Compensating Executives in a "Challenging" World

The rationale has always gone something like this: if you don't compensate your executives at least equal to their peers and if you don't reward their performance, you will never have a top tier executive group and your company will not succeed.

Is that statement true? Is part of it true?

We're getting much closer to finding out. The big news this proxy season is from shareholder proposals on executive compensation. That's right -- since Say-on-Pay votes are non-binding, shareholder groups are looking to force companies to put components of executive compensation to a binding shareholder vote.

Before getting into a few details, let's understand how most companies are reacting. It's not surprising, but as a group, large corporations do not think their shareholders understand executive compensation. They are seeking to keep these votes off of their proxies. As a precursor to doing so, they request what is known as a "no-action letter" from the Securities and Exchange Commission (SEC). In brief, when a government agency issues a no-action letter, it assures the requestor that it will not take action on a given issue. So, when a company seeks such a letter from the SEC, the company is asking the SEC to confirm that it will not take action, for example, for a failure to place a particular item in its definitive proxy.

One of the most ardent submitters of executive compensation proposals is the largest American labor union, the AFL-CIO. In a statement, the AFL-CIO said, "We opposed compensation plans that provide windfalls to executives that are unrelated to their performance."

On its surface, that seems very prudent. But, it may be a bit trickier in practice.

What makes compensation related to performance? How does one define performance? Is compensation as expressed in the Summary Compensation Table? Is it cash only? Does it include equity? Does it include the (proxy-includable) value of deferred compensation?

Here is how it would strike me.

• Base pay is not related to performance. But, generally, to the extent that such pay is deductible to the employer under Section 162(m) ($1 million pay cap), some observers will not consider it to be egregious. On the other hand, in today's world of pay ratios and calls for increases in rank and file wages, other observers will ask that it be capped at some multiple of either the median pay for the entire company or even that of the lowest-paid employees of the company.
• Bonuses are theoretically related to performance. To the extent that the criteria used to evaluate executive performance and by extension, executive bonuses, are appropriate, so should those bonuses be. To play devil's advocate, however, if an executive knows how her bonus will be calculated, she may take inappropriate risks (for the company) in order to maximize the expected value of her bonus. Similarly, she may find ways to accelerate certain items into the fiscal year in question while deferring others until the next year. 
• Long-term incentives are [nearly] always performance based. In today's world, it is expected that those incentive payouts will be based on the achievement of a set of goals related to metrics deemed appropriate for that executive. Often, there are circuit breakers (elements that if the executive fails to meet a pre-established minimum level of performance, he will not receive a payout or that part of a payout at all). But, long-term incentives are often paid in company equity. This means that compensation will, to a large extent, be tied to share price. As we know, however, share price is not always tied to corporate performance. On any given day, share price may be influenced by such as the state of peace or war in the Middle East, a speech given by the President of the United States, or the rise or fall of housing starts during the last month. 
• What about deferred compensation (here I am referring to traditional deferred compensation plans, either defined benefit or defined contribution)? It's rarely performance based. Theoretically, the company is paying an executive less today for a promise to give them some of that pay in the future. What sorts of plans should be challenged? If an executive voluntarily defers some of their compensation and it grows at a rate tied to some broadly investable index, is that okay? Suppose she has a DB SERP that looks just like the broad-based plan (qualified plan), but without limitations applicable to qualified plans. Institutional Shareholder Services (ISS) is generally fine with this, but major labor unions may not be. And, if that SERP looks very different from qualified plans, even if there is a good reason for it, this may be a situation where no institutional shareholders are satisfied.

What should Boards of Directors and their Compensation Committees do about all of this? ConocoPhillips shareholders are asking that the Compensation Committee develop a program to determine which portions of a bonus should be paid immediately, which portions should be deferred, and what adjustments should be made to those deferrals based on performance.

Perhaps this has some merit. If it does, however, it's a bit of a nightmare for people who need to figure out how to make such a plan 409A-compliant and for those who need to administer FICA tax payments.

On the other hand, if adjustments are to be made based on performance, can't the same executive who is able to manipulate performance metrics in the LTI scenario described above also find a way to manipulate them here? Where there are objective formulas, there are smart people who can figure out how to game the system. Where there are subjective evaluations, Boards will be accused of pandering to the executives of the companies.

More than ever, the Compensation Discussion and Analysis (CD&A) will be very key. Explaining why the mix of objective and subjective factors was chosen can go a long way to appeasing large shareholders. Explaining how levels of compensation were chosen is a must. And, for the first time, we may see companies rationalizing their levels of executive pay as compared to rank and file pay.

With all of these challenges to executive compensation, these are challenging times for Compensation Committees.

Benefits and Compensation After the Elections

Suppose there was a presidential election this year. Just suppose. And, further, suppose that election had a winner. Just suppose.

It is extremely likely that the winner will be someone nominated by either the Democratic Party or by the Republican Party. And, it is not at all unlikely that the party of the winner will keep or gain control of both houses of Congress.

From the standpoint of tax policy, and by extension, benefits and compensation policy, what will this mean for you, the employer or employee? Should you care?

I don't think we're far enough along to do a candidate-by-candidate analysis, but I do think that we are aided by the fact (at least I think it's a fact) that the remaining viable candidates fall generally into a few small buckets from these standpoints (yes, Carly Fiorina will give us a 3-page tax code (no idea what it might say) and Gary Johnson who has declared for the nomination of the Libertarian Party is a Fair Tax proponent). In fact, I think there are at most four such buckets remaining.

Let's identify them from left to right (that is how we usually read):

• The Democratic Socialist (DS) Bucket whose main component, Senator Bernie Sanders (I-VT, but caucuses with the Democrats and running for the Democratic nomination) has recently told us, "Yes, your taxes will go up."
• The Mainstream Democratic (MD) Bucket whose main component, former Secretary of State Hillary Clinton will, according to her website today (it did say something somewhat different on this topic at the end of last year), lower taxes for the middle class (and by extension the lower class) and raise taxes on the wealthy including big business.
• The Traditional Republican (TD) Bucket that includes the likes of [alphabetically] Chris Christie, governor of New Jersey; John Kasich, governor of Ohio; Marco Rubio, junior Senator from Florida; and Donald Trump (yes he is mainstream for this purpose), businessman from New York, which generally would lower tax brackets and flatten, or make less progressive, the tax code.
• The Conservative Republican (CR) Bucket that includes Ben Carson, retired physician from Maryland, and Ted Cruz, junior Senator from Texas which would replace the current income tax structure with a flat tax.

I'm going to make things a little tougher on you here Rather than reiterating these buckets, I'll comment on how different philosophies might affect things.

We all know the health care debate. Sanders wants to move to a single-payer system. Clinton likes the status quo under the Affordable Care Act (ACA). The Republicans with the exception of Kasich want to repeal the ACA and start over again. Kasich, on the other hand, thinks that this is an impractical solution and would keep some portions of the ACA and change others.

On the pension side, Republicans as a group are in favor of self-reliance. This would tend toward a world of nothing but 401(k) (and similar) plans. Their philosophy is that prudent Americans should be able to save enough for their own retirements, especially with the benefits of an employer match. Of course, many of them will be dismayed WHEN they read my blog to know that I disagree with that.

Clinton is much tougher to figure out on this. But, we can look to her stated tax policy and work our way back. When taxes on high earners and large corporations increase, so does the value of tax deductions. So, under a Clinton presidency, we might expect to see more high earners and profitable corporations accelerate contributions to benefit plans in order to accelerate tax deductions. Could this result in somewhat of a rebirth of defined benefit (DB) plans? Theoretically, it should, but in practice, I would expect that even if that rebirth occurs, it will be very limited.

Sanders would prefer to see a single government-run retirement system for everyone; that is, we would have expanded Social Security and Medicare with smaller benefits and less availability for those who have been the highest earners. In this scenario, although I personally don't see Congress going along with it, the prevalence of employer-provided retirement plans could decline significantly. On the other hand, it would not be antithetical to his philosophy to see a DB requirement in much the same way that the ACA leaves employers with a health care requirement. Could we see pay or play here?

With regard to executive compensation (nobody is saying much about broad-based compensation other than to say that under their Presidency, there will be more and better jobs and pay will increase rapidly), we have another large rift between the candidates. Here, one of the biggest elements is the view of what has probably been President Obama's second signature bill, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank). (Why couldn't they have given the law a short name like Fred so that I don't have to test my typing skills every time I cite the law?) 

Sanders is a huge fan of Dodd-Frank. That said, he doesn't think the law has gone far enough. He has said many times that the reinstatement of Glass-Steagall should have been part of Dodd-Frank. Sanders, much like Senator Warren (D-MA) as well as former Senator Dodd (D-CT) and former Representative Frank (D-MA) believes that one of the most important parts of Dodd-Frank is Title IX, the section on executive compensation. Sanders is a huge proponent of tieing levels of executive compensation to that of the rank and file and of their companies as well as generally limiting executive compensation. Under a Sanders presidency, do not be surprised to see a presidential proposal that would limit CEO compensation for example to a pay ratio as defined in Section 953(b) of Dodd-Frank to something like 10.

Clinton is also a Dodd-Frank fan. But, there is a big difference here. Secretary Clinton has long had both ties and obligations to the large Wall Street banks. She periodically invokes Glass-Steagall, but knows that its repeal allowed Goldman Sachs, for example, to grow into the financial giant that it has. At the same time, though, Clinton, who I believe is still far more likely than not to be the Democratic nominee, knows that the Democratic platform will be influenced by the likes of Sanders and Warren. Expect that the compromise will be in the form of promises to scale back executive compensation. As broad-based plans in which executives participate tend to be exempt from similar scrutiny, those higher-paid individuals may look to solutions that have been proposed over time in this blog.

On executive compensation, Republicans are fairly united. All, that I am aware, would push for the repeal of Dodd-Frank and for no more (or fewer) restrictions on executive compensation. As free market proponents, they would tell us to let the fair markets determine how top executives should be paid. All that said, proposals like that will be anathema to most (perhaps all) Democrats and unless the GOP were to gain a filibuster-proof majority in the Senate, such proposals are not likely to become law. However, as Republicans without exception are looking to lower the top marginal tax rates as well as corporate tax rates, look for more emphasis on current compensation and perhaps less emphasis on deferral opportunities.

As the 2016 election process matures and there are fewer candidates, we'll be able to dig deeper. In the meantime, you have my opinion. What's yours?

And, if you think my opinions have any merit, let me help you address what will be coming with the 2016 elections.

IRS Proposes Updated Pension Nondiscrimination Rules

I wrote recently about some of the causes of the relative demise of defined benefit (DB) plans. Last Thursday, although it was dated Friday, the IRS released a new proposed nondiscrimination regulation. We had been told that this was coming down the pike. It was going to be all good. It was going to provide relief so that a DB plan that was compliant and was frozen to new entrants (sometimes called soft frozen) would not suddenly become non-compliant due to natural turnover and promotions of active employees in the plan. That the IRS addressed this nearly 23 years after the regulations were finalized was long overdue, but good news.

We didn't know that there were going to be other changes. One of the hallmarks of the suite of nondiscrimination regulations (nondiscrimination, coverage, minimum participation) is that they provided objective tests to determine whether a plan discriminated unfairly in favor of highly compensated employees (HCEs). In fact, the final regulations tell us that satisfying the various tests included in them are the sole method of demonstrating nondiscrimination. While this caused a significant burden for some companies and their plans, it gave plan sponsors comfort in knowing that passing those tests meant that there plans were, in fact, nondiscriminatory. Many design and redesign studies were done because of this knowledge.

Then came last week,

I now digress into some technical mumbo jumbo the likes of which this blog has not seen for a while. If you don't like or care about the technical stuff, please stick with me; I'll return to the more common language soon.

The rules for nondiscrimination in amount under 1.401(a)(4)-2 and -3 contain something known as the general test. Under the general test, there exists a concept known as the rate group. For each HCE, there is a rate group consisting of that HCE and all other nonexcludable employees whose normal and most valuable accrual rates are at least as big as those of that particular HCE (people with similar accrual rates can be grouped to be considered to have the same accrual rate as each other). Once we establish the rate groups, we must demonstrate that each rate group satisfy the head counting portion of the same coverage test under Code Section 410(b) that the plan uses to satisfy coverage. So, if the plan uses the Ratio Percentage Test to satisfy 410(b), then each rate group must have a ratio percentage of at least 70%. On the other hand, if the plan uses the more complex Average Benefit Test to satisfy 410(b), then each rate group must have a ratio percentage at least equal to the lesser of the actual ratio percentage for the testing population or the midpoint of the safe and unsafe harbors (this threshold is far less than 70% and is frequently in the neighborhood of 30%).

This has been the case since 1993. In fact, there are now people performing testing who were not alive when we started doing testing this way.

Under the proposed regulations, however, that lower threshold would not be available to plans that have separate formulas for which there is not a reasonable business criterion. The proposed regulation tells us that naming names (common in designs often known as QSERPs) does not constitute a reasonable criterion. The problem is that when the word reasonable is used, we, the practitioners never know what someone else thinks is reasonable.

So, will we be left doing tests that we think are correct only to learn that someone else with a higher authority thinks that we have misconstrued what is reasonable? Is this a calling to just stop providing retirement benefits? After all, we could design perfectly good retirement plans for our clients today that we learn tomorrow have suddenly failed to still be nondiscriminatory.

From a personal standpoint, the good news is that even most of the aggressive designs that my colleagues work with would seem to satisfy the reasonable business criterion test. There are lots of plans out there, however, that do not, and these plans may be in trouble if and when the proposed regulations are finalized.

Would you like to know if your plans seem safe or potentially in trouble? I'll be happy to help you figure that out.