CAHRS Working Group

Managing Executive

Compensation in a

Complex World Hosted by MetLife

New York | November 13, 2018

Key Takeaways:

1. While proxy advisor services are conflicted and do not truly take the time to understand why pay decisions have been made, they remain a force to be reckoned with, due to their real influence on Say on Pay (SOP), equity plan approval and director election votes.

2. Designing Long-term Incentive (LTI) plans and selecting appropriate measures of performance is exceedingly challenging.

3. Pay equity is an important priority across many firms.

4. Balancing the interests of the various constituencies to the executive compensation process requires constant reassessment of priorities.

Participating Organizations:

American Express

Boeing

CIT Group

Colgate Palmolive

Cornell

IBM

JPMorgan Chase

MetLife

Johnson & Johnson

SC Johnson

Most of the organizations participating acknowledge that they have “made their deal with the devil” by subscribing to a proxy advisor’s services for more than $50,000 per year even though they derive little direct value other than to be able to predict their vote a few months earlier.

Firms acknowledge that if proxy advisors did not have such a strong influence over votes on Say on Pay (SOP), estimated at over 20 percentage points, they would not subscribe to their services or expend any real time trying to adhere to their guidelines.

They believe that there is a clear conflict of interest as they promote their own subscription and consulting services to help understand and overcome their voting recommendations. There is real concern that their recent purchase of an Economic Value Added (EVA) firm will lead to their promoting that as a primary Long Term Incentive (LTI) metric.

There was broad consensus that proxy advisors deploy limited resources to truly understand and appreciate the how and why of a company’s total compensation process. They automatically assume that any form of discretion means that executives are not held to rigorous performance standards. They also are very reluctant to change a preliminary voting recommendation even if clarifying information is provided. Their choice of peer groups is problematic.

What is the Best Way to Reform Proxy Advisors and Their Conflicts of Interest Bias?

There was acknowledgement that some of the items that they have promoted are positive, including:

Elimination of tax gross-ups on golden parachutes; Elimination of single trigger Change in Control (CIC) equity vesting; and Calling out excessive levels of executive compensation.

There was much discussion around whether long-term grants are forward or backward looking. Some felt that grants were made based on prior year performance and that therefore should be reported in the Summary Compensation Table, like bonuses, in the year that they were earned as opposed to the year they are granted. It was noted that this would require a rule change by the Securities and Exchange Commission. Others felt that LTI grants are predictable year on year based on organizational level and/or role and that performance is reflected not on grant size but on the future value of the award.

There was also some discussion as to whether there needs to be a separate decision process around salary level, annual incentive awards and LTI. An argument was made that all that matters is the change in year-on-year total compensation. That salary is simply an offset against the determined total compensation. Once salary is subtracted from total compensation the incentive can be calculated. The total incentive is then split between cash and equity based on a pre-set formula

This raised the question of whether it was better to have management discretion in award (or total compensation) determination or whether it should be more formulaic. Discretion allows for a more fulsome consideration of the multiple interrelated factors that go into performance. It does, however, rely heavily on management judgement and is subject to bias and inconsistency. Formulas, on the other hand, are by definition stupid. They can be “gamed” and often result in unintended consequences.

There was agreement that some combination for formulaic funding (or funding ranges) — and then more discretion in allocation is probably optimal.

To be successful in this process, managers need to be trained (and managed) to make good thoughtful decisions that truly reward and recognize superior performance. There was much discussion as to whether competent managers are required in order to introduce judgement into the compensation process or whether a compensation system demanding good judgement and discretion builds strong managers.

There was a good discussion about the relevance of the United Kingdom reporting rules examining the differences in the average pay for men versus women. There was broad agreement that the issue lies not which differences within a given position but rather differences by sex in what positions men hold versus women. That continues to be a challenge for organizations.

There was also discussion about how these differences also exist between races. The participants felt strongly that this was a long-term issue of changing the career choices of women

and minorities (e.g. greater participation in Science, Technology, Engineering and Math areas) and developing programs to allow them to flow into more senior levels.

While the UK regulations and potential requirements in various United States locations were a catalyst to develop analytics, there was a strong belief that this is an area that was already being examined.

As an example, some organizations have a formal process where they look at pay distribution based on demographics and make “special awards” to correct any anomalies.

These efforts were typically jointly managed by compensation, diversity and career management.

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CAHRS Working Group Managing Executive Compensation in a Complex World November 13, 2018

What is the Best Way to Address the Issue of Pay Equity?

What Changes to Long Term Incentive Design Have People Found to be Effective?

We discussed all the constituencies who have a point of view and influence on the executive compensation process. These include:

Regulators; Institutional shareholders and their advisors; The Board and the Compensation Committee; The press and public opinion; The executives themselves; Independent advisors to the compensation committee; and Rank and file employees.

It was felt that the executives, the compensation committee and institutional shareholders require the most day to day attention and more directly influence the decision process. Often plans are restructured with an eye to passing muster with large institutional investors. The executives often have strong preferences (and regularly make proposals) and the committee exercises final decision powers.

The other constituents often influence the decision process of one of the three principals outlined above. The place this most often comes to a head is the trade-off between discretion (favored by boards) and

formulas (favored by regulators) in the determination of annual incentives and the valuation of long-term performance plans. There was broad agreement that executive performance is complex and reducing it to a few quantitative metrics over simplifies the necessary tradeoffs and is ripe for manipulations or unintended consequences.

Most felt the Board could, and should, have the ability to use judgment to determine incentives in the context of real choices management has to make between investment and earnings, for example.

Often the various constituents are in conflict in terms of their priorities and interests. Regulators may want to reduce risk to zero, while the Board wants risk “managed” but not eliminated. Employee groups want lower levels of executive compensation while management wants the opposite.

We discussed the process of shareholder engagement and the challenges of getting to the right people within an institutional investor who actually exercises voting control. Most organizations have a practice of regularly reaching out to the top 10 to 15 institutional investors (voting 60%+ of the shares) but often they:

are not interested in having a conversation; have meeting representatives who do not actually vote the stock; have a strict policy of following proxy advisor recommendations; and do not have any issues with the compensation program.

We discussed the Chief Executive Officer pay ratio disclosure and agreed that while it was a fair amount of work requiring lots of assumptions, it turned out to be a non-event. The press did not make a big deal about the differences. In fact, the item that garnered the most interest was the median pay level, where now every employee knows whether they are in the top half or bottom half of the organization.

This was, of course, mitigated by the fact that lots of part time and international staff were included, making direct comparisons difficult.

There was some concern that after this year’s proxy reporting, the press and others will try and draw conclusions based on year-on-year trends for both the CEO and the median employee.

There was some discussion as to what metrics and compensation vehicles are best in a difficult business

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What’s the Best Way to Balance the Interests of the Various Constituencies to the Executive Compensation Process?

Other Issues Discussed

CAHRS Working Group Managing Executive Compensation in a Complex World November 13, 2018

environment. Representatives from companies in the consumer goods sector were being challenged by lower growth when historically they had been able to set and meet challenging goals and equity prices steadily rose.

There was some discussion of how a long-term perspective and the continued use of options may mitigate the problem.

There was also some discussion about refocusing on strategic goals to balance financial ones to ensure there is focus on the required initiatives to turn the business around.

There was some interest in the notion of increasing the perceived value of long-term incentives by introducing choice and allowing executives to pick between (for example) options and restricted shares.

This led to a discussion about increasing happiness by managing expectations about the size of the awards. It was also noted that that the degree of “stretch” in goals can heavily influence a perception of fairness and the expected value of the award. Too much stretch reduces the motivation to achieve what is perceived as an unattainable goal.

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This Summary Report was prepared by Brian Dunn for

participants of the Managing Executive Compensation in a

Complex World CAHRS Partner Working Group.

The Center for Advanced Human Resource Studies (CAHRS) is an

international center serving corporate human resources leaders

and their companies by providing critical tools for building and

leading high performing HR organizations. CAHRS’ mission is to

bring together Partners and the ILR School’s world-renowned HR

Studies faculty to investigate, translate and apply the latest HR

research into practice excellence.

CAHRS Working Group Managing Executive Compensation in a Complex World November 13, 2018