The Value of People -Insights of Human Capital

ne of the hottest topics in recent years is executive remuneration governance, and we predict that it will stay top of mind for companies and their shareholders well into the future. Public debate over executive pay lev­els, termination payments and the appropriate relationship between pay and performance continues to be fueled by the media and shareholder activists. Meanwhile, regulatory changes in the areas of disclosure, accounting and taxation are resulting in a decision-making process that is ever more complex. Remuneration committees themselves are also facing greater scrutiny and are being held to higher standards regarding their independence, demonstrable technical skills and alignment with shareholder interests.
In order to help companies successful­ly navigate these challenges, Mercer has highlighted recent developments in executive remuneration around the world and identified several best practices to strengthen executive remuneration governance whether your company is in Sydney, Stockholm or San Francisco.
Recent developments in executive remuneration
There have been a number of develop­ments that have increased the com­plexity of the executive remuneration environment:
Australia
The biggest change in Australia has been the introduction of a shareholder vote on the directors’ report on execu­tive remuneration. The shareholder vote generated some criticism of remuneration practices for a small number of companies and led to improvements in transparency for others, but overall it did not result in significant changes to executive remu­neration program design or levels. The expensing of share-based payments also recently took effect, although the impact on long-term incentive (LTI) practices has been minimal given that equity-based compensation in Australia is already relatively conser­vative compared to other mature markets.
Canada
The Canadian Securities Administrators finalized new gover­nance guidelines and disclosure rules that formalize corporate governance best practices. In a related develop­ment, the Canadian Coalition for Good Governance released its working paper, Good Governance Guidelines for Executive Compensation, pressing for greater independence in executive compensation decision making, enhanced linkages between pay and performance; adoption of share own­ership guidelines; and even more dra­matic changes in the form, context and timing of executive compensation disclosure. With the banks taking the lead, some Canadian companies have begun disclosing pension expenses and liabilities and including the expected value of stock options and other equity awards in their calcula­tion of total compensation.
Continental Europe
Across the continent, companies are under mounting pressure to enhance pay disclosure. In the Netherlands, the Dutch Monitoring Committee Corporate Governance Code in its December report advocated more uniform disclosure of executive com­pensation practices in annual reports, with information presented in a sim­ple and straightforward manner with more transparency between pay and performance. In Germany, for 2006 annual reports, listed companies are required for the first time to disclose individual executive compensation practices. We expect that companies currently behind the curve will volun­tarily act to improve disclosures; otherwise, additional regulatory activity is likely to follow.
United Kingdom
Pensions have dominated the agenda of many UK remuneration committees as a result of the proposed changes to pension legislation from April 6, 2006 (A-Day). The introduction of account­ing for share-based payments has acted as a catalyst for many compa­nies to review their LTI arrangements as well. The Association of British Insurers issued their updated Principals and Guidelines on Remuneration. The updated guidelines called on remuner­ation committees to step up their scrutiny of pay programs and, in par­ticular, to be more thoughtful in iden­tifying the drivers of shareholder value when linking pay to performance.

United States
In the US, dozens of shareholder pro­posals related to executive remunera­tion have been submitted in recent years, with results showing growing support for limits on executive sever­ance, the implementation of claw­backs of incentives where financial reports are restated, and mandatory use of performance-contingent equity. Several regulatory developments have come to fruition, including new tax rules that limit the flexibility of popu­lar executive deferred compensation rules and FAS 123(R) accounting for stock-based compensation. The Securities and Exchange Commission (SEC) also took a series of actions to strengthen disclosure of executive compensation, culminating in the final rules issued in August 2006.
Among the five regions highlighted above, several common threads emerge: enhanced disclosure, linking pay to performance, and the expensing of share-based payments. Some coun­tries may be further along than others, but all remuneration committees will continue to wrestle with these issues and their consequences well beyond 2006.
The outlook for executive remunera­tion governance
We expect to see continued focus on improving transparency around execu­tive remuneration programs and deci-sion-making processes. Enhanced dis­closure may serve as a panacea for disgruntled shareholders who have been clamoring for information, but we may also find newly disclosed plan details being used to fuel further criti­cisms about executive pay practices or perhaps even resulting in unintended consequences, such as increasing executives’ expectations of baseline compensation and benefit levels. Better disclosure will likely compel committees to more closely examine executive compensation programs from a shareholder perspective, especially those elements that have generally been less visible, such as
severance and change-in-control benefits, executive perquisites, and supplemental executive retirement programs. While these elements are sometimes overlooked, they often represent a substantial component of total executive remuneration and deserve the same careful considera­tion given to base salaries and incen­tive compensation programs.
It is likely that equity compensation and performance-based equity,in particular, will stay top of mind for committees as well. Mercer’s compen­sation studies suggest that more and more companies in the US and Canada are using performance-based equity as part of their LTI strategy. And in the UK and Australia, where the use of performance-based equity has long been common practice, companies are beginning to look beyond total share­holder return and earnings per share to incorporate metrics that are more closely aligned with their business strategy.
Thirteen steps to strengthen governance and drive results
By strengthening governance practices and procedures, companies will be better positioned to tackle the chal­lenge of achieving responsible execu­tive remuneration programs in an increasingly complex environment. Based on our work with clients around the globe, we believe the following 13 steps reflect the best practices of remuneration committees with a track record of making sound decisions regarding executive compensation.
1. 1. Plan the annual agenda. Actively managing the annual agenda is critical to enhancing governance because it determines the commit-tee’s work for the year. We recom­mend comparing the agenda to the committee charter to ensure that all of the committee’s responsibili­ties are discharged over the year. It is also important that the time allotted is sufficient to cover the agenda items; important decisions regarding compensation, equity strategy and shareholder approval warrant robust discussion. This may require two or even three meetings: one for information gath­ering, a second for in-depth discus­sion and preliminary consensus on direction, and a third to make final decisions and plan for implementa­tion, including disclosure.
2. 2. Don’t make decisions in a vacuum.

The committee should be familiar with industry practices as well as general market practices. In partic­ular, peer company practices should serve as a touchstone for commit­tee actions. This raises two impor­tant issues: First, the quality of the peer group is critical to the credibil­ity of the story the data tell; it is worth investing the time to ensure the comparator market is appropri­ate. Second, care must be taken in looking to the external market to identify new approaches. The external market should inform decisions, not make them. To be effective, compensation decisions need to also reflect the company’s corporate and HR strategy as well as recognize its life-cycle stage, corporate culture, compensation philosophy and degree of difficulty in attracting and retaining high-quality executives.
3. Don’t abandon benchmarking, but don’t forget performance.
Many critics blame the use of external benchmarking for elevat­ing executive pay levels over time. Benchmarking in and of itself is not the problem; it can be a very useful framework for assessing the com­petitiveness of compensation lev­els. But benchmarks only make sense when they are considered within the context of performance. This is particularly true at the executive level, since executive compensation programs can devi­ate significantly from year to year or company to company based on performance results. Also, in some cases it may be appropriate to use different peer groups for pay and performance. Pay comparisons should reflect jobs of similar scope and responsibility, generally mean­ing businesses in a similar industry, of similar size and complexity. Performance comparisons, on the other hand, may reflect additional factors, such as capital intensity, cyclicality or business maturity.
4. Challenge the performance meas­urement process. Although linking pay to performance is the goal of most executive compensation pro­grams, few have succeeded. The pressure on performance-goal selection, target setting and calibration to payouts is increasing; institutional investors are pushing to have performance-contingent equity awards. Shareholders expect companies to be able to explain how pay reflects company perform­ance. And, the question is increas­ingly being posed in the context of relative performance against peers. Be prepared to hear from share­holders if your performance against your peer group is weak, especially if your executives’ compensation and benefits are relatively high. There are good analytic tools and methodologies that can be used to develop an independent evaluation of whether the company is focused on the right goals, whether there is sufficient stretch and whether pay­outs are appropriate for the per­formance achieved.
5. Be holistic. Review all the elements of the executive remuneration pro­gram at the same time. It is difficult to implement a compensation phi­losophy and to ensure that pay is linked to performance if decisions regarding salary, incentive opportu­nity, performance goals and equity awards are made at different points throughout the year or in different years. And don’t overlook executive benefits and perquisites. For exam­ple, the committee should review the competitiveness of pensions in the context of the broader total compensation package received by executives in comparator compa­nies. This annual review should also include an update of the com-pany’s current and projected costs – earnings expense, cash cost and accrued liabilities – and executive benefits on an individual basis. Before implementing compensation program changes, committees should understand the implications (including costs) for any executive benefit or perquisite programs.
In addition, evaluate all programs – incentive plans, equity awards, retirement benefits and change-in-control and severance arrange­ments – under the best- and worst-case scenarios. Even if a low-proba-bility event occurs, you should be comfortable with the outcome or at least be prepared to weather the reaction. And know what will hap­pen upon the termination of each executive officer – for what reasons and at what cost.
6. Question your assumptions.
The environment has changed dra­matically; many of the old premises are no longer relevant. Companies should revisit the rationale behind all of their cash, equity, benefit and perquisite programs. Programs may not need to be abandoned, but they should be affirmatively continued because they are consistent with the company’s compensation phi­losophy and connected to business-related goals. For example, to ensure certain items are revisited, some companies are adopting a strategy to provide sunsets in new programs and agreements. So a new severance or change-in-control program might have a two-year life, at which time it will expire unless the committee affirmatively adopts a replacement program.
1. 7. Think about executive compensa­tion as a fundamental part of strategic planning. Strategic plan­ning charts the future course for the organization and reveals signifi­cant implications for the appropri­ate go-forward executive talent strategy. For example, shifting your target sales mix toward higher-margin products may mean that incentive plan metrics and goals need to be realigned. Implementing a new business model that focuses on customer service rather than cost to achieve competitive advan­tage may mean making additional investments to attract, retain and motivate top talent to execute the new vision, while reducing invest­ments in less critical roles.
2. 8. Capitalize on your company’s HR expertise. Many organizations have strong HR staff who have expertise on a wide array of issues that the committee will confront over time, including establishing a process and criteria for assessing potential board and executive candidates, implementing succession planning and leadership development, devel­oping an executive performance evaluation process, administering equity and incentive plans, and educating board members on industry trends and developments relevant to compensation and benefits.


1. 9. Develop a succession plan – and use it to actively manage your talent. Very few actions can have a more dramatic impact on stock price than the unexpected loss of a successful CEO. While the majority of companies say they have a suc­cession plan, this usually consists of a list of “A” players and, possibly, an estimated timetable for readi­ness. Yet a succession plan should involve not only the “who” and “when,” but also the “why” and “how.” Rather than asking manage­ment to identify potential succes­sors in their same mold, the board should articulate the skills and competencies needed to execute the company’s long-term vision, thereby providing an objective framework for identifying the right talent to meet the company’s evolv­ing needs. For the succession plan to be a true management tool, it must also include a comprehensive strategy for developing and moni­toring top talent once it has been identified. This includes identifying training, on-the-job experience and leadership development needs as well as developing an explicit plan to fulfill those needs.
2. 10. Understand how your executives value their remuneration. Many companies are taking a hard look at their LTI strategy and are strug­gling to understand the pros and cons of the many alternatives. A variety of factors should be con­sidered, including the associated accounting expense, tax

consequences, potential share dilution, alignment with the busi­ness strategy and administrative complexity. But the value per­ceived by executives should not be overlooked. For example, depend­ing on a potential recruit’s risk preferences, a sign-on package consisting primarily of perform-ance-based restricted stock with a $50,000 accounting charge may actually be more attractive than a stock option package valued at $150,000. This example also high­lights the importance of regularly communicating the potential value of the total remuneration package to executives in order to maximize return on the com­pensation investment. For any compensation program to drive results, participants must have a clear understanding of the expect­ed performance and associated rewards.
11. Talk with your major sharehold­ers. Shareholder advisory groups, which generally apply rigid mod­els to make recommendations on a limited number of governance topics, do not speak for all share­holders. Institutional investors may apply their own criteria for deciding how to vote at the annual shareholders meeting and certain­ly use their own discretion in determining whether to divest their interests in favor of more attractive alternatives. Many investors appreciate an open dialogue about matters such as potential board nominees or equi­ty grant reserves, and their input can generally give you a sense of broader shareholder views. The conversation doesn’t have to be limited to those matters over which they have voting rights – asking investors what financial metrics they follow closely may provide valuable insights into how third parties measure value cre­ation in your industry.
12. Read the board HR committee report in the proxy statement as if you were a shareholder.
Shareholders use the report to understand how the committee makes decisions, the rationale behind programs and how pay and corporate performance are linked. If the discussion is sparse, then shareholders must rely on finan­cial statements and disclosure tables in the proxy statement to formulate their own judgments. We see companies increasingly using their proxy statement as an opportunity to demonstrate trans­parency and to minimize surprises later. We encourage companies to proactively disclose information about the pay-for-performance link, perquisites and benefits. And finally, if you want to test the quality of your report, read those of your peer group and other com­panies’ reports that are being praised by the governance com­munity.
13. Make the best use of external advisers. Because executive remu­neration is an area of increasing complexity, specialist advice is critical. The committee should conduct executive sessions (with­out management present) as part of their regular meetings and use a portion of these sessions for a candid conversation with their outside advisers about market­place developments and program changes. Candor works both ways; we have also witnessed committee members being more forthright about their views on programmat­ic changes and developments. Making such discussions routine reduces the “sting” they’ve previ­ously had for management.