plans that encourage risky behavior has further increased scrutiny of executive pay, making it a critical oversight area for boards of directors.

Compensation committee members should address the following questions to assist in exercising sufficient oversight:

  1. What is the board’s required level of oversight on executive pay? Emerging best practices are pushing compensation committees to go beyond the technical requirements for approving and disclosing CEO pay set by the U.S. Securities and Exchange Committee and stock exchanges. It is now becoming a best practice also to include a broader view of human resources-related issues, including how a company allocates resources toward compensation and benefits, how incentive plan metrics interact with desired behaviors, and the board’s involvement in proactive succession planning.
  2. How can compensation committees operate with the greatest efficiency? Compensation committee agendas tend to follow a similar pattern from year to year across companies, but certain practices can ensure meetings run more efficiently. For example, following an established cadence of pre-calls in advance of meetings between management and the committee chair, the committee chair and the advisors, and among other committee members can help them run smoothly. Many committees also reference the agenda at the end of each meeting to ensure that all parties’ expectations are aligned. Selecting and working effectively with outside advisors can further enhance efficiency and keep the committee as a whole up to speed on potential pitfalls and implications of pay and governance decisions.
  3. How do compensation committees evaluate incentive plan designs and set performance goals? Incentive compensation is an important lever to encourage behavior and align management with shareholders. Recently, goal setting has received increased scrutiny from shareholders and proxy advisors who have raised concerns about significant payouts to management when performance did not yield a sufficient return for investors. Whether goals are set on an absolute basis or relative to peers, compensation committees often review models that stress-test payouts under various growth and return scenarios to avoid windfalls to executives. In defining acceptable target performance levels, compensation committees may consider multiple perspectives of the company’s expected future performance, such as past performance, peer performance, analyst expectations, internal budgeting and planning, financial modeling, and correlation between the company’s share price and the general market.
  4. What are shareholders really looking for in compensation plans? Institutional investors and proxy advisory firms have views on compensation levels and design that are generally well documented. Committees should consider how compensation design features and pay decisions will be perceived by the company’s major shareholders and the proxy advisory firms. Typically their voting guidelines stem from the principal of pay for performance, but subtle changes to a compensation plan design can make it more acceptable to particular stakeholders. For example, investors have different views on acceptable levels of dilution from stock-based compensation. Knowing those levels may steer a company toward cash-based phantom shares for certain levels of employees to avoid triggering a dilution concern from a major shareholder. In addition, directors should be aware of trends in shareholder proposals, litigation risks, and how and when to engage directly with shareholders on issues related to compensation.
  5. What keeps compensation committee members up at night? Succession planning, risk mitigation, environmental and social goals, gender pay equity, board diversity, director pay, and executive employment agreements are just some of the areas that have bubbled up to the compensation committee agenda recently.  US tax reform is also affecting compensation plans and processes. Most notably, the elimination of the performance-based exception to Internal Revenue Code Section 162(m) means that compensation above $1 million paid to certain executives cannot be deducted by a public company, even if it met the former Internal Revenue Service definition of “performance-based.”  The elimination of the performance-based pay exception gives companies more flexibility in how plans are designed (e.g., goals can be set later in the year and subjective judgement can be used to set and evaluate performance against goals). However, companies may not want to abandon the best practices dictated by the performance-based exception since shareholders and proxy advisors may object.

To help directors with their oversight responsibility, Mercer has partnered with NACD to publish the Director Essentials Guide to Board Oversight of Executive Pay. The goal of the publication is to provide directors with a clear and concise reference guide to basic principles that affect design and governance of executive compensation programs. Mercer and NACD are committed to helping directors stay ahead of the curve and aware of evolving trends. We hope you find the guide a useful reference and welcome your feedback in the comments section below.

Teresa Bayewitz is a principal in Mercer’s rewards consulting practice based out of New York City.