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【惠悅講堂 WW lecture room】 Executive Compensation: The Role of Boards By Dr. Hans Kothuis, Director Executive Compensation, China & Hong Kong, Watson Wyatt Worldwide

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For the past 12 years I have been providing advice on executive- and stock based compensation to companies in China and Hong Kong, and I wanted to share with you some insights on the role of Boards in developing executive compensation plans. What is the Role of the Board?

What is the Role of the Board?

First I want to say a few words about the role of the Board. Boards exist to improve the performance of the Company. They need to pick the right CEO and senior executive team, monitor their activity and incentivize the management team to perform and achieve a degree of effectiveness for growth. Executive compensation decisions by the Board should focus primarily on motivation and incentivization. The incentive component of the executive package reflects what the Board has agreed in terms of strategy, and is intended to motivate the executive to achieve that strategy.

Boards must establish principles that guide compensation plan design. Bonuses are granted not just to be nice to executives, but to hold executives accountable, so that they will do what they say they are going to do. It is in compensation that the focus of director responsibility should lie. Connecting compensation with performance is the most important role that the Board has. Compensation is more than approving the contract of the CEO. Boards need to understand their responsibility of determining whether the whole of the compensation philosophy of a company makes sense. An executive compensation program reflects the thinking of the Board about the Company and its strategy to success.

Boards should start with figuring out what they are trying to achieve with their executive compensation policy, and ask themselves the question: “What are the objectives for which we compensate the CEO?” A viewpoint and approach needs to be adopted on how the various components of the package fit together and how it furthers the goals of the company. Boards need to articulate the rationale of the program against business objectives. The “design” of a plan always comes first, and legal, tax, accounting and administrative considerations come second.

Boards should examine whether a plan is aligned to the business strategy and objectives of the corporation, whether it leads to the retention of key executives, and whether there is sufficient pay for performance. Board should look at award sizes, eligibility criteria, the cost of the program versus its return, the mix of pay between fixed and variable pay and between short and long-term pay, the performance metrics and goals (e.g. whether absolute or relative measures should be used) and what the pay-off is under various performance scenarios. It is not just that because a programs looks good, sounds good, that it therefore must be good. No, programs should be carefully tested under multiple scenarios, while retaining a focus on what your organization is trying to achieve.

Principles of executive compensation plan design

How should Boards go about their task to improve performance through their decisions on compensation? Listed below are seven principles Boards should follow:

1. Use compensation surveys and market information fairly and reasonably.

More and more compensation consulting firms operating in China are providing market information on compensation levels for many jobs in multiple industries. First of all, it would make sense for companies to use multiple surveys. Boards should not have to depend on just one survey. But more importantly, survey results need to be interpreted, provide context and a perspective on market pay rates for executives. The issue of course is that unlike a thermometer, which has no effect on what you measure, surveys do. The Board needs to apply judgment whether pay is reasonable in relation to the external pay market, and whether it is appropriate in terms of the company’s own business rationale. Survey results should not be the sole factor in determining the pay package. One has to remember that survey results tend to look very precise, but that the input into the survey process is often far from precise. Surveys only measure what is available and known. For example, in a survey, the values of the long-term incentive component are typically based on some valuation technique (e.g. the Black-Scholes method in share option valuation). But these values are theoretical, and the actual value realized is going to depend on the actual performance of the company.

In addition, if a well designed and somewhat generous executive retirement benefit program has served your company well for many years in retaining executive talent – as it has for a number of major companies in Hong Kong – then you may not want to change this component, even though the market indicates that you are somewhat over-competitive in this regard. As an aside, I believe that there has been insufficient focus on executive retirement benefits in China. The area of executive retirement benefit is currently under-developed, and it is becoming critical that supplementary executive retirement plans be developed in China.

In interpreting survey results, Boards should inquire about the appropriateness of the peer group of companies, in terms of revenue, market capitalizations, net income, total shareholder return, industry, and other factors. If a company’s philosophy is to pay at the upper quartile of the market, then the Board should ask whether upper quartile pay is in fact supported by upper quartile performance.

2. Best practices should be combined with best fit.

Best practices are only ‘best’ because they fit in the best possible way to nature of an organization. Naturally, it makes sense to benchmark your practices with those of the best in the market. However, the results of a practice should not be adopted slavishly. What, in fact, is a best practice? All it means is that in another organization a given practice has led to favourable results. But, was it really the practice that led to the result, or the prior process of arriving at that practice? Not all birds fly in the same manner. Each manner of flying fits that bird’s particular nature, and is developed over many millennia of evolution. In the same manner, not all organizations ‘fly’ in the same manner. Their manner of ‘flying’ fits their own nature, and it takes practice over many years to figure out which ‘manner of flying’ fits your organization most suitably. Practice by definition means doing things yourself many times, over and over again. Companies with best practices that fit their nature arrived at those practices after many years of trial and error. So, the result of a practice cannot be copied slavishly. But what should be copied are the underlying processes, procedures, and grappling with often very human considerations in any organization.

For an organization to “fly”, its practices, including its pay practices, need to fit its nature. A capital intensive company will have a different pay practice than a people intensive company. Or, a centralized company will develop different pay programs when compared to a decentralized company. A company focused on retention and people staying in their jobs and with the company for a considerable period of time will have different pay programs when compared to a company where job rotation and an up-or-out performance management system are in place. In a company where the leadership is exercised more in a shared manner, considerations of internal equity and proportionality between the CEO’s pay and that of the COO and the Division Presidents is likely to be more important that the pure external market rate for a CEO.

3.It is not just compensation, but it is also talent management and succession planning.

Many compensation committees spend a good deal of time on getting the right compensation structure in place for their senior executive team. They grade the positions, conduct benchmarking exercises, develop pay structures, and determine the mix between the various components of the pay package. They tend to look at compensation in isolation. But compensation can take you only so far. The Board also needs to make sure that the right people are filling the right positions. Succession planning should have a high priority at the Committee and Board level.

I have noticed that in many Chinese organizations the role of a COO is not as well developed as in many western companies. Naturally, there are many factors to consider whether a company needs a COO, such as the CEO’s leadership style and the strength of the line management team. But a strong COO or team of division presidents allows Board to test and examine candidates to succeed the CEO.

In fact who is really an executive in an organization? The salary level, job grade, position title and reporting relationship are merely the result of what an executive does. Executives – as the word suggests – execute, they make decisions that have an impact on the success of the organization as a whole. It is this capacity to make decisions of great organizational impact that is rewarded through executive pay programs. This capacity can be learned, but it requires years and years of hard work and practice. Few succeed, just as few succeed in becoming a concert pianist or opera singer after years and years of practice. It is because of this scarcity of people who have succeeded in mastering the practices that lead to effective decision making that benefit the organization as whole that executives are paid so much more.

4. Do not forget about your investors.

Increasingly Boards and management needs to talk to investors and obtain their input on what is important to them in compensation plan design. Investors should provide input on performance metrics and pay practices they value most. In any corporation there exists the principal versus agent problem. The shareholder is the principal, and the executive is the agent. By tying incentives to shareholder value creation, compensation can be an important tool to address this inherent conflict. Hence, Boards should develop a strong relationship with their investors in terms of compensation program design.

5. Manage compensation in terms of the relationship between pay and performance.

In designing incentive programs, whether short- or long-term, it is first of all important that the principles that underlie to whole approach to pay-and-performance be articulated. Boards need to figure out why a particular approach is adopted, and how things fit together, and how it furthers the goals of the company. The relationship between pay and performance needs to be carefully modelled and analyzed. Boards should ask for sensitivity analysis of pay-outs before approving a new incentive plan.

There needs to be a good discussion on performance measures and targets with the CEO and members of the senior management team. These measures need to tie into your business. For example, for a pharmaceutical company in which new products come on line only after many years of research and development, the compensation program will be very different from an organization where products are developed much faster.

In selecting performance metrics, the focus should be on both the creation of corporate value and the creation of shareholder value. Hence, an incentive program should focus on a range of combined outcomes of corporate performance (e.g. sales growth, market share, profit growth, etc.) and incremental market value created. In this regard, Boards should ask their advisors to provide them with decision tools that help them manage compensation from the perspective of the relationship between pay and performance.

Naturally it remains very important that Boards look at alternative programs from an expense perspective. With the new accounting standards it is now quite clear how pay programs should be expensed. Hence, Boards should ask the question how a given amount of compensation expense can be delivered through alternative pay programs.

Some programs have a high degree of risk, but would also have high leverage and upside potential. These programs have real performance criteria and give leverage for out-performance. Nowadays there is clearly a market for executive talent, and executives will shop around, and analyze the package on a risk adjusted basis. Giving someone RMB 3 million worth of share options is – on a risk adjusted basis – very different from giving him full value shares with service- , but not performance-, based vesting conditions, or to give him RMB 3 million in additional retirement benefit. In fact, one can say that executives are in fact ‘buying’ a long-term incentive arrangement, and they will want to look at the risk versus reward ratio of a particular program. Executives are buying a ‘pay instrument’ and are paying for it with their time and energy.

I have noticed that some companies are paying twice for the same performance, because they use the same metric in multiple annual bonus plans and often in the long term incentive plan as well. Such a practice does not really make sense. We need to be clear that there are programs that focus on the long- term and others that focus on the short term. Some may be more growth oriented, while others are profit focused, and a third type of program may be more return based (e.g. return on capital employed). There should be one set of measures for one type of program.

6. Focus on total compensation for life-time achievement

By this statement, I mean that Boards should look at the overall wealth an executive is likely to accumulate over a life-time, if he performs . There are two aspects to this principle. Firstly, look at total compensation, and do not make decisions on various compensation programs in isolation. It might make sense to dedicate a particular meeting of the Compensation Committee or of the full Board to discuss the technical details of the annual bonus, the long-term incentive, or the retirement plan. But when a final decision has to be made about grant sizes of a particular program, the Board should have the total package in view, including the knock-on effect of one component of the package on all the other components. Boards tend to look at individual programs too much in isolation. Boards should ask their advisors to show them clearly and graphically the flow-through cost and benefit implications from changing one component of the package on other components.

Secondly, when a new executive is appointed it makes sense for the Board to have a mental image of the type of wealth that this executive might accumulate during their tenure if the company performs according to the Board’s expectations. Wealth accumulation over a life-time can be expressed as a percentage of shareholder value created over this period. Creating such a life-time perspective may require that the Board sets holding requirements, so that executives are expected to hold onto the shares that they obtain e.g. upon option exercise or vesting of restricted shares. These holding requirements can extend until retirement, termination of employment, for a number of years or until a minimum level of ownership is achieved.

7. Realize that compensation plan design is multi-disciplinary.

Boards need more outside advisors as management is conflicted. Compensation plan design is a multi-disciplinary exercise. It involves compensation experts, internal and external legal counsel, accounting and tax experts, and plan administrators. But as this article has shown in the first instance Boards have to make sure that they do the right thing in terms of compensation plan design, rather than just doing things in the right manner. This means that from the very outset Boards need to seek advice from outside experts that provide a market perspective, logical analysis based on fundamental principles of compensation plan design, and scenario analysis that shows the impact of alternative plans.

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