For years, it was an unquestioned system. Board directors determined the compensation for the senior management team … and themselves. But these days there are questions, and even lawsuits, over excessive director pay, and companies are looking for a transparent, hands-off way to pay directors and satisfy stakeholders.
The alternative that’s gaining attention is a rules-based formula that shareholders can vote for, says Irv Becker, Korn Ferry’s vice chairman for Executive Pay and Governance. Boards could set total director pay at the industry average, and directors could get additional compensation based on company performance. Both aspects of the plan would be approved by shareholders. “There’s an awkward back and forth and a lot of angst directors and management go through in setting each other’s pay,” says Becker. “This approach minimizes that discomfort and gives shareholders the ability to approve something they didn’t get to approve before.”
Ironically, firms have tried the formula approach before. Back in the mid-2000s, a large public company gained attention when it said it would tie board compensation to company performance. The plan was hailed as a bold and innovative experiment in aligning director and shareholder interests.
It failed miserably. Meant as a way to address charges of overcompensating executives and directors, the plan ended up enriching them instead. However, experts say the flaw wasn’t in the idea but in its execution.
Becker thinks that a system to automatically set pay levels based on specified rules should have some level of built-in support among both directors and shareholders this time around. He cites the fact that most organizations already base changes to their pay programs on peer group medians, and that the variance between director pay levels is immaterial when compared with the difference in executive compensation levels. For example, a Korn Ferry study found a difference of only $52,000 in total pay for directors in the 75th percentile versus those in the 25th percentile. By contrast, the difference in total pay for CEOs in the 75th percentile versus those in the 25th percentile is around $8 million.
Part of the reason for the wide variance is because executive compensation is based on the peer group position median, while director pay levels are based on the size of the organization by revenue and within the industry. The former allows for wide variation between the highest and lowest paid executives at a particular level. The difference between the highest and lowest paid directors, by contrast, is basically immaterial.
The current corporate climate may make many boards explore an alternative approach to compensation before shareholders force them to consider one of their own. “There’s been an increase in legal and governance focus around director pay,” says Becker, noting recent lawsuits brought by shareholders against companies for providing “excessive” compensation to their non-employee directors. Starting next year, proxy advisory firm Institutional Shareholder Services may recommend against the reelection of board members responsible for approving “excessive” non-executive director pay as well, though the firm doesn’t specify what constitutes “excessive.”
There’s also the added complication of board members working with management to set their own pay levels, which could be perceived as a conflict of interest on both sides. In recent years, boards have sought to protect themselves from litigation by imposing annual limits on stock awards, if not total compensation. But merely having a limit on director pay does not insulate companies from lawsuits. Moreover, limits could impact an organization’s ability to attract high-caliber directors. Taken together, “directors may be open to a different approach,” Becker says.
To be sure, the formula idea isn’t a total panacea. It doesn’t address concerns that director pay may be simply too high in general. Another drawback is that boards would be forgoing their ability to increase or otherwise differentiate pay levels outside of the preapproved rules. Nevertheless, “a formulaic approach to setting director pay levels approved in advance by shareholders can help boards avoid becoming a compensation outlier,” Becker says.