Expect Reported CEO Compensation to be Down for 2015

Last year, there was an uproar. CEO compensation had gone through the roof. Or, so people thought. I predicted it would happen and I was correct. We heard the cries from all directions. Politicians including presidential hopefuls talked about the millionaires and billionaires and oftentimes, they pointed to executive compensation.

As the 2016 proxy season evolves, perhaps some will tell you that their cries were heard. But, were they?

I predict that reported (in proxies) CEO compensation for 2015 generally will be down from 2014. There are several reasons that you don't hear in the campaign ads, notably:

• Pension discount rates have risen
• Equity markets generally did not perform well

What does all that have to do with CEO compensation?

People who recall my tirade last year know that many CEOs, especially those who run large companies and do have very high compensation have a defined benefit (DB) SERP as part of their compensation package. And, when discount rates fall as they did during 2014, SERP liability generally increases and that increase is considered by the SEC to be part of executive compensation. Similarly, when discount rates rise, SERP liability generally decreases meaning that the contribution of many SERPs to reported DB compensation for 2015 will be 0 (you're not permitted to report a negative number). When pay ratio reporting finally kicks in, this may be a really big deal.

What does the performance of equity markets have to do with CEO compensation? Again, most large public company CEOs receive sizable chunks of their compensation in stock whether that be in options, restricted stock, or some other form of stock compensation. When the value of that stock decreases, so does the value of that piece of their compensation.

This leads to an interesting question with an obvious answer. Did the economic conditions in 2014 that resulted in extremely large reported CEO compensation meant that CEOs were overpaid in 2014 compared to other years. And, similarly, were those same CEOs underpaid in 2015 compared to 2014? 

The answer to both questions is of course not. For most of these people, their pay packages were extremely similar in 2015 to what they were in 2014 and similarly in 2013. It's not that often that we see radical changes in the way that a particular CEO is paid. 

But, these external factors drive the numbers and those numbers often drive the conversation.

The final pay ratio rules won't be effective for about 2 years. Of course, companies are being encouraged to disclose earlier and some will. Perhaps this is the proxy season to start. Perhaps this is just the proxy season to understand how volatile it will be.

I can explain it. I can help.

How The SEC Got DB Plans All Wrong

Yesterday, I wrote that the SEC contributed to the downfall of defined benefit (DB) plans. I promised to explain in more detail in a future post.

Well, the future is now (I wonder if anyone else ever used that line before).

As readers of this blog well know, for about 10 years, issuers of proxies under the auspices of the Securities and Exchange Commission have been required to disclose compensation for their five highest paid employees. This compensation has been disclosed in a little beast known as the Summary Compensation Table and in more detail in several other places.

Some of the disclosure makes sense. For example, the salary that an individual actually receives is what it is. There is no disputing that. Similarly, the matching contribution that an individual receives in her 401(k) plan or in the nonqualified analog is what it is.

Some of the disclosure makes less sense. Fingers point to the defined benefit disclosures.

What the rules ask be disclosed as compensation with respect to a defined benefit plan (qualified or nonqualified) is the increase, if any, in the actuarial present value of accrued benefits from one measurement date to the next. That seems simple and reasonable enough on its face, but that is exactly where, how, and why the SEC went wrong.

Let's make up some Illustrative numbers for Well Paid Executive who we will refer to as WPE.

• Total pension accrued benefit as of 12/31/2014: $1,000,000
• Total pension accrued benefit as of 12/31/2015: $1,100,000
• Actuarial present value "factor" as of 12/31/2014 using 2014 discount rates and 2014 mortality table: 11.00
• Actuarial present value "factor" as of 12/31/2015 using 2014 discount rates and 2014 mortality table: 11.50
• Actuarial present value "factor" as of 12/31/2015 using 2015 discount rates and 2015 mortality table: 12.50

So, the actuarial present value of WPE's defined benefit as of 12/31/2014 was 11*1,000,000 or $11,000,000. 

The actuarial present value of WPE's defined benefit as of 12/31/2015 was 12.50*1,100,000 or $13,750,000.

The compensation due to defined benefits that must be reported for WPE was 13,750,000 - 11,000,000 or $2,750,000.

But, this is not an apples to apples comparison. Really Big Company (RBC) did not actually compensate WPE for the fact that interest rates on bonds declined during the year. RBC also did not actually compensate WPE for the fact that the Society of Actuaries had finished a new mortality study. 

The actuarial present value of WPE's defined benefit as of 12/31/2015 using 2014 actuarial assumptions was 11.50*1,100,000 or $12,650,000. This means that the increase, on an apples to apples basis, in the actuarial present value of WPE's defined benefits was 12,650,000 - 11,000,000 or 1,650,000. The other 1,100,000 was due to changes in actuarial assumptions and DOES NOT REFLECT THE AMOUNT THAT RBC PAID WPE DURING 2015.

The SEC's methodology has thrown proxy disclosures out of whack. In light of Dodd-Frank and its Say-on-Pay requirement and Pay Ratio Disclosure requirement, the SEC methodology puts an inappropriate burden on companies sponsoring DB plans. For some, this may signal a reason for them to exit that space ... for all the wrong reasons.

How to Handle Your Pay Ratio Disclosures

This is an article that I wrote for Bloomberg BNA that was published last Friday, August 21. Note that you may not reproduce this article without express written permission from BNA.


Reproduced with permission from Pension & Benefits Daily, 162 PBD, 08/21/2015. Copyright 2015 by The Bureau of National Affairs, Inc. (800-372-1033)
 http://www.bna.com


Pay Ratio Rule: Practical Tips for Making the Best of a Bad Disclosure Day

 BY JOHN H. LOWELL

Introduction
I t’s been about five years since Congress passed and President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act. In response to the financial crisis that escalated in 2008, legislators sought to put more controls on primarily the larger financial institutions that do business in the U.S. But, buried in this law was a little-debated provision sitting in Section 953(b). It has become known as the ‘‘pay ratio’’ rule.

On its surface, the pay ratio rule seems innocuous. Filers of proxies are to disclose the ratio of the compensation of the median-paid employee of the company to that of the CEO. However, as many have learned, this may be more difficult and more inflammatory than it seems.

In early August 2015, the Securities and Exchange Commission issued a final rule, effective for proxies for fiscal years beginning after 2016, explaining exactly who needs to disclose this ratio and how this is to be done. To its credit, the SEC tried its best to satisfy the needs of those who view this ratio as an important data point for a company and to satisfy companies that complained of potentially large expenditures to produce what they view as a seemingly meaningless number.

If what you need are the technical details specific to your company as to how these calculations are to be done, you can find summaries all over the Internet. Securities or executive compensation counsel will be more than happy to help you. What you may have more difficulty finding are explanations of how to prepare for that 2018 proxy season and what strategies your company may employ as permitted by the final rule.

Key Elements

Before we dive into that, it’s important to review some of the key elements of the final rule, particularly in places where either the SEC has made changes from the proposed rule or where it has afforded employers certain options.

• While the statute tells us that the number disclosed shall be the compensation of the median employee divided by that of the Principal Executive Officer (CEO for our purposes), both the proposed and final rules specify that it is in fact the reciprocal of that (a positive integer is intended). 
• Generally, all employees of the parent company and subsidiaries included in the consolidated financials must be included, but:  
• who is an employee may be determined as of any representative date within three months of the end of the fiscal year; 
• compensation for full-time employees may be annualized, but part-time, temporary and seasonal workers’ pay may not be annualized; 
• workers from countries with privacy rules that may preclude obtaining the necessary data may be excluded (if you exclude one worker from a country, you must exclude all of them); and 
• companies may exclude all workers from additional countries up to a total of 5 percent of the total company employee population. In doing so, first the employees excluded due to privacy laws are counted. If that gets the company to 5 percent or more, then there are no more exclusions. If not, then additional countries may be excluded so long as the total of privacy exclusions and selected exclusions does not exceed 5 percent of the total number of employees of the company. 
• Determination of the median-paid employee has been simplified: 
• solely for purposes of determining who is the median employee, the company may look to compensation amounts from payroll or tax records; and 
• once a median employee is chosen, the company may use the same employee as the median for two more years so long as there have not been changes to the company’s population or pay practices significant enough to make that determination unreasonable. 
• Companies may apply cost-of-living adjustments to equalize pay between countries. s Companies may add to their disclosures so long as the additions are no more prominent than the required disclosure. All that gives companies some useful options, but with options comes analysis to determine what to do and where the data will come from. 
• Determine which countries the company operates in. For those countries, determine: 
• whether privacy laws preclude obtaining necessary data, 
• what percentage of employees is excluded due to privacy laws, and  
• if less than 5 percent, are there other countries that it would be possible and beneficial to exclude? 
• What will it take to get payroll or tax records from all the countries? Alert people responsible for them in each foreign country now as to what you will need. 
• Consider whether the value in using cost-of-living adjustments outweighs the cost of doing so. For some countries, good cost-of-living data may be very difficult to obtain. For others, while the national cost-of-living index may be high or low, the cost in the areas in which your employees work may be very different.
• Consider the benefits of sampling employees rather than using the whole population. Based on the descriptions of sampling techniques described by the SEC in both the proposed and final rules, for most companies, this exercise will not be worth the trouble of understanding the sampling techniques. 

Perhaps the most important decision that a company will make regarding the pay ratio is what it chooses to disclose. Some companies won’t have to worry about it every year, but in some years these pay ratios are going to be very large. Even if the company’s board of directors feels certain that CEO compensation at their company is reasonable, the optics will be bad.

Good consultative thinking can be very helpful here. Let’s consider a few possible situations.

Examples

Company A – Many Seasonal Employees.

Company A (calendar-year filer) does significant business around the holidays. In fact, its workforce is typically about three times as large between September 15 and January 15 as it is the rest of the year. Because of that, the median-paid employee of Company A is likely to be a seasonal employee (recall that companies are not permitted to annualize the compensation of seasonal employees). Additionally, those seasonal employees likely never meet the requirements to participate in most of Company A’s benefit programs including its pension plan. This pay ratio is going to be high. Company A should consider making an additional disclosure showing a comparison of the compensation of its CEO to that of its median full-time employee. While this won’t change the required number, it will improve the optics significantly.

Company B – U.S. Pension Only.

Company B is a multinational organization with significant employees in countries around the globe. Most of the U.S. workforce is well-paid, making it unlikely that the median employee will be from the U.S. Company B has provided both a broad-based and a nonqualified pension plan in the U.S. for many years. In most of the countries in which it operates, providing pensions is not the norm and doing so would make Company B less competitive. Because the increase in the actuarial present value of accrued pensions is part of the calculation of ‘‘annual total compensation,’’ the pay ratio is going to be larger than Company B might like and its board thinks the required ratio is not representative. Company B should consider providing a ratio for the U.S. only and a ratio without regard to pensions as supplemental disclosures.

Company C – Excellent Performance Leads to Larger-Than-Usual Incentive Payouts.

Because of extraordinary performance over the period ending Dec. 31, 2016, Company C’s executives received much larger-than-normal cash incentive payouts (short-term incentive) and equity grants and awards (long-term incentive) in 2017. The pay ratio here is going to be very high, but the board’s rationale is that the CEO deserved it. There may be many readers of the pay ratio who don’t agree. Perhaps they won’t look at the reasons for the high pay ratio, but simply the number itself.

Company C might consider a number of options. First, there might be a narrative describing why certain elements of compensation were as high as they were. Second, Company C might disclose what the pay ratio would have been had the company (and CEO) merely met goals for the year rather than exceeding them. Third, Company C might disclose what the pay ratio would have been had its CEO received his average incentive payouts for the last three years or five years. Any or all of these will help to lend some perspective to the otherwise high pay ratio.

Company D – Varying Global Economies.

Company D has its operations primarily in the U.S. and in South America. It provides broad-based and nonqualified pensions in virtually every country in which it operates. During 2017, the economy in South America was vastly different from that in the U.S. As a result, while interest rates dipped in the U.S., they rose significantly in every country in South America in which Company D operates. This combination produced massive increases in pension values in the U.S. (for executives and for rank-and-file), but decreases (zero for annual total compensation purposes) in all of South America. Since pensions are a significant portion of actual compensation for Company D’s South American employees, their compensation will appear understated for 2017 while the CEO’s compensation will appear overstated.

Company D should consider several additional disclosure options:

• Disclose a ratio for its U.S. employees only,  
• Disclose a ratio assuming that pension discount rates had not changed in any country, or 
• Disclose a ratio without regard to pensions. 

Company E – Highly Diversified Global Business.

Company E is probably the most complex situation we will face. In the last few years leading up to and including 2017, it has generated a significant part of its revenue and most of its profits from its financial services division, which operates mostly in the U.S. Its CEO has to operate like the leader of a large bank and is therefore compensated commensurate with that. But, as a hedge against cyclical issues, Company E also operates in a variety of other industries and in multiple countries. The industries that are the most labor-intensive also employ the majority of their workers in low-paid third world countries. And, to the extent that Company E is involved in those industries in the U.S., its workers are largely unionized.

Company E has considered sampling to simplify the process. However, upon an examination of the rules, Company E realizes that it will have to do samples of each of its industry groupings in each country in which it operates. While it might reduce the number of employees that it has to evaluate, the expense of getting through the samplings outweighs the gains.

Company E realizes that its pay ratio is going to look very high. Philosophically, it is fine with that as its board feels certain that it is justified. But with multiple union contracts coming up for bargaining, Company E also knows that the unions will use the pay ratios to wage multiple media campaigns against Company E and its CEO.

In its disclosures that will go along with its required pay ratio disclosure, Company E needs to consider all of this. Here are some of the disclosures that Company E might make:

• U.S.-only pay ratio, 
• Disclosure of median pay for a typical employee in each of the U.S. unions with a breakout highlighting the company’s large expenditure on union pensions,  
• Salaried-employee-only pay ratio, or 
• Additional pay ratio compared to the union employee’s median pay encompassing elements not normally included in annual total compensation such as health care expenditure. 

Each of these additional disclosures has a cost associated with producing it. But, in Company E’s view, not producing ratios like this may be more costly than the hard costs to generate them.

Now What?

If you happen to be a part of one of the fortunate companies for whom this disclosure will neither be a calculational nor public relations problem, then your job should be easy. If, on the other hand, your company is closer to one of these more problematic situations, then you might have your work cut out for you.

Chances are that most in your company will not focus on this until after the end of fiscal year 2017. That may be okay, or it may not. Developing some of the ratios that we’ve discussed may be time-consuming and data-intensive. Trying to do that at the last minute may not be advisable.

Similarly, for a number of companies, this will be more than a calculation. It will be a strategy. Given the potential cost in investor relations and perhaps a battle over say-on-pay, it might be wise to have someone independently thinking about these issues. While using consultants haphazardly can create problems that were never there instead of solving them, here using a consultant who has thought through the issues and can help your company do the same would likely be money well spent.

You know that your company pays both rank-and-file and executives appropriately. Now you have to ensure that you manage the message so that all the interested observers know that as well.

Bloomberg Article on CEO Compensation

Proxy Hysteria Arrives -- I Was Right

I told you it would happen, didn't I? I said that companies whose executives participate in defined benefit (DB) pension plans, especially nonqualified plans were going to report massive increases in CEO compensation. I said that there would be a big name company for which the increase in CEO compensation due in large part to the amount from pensions would create hysteria.

It has happened. Bloomberg reported in a video and an article that GE CEO Jeffrey Immelt was rewarded with an 88% increase in compensation despite sluggish performance. The company attributed the compensation increase to his reshaping of the company and to an increase in the value of his pension.

In my opinion, this could have been handled better. They could have focused on the message from my January 7 post. It said right there what was going to happen. I wouldn't lie to you and I wouldn't lie to GE.

Let's digress for a moment and think about how executive compensation is disclosed for the named executive officers (NEOs), including the CEO, at a public company. The company discloses compensation generally in the Summary Compensation Table (SCT) of the proxy. In the Compensation Discussion and Analysis section (CD&A), the company is afforded the opportunity to discuss its compensation practices, procedures, and policies. As the CD&A is a narrative, the company is required to discuss its rationale for its policies, but it is certainly not precluded from explaining changes. In fact, this is a great place for the company to explain what happened.

According to the Bloomberg article, Immelt's total compensation was approximately $37.3 million. I am neither condoning nor condemning that level of compensation here; that's not my point. Bloomberg says that that amount represents an 88% increase in compensation. Using that figure suggests that Immelt's compensation in the previous year was approximately $19.8 million. Further, Bloomberg says that GE noted that without the pension increase, Immelt's 2014 compensation would have been $18.9 million.

Opportunity knocked, but nobody opened the door. Apparently, GE did give Immelt a roughly 6% increase in base pay apparently from $3.2 million to $3.4 million. There appear to have been no other changes in compensation structure or policy with regard to the CEO.

Suppose GE took the step of explaining the pension increase. The pension plans in which Immelt participates did not change. He wasn't granted a massive benefit increase resulting in his total compensation doubling. What happened was that his 2014 compensation replaced his 2009 compensation (remember 2009 was a horrible year for the US and global economies) in a 5-year average, pension discount rates dropped (this increases the present value of pension benefits), and the Society of Actuaries released a new mortality table (I suspect GE adopted it) reflecting longer life expectancies in general.

What could GE have controlled in an effort to keep Immelt's disclosed compensation relatively steady? They could not have controlled discount rates as they are based largely on the high-quality corporate bond market. They could have chosen, subject to the approval of their external auditors, to not update the mortality table to use for the calculations, but that would only have been obfuscating the issue and frankly, the updated table is likely more appropriate for them. Finally, 2009 happened in 2009. It can't be undone. Incentives paid out more in 2014 than they did in 2009. That's true for almost all companies. What it is reflective of, that corporate performance has improved, is true for many companies and it's a good thing.

So, GE and Immelt didn't do anything evil. Their crime, so to speak, was not an error of commission, so much as it appears to have been one of omission.

GE had to know that this "increase in compensation" would set off alarms. Bloomberg appears to have received or at least heard statements from GE. Why did GE not prepare its spokesperson to address this? The fault was not in changes to their compensation program; the fault was in their lack having a prepared message.

I don't expect that they will be the only company to face this issue. I can help you craft the message. Get out ahead of this problem.

You'll thank me later.

Proxy Hysteria Coming For Companies With DB Plans

You read it here first. During the upcoming proxy season, there is going to be hysteria over the executive compensation disclosures in proxies for companies with defined benefit (DB) plans, especially those with nonqualified plans for their named executive officers (NEOs).

What's going on? As part of an NEO's compensation, filers are required to include the increase in the actuarial present value of DB plans. The actuarial present value is a discounted value of the anticipated payment stream just as it was a year earlier. While there are many assumptions that actuaries select in determining an actuarial liability, two, in particular, have changed for many companies from 12/31/2013 to 12/31/2014. One is the discount rate which will have decreased by somewhere in the neighborhood of 100 basis points and the other is the mortality assumption. Late last year, the Society of Actuaries (SOA) released its newest mortality study and many companies elected to adopt the new tables.

The effect of the change in discount rate will vary, largely on the age of the NEO in question, but it's not unreasonable to think that for most NEOs that just that discount rate change will have increased the actuarial liability attributed to them by 8%-12%. Yes, Americans are living longer. Mortality assumptions should be updated from time to time. But, for proxy purposes, the year of the update causes an additional spike in the liability attributed to the individual NEO, perhaps an additional 5% depending upon age and gender.

So consider an NEO whose 2013 compensation included $1,000,000 due to the increase in the actuarial present value of accrued pension benefits. If that person is still an NEO at the end of 2014, he or she will have had an increase in liability due to surviving one more year (interest and mortality totaling perhaps 6%), an increase due to increases in included compensation (a large bonus could have increased even 3-to-5 year average compensation by 25% (recall that in the case of a 5-year average that 2014 which was a good year for many businesses replaces 2009 which was a dismal year for many businesses)), and increases due to changes in discount rates and mortality assumptions.

So, with no changes in compensation practices, our NEO who had $1,000,000 of compensation attributable to him or her in 2013 might see that turned into an increase of $1,500,000 in 2014.

There will be outrage. Proponents of the pay ratio rule of Dodd-Frank Section 953(b) will point to these increases and say that the rank-and-file got 2%-4% increases. The media will not understand what happened. Congress, and this might be the year that it matters as the new Republican control has suggested that it will try to repeal some parts of Dodd-Frank, will not understand.

But those people who chose to read my ramblings will get it. Companies that foresee the issue can address it. It can't be solved in its entirety, but it can be managed.

I know how.

Do you?

Asymmetric Risk Situations

These days, a good bit of my consulting practice is dedicated to defined benefit pensions and executive benefits and compensation. Over the last several days, in reading the news, it occurred to me the significant asymmetries in the two practice areas.

For those who have been living under a rock, certainly, at least in my opinion, the biggest business news has been the trading debacle at JPMorgan. Ina Drew, a long-time employee of JPMorgan who oversaw the trading unit is being held responsible. According to JPMorgan's proxy issued this spring, Ms. Drew earned approximately $14 million last year (frequent readers may know that the total annual compensation disclosed in a proxy may not be an excellent representation of the actual amount earned) making her, according to the proxy, the 4th highest compensated employee of the bank.

By all publicly available information that I could find, Ms. Drew has a reputation as being one of the best at her field. This from a Reuters article, "Until the loss was disclosed on Thursday, Drew was considered by some market participants as one of the best managers of balance sheet risks."

For full disclosure, I was once an employee of JPMorgan. I became one when my employer at the time was acquired by a JPMorgan unit. My employment there ended when the division of which I was a part was sold by the company. As a result of JPMorgan's incentive compensation plan which requires certain employees to defer parts of their incentive compensation ( the plan has previously been disclosed publicly), I have control of a relatively small number of shares of JPMorgan stock. This post is neither intended as approval nor condemnation of the company or its employees. JPMorgan happens to be in the news, currently, but on a different date, I could have chosen a different company.

So, where am I headed with this? Pension plans and individual (executive or commissioned) compensation represent entirely different risks. Each is asymmetric, but in opposite directions. So, this post is about behavioral risk management. It could easily be extended elsewhere, but I have no expertise in social psychology, for example (you may argue that I have none in the fields that I am writing about either, but I am going to defend that I have some, at the least).

Under current US pension law (see for example, Internal Revenue Code Sections 430 and 436), if we leave out transition rules and there are many, non-governmental qualified defined benefit plans typically get treated differently at funding levels of 60%, 80%, and 100%. Speaking in significant generalities, if your plan is less than 60% funded, there is not much that you can do with it. Participants generally cannot accrue new benefits, the plan sponsor can't improve the plan; essentially, all you can do is fund it, and the funding rules for plans less than 60% funded are pretty onerous (not judging the appropriateness of this part of the law here). Once a plan gets over 60% funded, but less than 80%, things get somewhat better. Restrictions are less. Between 80% and 100%, things are generally pretty uniform and a plan sponsor can operate on a normal ongoing basis, so to speak (this is not intended to be a course in pension funding law; it's illustrative). If your plan is better than 100% funded, it may be unusual these days, but funding gets easy. Note that there is no nice threshold in excess of 100%.

What does this tell us? If your plan is less than 60% funded, there are no more downside thresholds. The sponsor, oversimplifying significantly, has little downside risk. Between 60% and 100%, there is both upside reward and downside risk, and while they are not identical, there is certainly a degree of symmetry. Once your plan is better than 100% funded, there is almost no upside reward, but there is downside risk.

These risks and rewards should inform the asset allocation decisions. They should inform the fiduciary decisions and, in my experience, they often do.

Let's turn our discussion to compensation, specifically that of two types of individuals: 1) top executives whose incentive reward potential often dwarfs their base pay, and 2) commissioned salespeople whose commissions have the potential to exceed their base pay or are their entire compensation.

Here are some facts about the compensation of many of the people in both of those groups:

• There is little, if anything, that applies in practice that limits the upside of their incentive compensation. Even to the extent that it is limited, those limits are very rarely reached. (Some plans are not designed this way, but many are.)
• Unless a plan has clawbacks (a means for recovery of compensation for various reasons, often related to fraud or other criminal activity), employees don't receive a negative bonus. At least, I have never seen it.

In the context that we used for pensions, there is plenty of upside reward potential, but there is little downside risk. Suppose I am a commissioned salesman. Further suppose that my compensation is entirely based on a percentage, 3% for example, of my sales. The smallest that my compensation can be is $0. I cannot sell less than nothing. The most that my compensation can be is 3% of infinity. That's a big number. I have an incentive to take risks. 

In their best-selling book, Freakonomics, authors Levitt and Dubner discuss this in the context of real estate agents (excerpts can be found here). Oversimplifying, a real estate agent can sell two types of homes: someone else's or their own. When selling someone their own home, an agent has an incentive to sell for the highest price. For each additional dollar of sales price, the agent receives nearly 100 cents (their broker and the agent on the other side each receive something). When selling a client's home, out of every additional dollar of sales price, the agent gets about 3 cents. According to Levitt and Dubner (and I agree), the agent selling your home has an incentive to get sell your home quickly. If they can get an additional $300 for getting you an extra $10,000 in sales price, the system motivates them not to do it because $300 doesn't mean anywhere near as much to them as $10,000 does to you. Speed is more important. But, if they are selling their own home, that $10,000 represents more than $300,000 in sales of other people's homes. If they can afford to, that system motivates them to hold out for more.

Executive compensation is not quite the same. But, often, it's closer to the real estate agent model. Incentive payouts for many CEOs and their direct reports is discretionary. It may have theoretical limits, but according to dozens of proxies that I have examined (you can get proxies at the SEC website),an executive who has a fantastic year may have their compensation exceed even the upper limits specified in a plan. Upper limits are often more than twice a target. The incentive is there to take risk. 

Why do people play the lottery? It's a losing proposition ... for all except the winners. The upside is huge, however. But, it's a game of chance. You know that going in. And, if you play, you are willing to risk some amount for a huge potential upside. 

Should you treat your pension plan as a game of chance? I don't think so. The system has been set up against it. The system has rules and those rules should, in my opinion, inform your behavior. Whether the current system is the correct one is irrelevant. It is the current system.

Should your executive compensation program be a game of chance? Should it contain asymmetric incentives? When I am a shareholder with an opportunity to vote my shares, my bias is against it. I prefer the companies of which I am an owner to not take inappropriate risks. It's human nature. Even for an incredibly ethical person, incentives matter. If you give me an asymmetric bet, and that bet is in my favor, if I use the logical part of my brain only, I should take it. We would like executives to use logic.

When we give them an asymmetric risk opportunity, are we not asking them to take perhaps inappropriate risks? Are they risks that you wouldn't take in your pension plan?

How Much Should a CEO Be Paid?

That sure sounds like a simple question. It has no difficult words. It's not a compound question. It's the type that if an attorney asked a witness on cross-examination, there would be no objection as to form.

I've noticed the Occupy [Wall Street] movement and one of their major beefs is how much CEOs of US companies are being paid. On Facebook, I have seen a chart suggesting that US CEOs make on average 475 times as much as the median US worker (the data being used suggests that the median worker earns $33,840 per year) which suggests that the average CEO makes somewhere in the neighborhood of $15 to 16 million per year. That's a lot of money, but there are not a whole lot of CEOs that actually make that much. And, when the people who put together that chart did their homework, so to speak, they used compensation from proxy disclosures.

Executive compensation (and related topics) practitioners will know that this is not an apples to apples comparison. While many of the components of CEO pay do not apply to the median worker, note that CEO pay includes the value of retirement plans, for example, while median worker pay does not. Further, in the years where CEO pay, relative to the median worker is highest, this is significantly a function of prevailing interest rates on corporate high grade bonds. I'm not saying that this is the right way or the wrong way to do this, I'm just saying that this is the way it is.

But, we still haven't approached the answer of how much a CEO should be paid. So, I asked a few people who have been objecting quite strenuously to CEO compensation. They don't know either. But, the only answer that I got more than once was "less than 10 times what the average worker makes."

You know what. I know a few corporate CEOs (not real well, but in passing). And, not a single one of them would do their job if their pay was limited to less than 10 times what the average worker makes. A good CEO delivers value to a company. How much value? I don't know. Perhaps we will see as we watch Apple over the next couple of years in the post-Steve Jobs era.

Should a CEO earn more than 'talent'? In my opinion, generally a good CEO should earn more. They have larger responsibilities. While talent can swing earnings significantly for a segment of a business, the CEO sets the direction for the business.

So, I asked one of these people who thought that CEOs should less than 10 times what the average worker makes how much they thought that talent should make. I asked them if Lady Gaga should have made upwards of $50 million in 2010. They answered probably not. PROBABLY not! That means that there is a chance that she should earn that much, but the person who is responsible for having a recording contract shouldn't earn more than about $340,000. How about Peyton Manning. I think his football earnings for 2011 are between $10 and 20 million. Add that to his endorsement earnings and he is pretty well compensated. Is he earning that much in 2011? Does he deserve it? He's had a pretty good career, far better than most, but if he were a CEO in 2011, his compensation would be hit a lot more by his inability to do his job this year.

I know. CEOs don't get career-limiting injuries. But, in any case, it's a tough comparison to make. I don't know how much a good CEO or a bad CEO should make, but neither do the protesters. Perhaps, though, they should get a few facts straight before they present them.

Say on Pay Final Rules

If you're a follower of executive compensation issues, you undoubtedly know that Dodd-Frank Wall Street Reform and Consumer Protection Act became law last year. It made sweeping changes for most public companies. With regard to the executive compensation issues, the Securities and Exchange Commission (SEC) generally is responsible for interpreting the statute and writing the rules. In fact, they issued final rules for Shareholder Say on Pay (SSOP) and Shareholder Say on Golden Parachutes (SSOGP) earlier this week.

WARNING: This is really technical stuff and if you want the really technical version, you can read the briefings that virtually every major law firm is doing or already has done on this.

BENEFITS OF READING THIS INSTEAD: I think this is a pretty good summary of what's in there though. You may laugh a little bit, which probably won't happen if you read the law firm versions (I just have to pick on lawyers once in a while). I don't use fancy legal terms unless I have to. So, you won't see anything like estoppel, res ipse locutur, or aberemurdo.

I'm going to address them, hopefully from a practical standpoint, here, but first, as is my prerogative, I digress. This is a bad name for a law. It has no useful acronym. Back in the 70s and 80s, we got useful names for laws. They had great acronyms like ERISA, TEFRA, COBRA, and ERTA. I can pronounce all those things. I cannot for the life of me pronounce DFWSRCPA. Maybe you are more proficient with new diphthongs than I, but my tongue is twisted. And, yesterday, Congress showed they can still do it. A bill to enact medical malpractice reform was introduced with the catchy acronym of HEALTH Act. It's too bad that it has the full name of Help Efficient Accessible Low-Cost Timely Healthcare Act of 2011, but it last I can say the acronym.

OK, back to serious stuff. What are the differences between the Dodd-Frank final rules and the proposed rules and what stays the same?

Differences


Say on Pay

• SSOP votes are required only at meetings where directors are being elected. The vote may be more frequent, but it must occur no less frequently than once every three years.
• The only required vote is on the executive compensation of named executive officers (NEOs). Don't despair, though, companies may choose to solicit shareholder opinion on other compensation issues. Here's a guess that most companies won't do that.
• Companies with share value available to be traded by the public of less than $75 million (some people refer to this as the float) get a 2-year delay in needing to comply.

Say on Frequency of vote (SSOF)

• Again, these are required only with respect to annual or special meetings at which directors are being elected, and not less frequently than every six years. Is it ironic that votes on frequency do not need to occur frequently?
• Companies with a float of less than $75 million get a two-year delay here as well.
• Not less than 150 days after the annual meeting and not less than 60 days before shareholder proposals for the next annual meeting are due, the company must file an 8-K explaining how often it will hold SSOP votes in light of the results of the SSOF vote.
• If one of the three frequency alternatives (annual, biennial, triennial) gets a majority of the shareholder vote (more than 50% as compared to a plurality which is simply the largest vote-getter), and the company chooses to adopt that frequency of vote, then the company may reject any shareholder proposal calling for a SSOP or SSOF vote.
• Proxy statements must disclose the frequency and next occurrence of SSOP votes.

Say on Golden Parachutes

• Smaller companies (float < $75 million) get a 2-year delay
• These rules apply to any filings after April 24, 2011

The Song Remains the Same

These items are significant, IMHO, but unchanged, or largely unchanged from the proposed rules issued last October.

Say on Pay

• There is no specific language requirement. Companies should just make sure they do not mislead shareholders.
• Director compensation need not be voted on in the SSOP.
• The result of the SSOP vote must be disclosed to shareholders within 4 days after the meeting.
• The vote is non-binding. The proxy statement must disclose that it is non-binding. Editorially, of the shareholders who actually read the proxy information, I wonder how many will not realize that the non-binding nature is simply following the law, and will have a "why are they doing this" moment.
• In the next Compensation Discussion and Analysis (CD&A), companies must discuss whether and how they considered the most recent SSOP vote, and how that vote has affected their executive compensation, as well as their policies and decisions with respect to that compensation.
• Institutional investors are required to file their SSOP voting record with the SEC.
• Companies still under the auspices of TARP are exempt from these rules (until they have fully repaid and been released from TARP), but they are subject to the TARP SSOP rules.

Say on Frequency

• The same 8-K 4-day rule as applies for SSOP applies here.
• This is non-binding and the proxy must disclose such non-binding nature.
• There are no specific language requirements.
• Four and only four choices must be presented for the SSOP vote in the SSOF vote (I wonder what would happen if the majority vote were abstain. If that were the case, would the company by somehow adopting abstain be allowed to ignore shareholder SSOP and SSOF proposals? I don't even know what that means.):
• Annual
• Biennial
• Triennial
• Abstain

Say on Golden Parachutes

• The information already provided in the proxy entitled "Potential Payments upon Termination of Employment or Change in Control" (Item 402(t)) does not satisfy the Dodd-Frank requirement. However, they still have to provide that other information. Talk about overkill ...
• Item 402(t) disclosure is required whenever a proxy solicits change-in-control approval, whether or not the company is required to have a SSOGP vote
• Disclosure for the SSOGP vote must be in both tabular and narrative form. This way, both the verbally and the mathematically challenged get a second bite at the apple.
• Here are the goesintaz (that's what must go in) for the tables. The comeoutaz (what the executives get may be pretty massive). There is no de minimis exception:
• cash payments
• value of accelerated payments and stock awards
• payments in cancellation of options and stock awards
• enhancements to pension and nonqualified deferred compensation arrangements
• perqs and other personal benefits
• health and welfare benefits
• tax reimbursements and gross-ups
• any other comeoutaz (see above for what this means) that don't fit into any other category
• The aggregate amount
• Footnotes
• other pertinent information
• single or double trigger
• The narrative must disclose the specifics of the events that would trigger these payments, who would make the payments, whether they will be made in lump sums, installments, or some other way, and any restrictive covenants (such a fancy name for a non-compete or non-solicitation agreement) that apply.

Time for Say on Pay

It's "say on pay" time, or at least that's just around the corner. Companies are struggling to decide (or maybe they are not struggling) how frequently to hold say on pay votes. According to a December 2010 Towers Watson survey, of 135 publicly traded respondents, 51% plan to hold annual say on pay votes, 10% biennial votes and 39% will hold their votes only as frequently as required -- once every three years.

What does it say about those various companies? In my opinion, in today's climate, a company that is not willing to hold an annual say on pay vote is just spitting in the collective faces of its shareholders. Of the companies who have decided how they will evaluate their shareholder votes, most, according to the survey, say that an 80% shareholder approval rate will be considered successful.

If we consider the typical shareholder profile of a typical publicly traded company, I suspect that significant numbers of shares are held by institutional investors. Of the shares held by regular old people like you and me, far more are higher-income individuals than not and will not be immediately scared off by currently reasonable levels of executive pay. If you can't get 80% approval annually, you are doing something wrong ... and you should change.