Special Report: Executive Pensions

New corporate governance disclosure guidelines reveal how many companies are facing millions in liabilities to fund gold-plated executive pensions.

2006 | 2005

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Retirement is supposed to be the golden years, a time when hard-working executives can finally relax and enjoy the fruits of their labour. And for managers of some of Canada's largest publicly traded companies, generous pension plans ensure a truly golden retirement. Details of the plans have been kept largely out of shareholders' sight, but new corporate governance disclosure guidelines that came into force earlier this year reveal how many companies are facing millions in liabilities to fund gold-plated executive pensions. “There is going to be a lot of sticker shock out there when investors see the cost of a lot of these plans,” says Brian Gibson, senior vice-president of public equities at the Ontario Teachers' Pension Plan.

Directors on U.S. compensation committees have already begun to feel the backlash from shareholders, regulators and governance advocates in the wake of the 2003 scandal at the New York Stock Exchange. News that former NYSE chairman and CEO Richard Grasso would qualify for nearly US$190 million in retirement and other pay sullied the reputation of the Wall Street bigwig and cast a harsh light on the elite directors who approved his excessive pension. While few, if any, Canadian executives would qualify for a pension quite that large, many are already guaranteed well over $1 million in benefits annually for life.

Here's how it works. Supplemental executive retirement plans (SERPs), or “top hat” plans as they are often referred to, were created decades ago to get around a government cap in pension payouts that affects managers earning more than $100,000 per year. With the cap in place, managers earning $500,000 receive the same pension payout as an employee with the same tenure earning just $100,000. The top hat plans allow highly paid execs to earn the same percentage of their income in their pension as lower-paid workers. But while regular worker pensions are tightly regulated and the cost of those plans must be disclosed on the company's balance sheet, SERPs are largely unfunded — and any disclosure of the costs and benefits of the plans is still voluntary.

Moreover, unlike regular pension plans — which are based on a simple formula that multiplies a percentage of the employee's base salary by the number of years worked — top hat plans now often include not just the manager's base salary but also bonuses, long-term incentives and other perks that can drive the cost of the pension through the roof. As well, it is not uncommon for the executives to qualify for a full pension after only a few years of service — and they can be credited with additional years of service.

Look at the case of Paul Tellier, whose brief tenure as CEO of Montreal-based Bombardier Inc. (TSX: BBD.SV.B) ended in December 2004, less than two years after being hired to turn around the floundering aerospace giant. In addition to the one million stock options he was awarded when joining, the $2 million in mid-term incentives and the $3.8 million in severance payments, Tellier also qualifies for an annual company pension of $360,000.

The pension payouts are even larger for long-serving executives. Over at Toronto-based Manulife Financial Corp. (TSX:MFC), which has taken the lead in disclosing the total cost of its executive compensation and pension expense, if president and CEO Dominic D'Alessandro were to retire today, he would qualify for an annual pension of more than $1.6 million after some 23 years of pensionable service. That generous retirement package increases to more than $2.9 million annually if he retires at age 65 in eight years, because the company credits D'Alessandro with two years of pensionable service for every year he works between 2004 and 2009. Manulife estimates it will cost the company more than $18 million to fund D'Alessandro's pension plan were he to retire now. If you add all the other Manulife executives covered by the company's Canadian SERP, that cost skyrockets to more than $180 million.

That may seem like a lot, but it's not uncommon. At Calgary-based Shaw Communications Inc. (TSX: SJR.NV.B), CEO Jim Shaw qualifies for an annual pension of nearly $2.5 million, while his father, company founder J.R. Shaw, will be paid almost $2 million annually when he retires as executive chairman. Those payments, as well as payments to other Shaw executives, will cost nearly $62 million to provide.

Unlike regular pension plans, the executive pensions are an unfunded liability; companies start paying only once the exec retires or if there is a change of control. That change-of-control clause essentially turns some of the priciest executive pension plans into an unintentional “poison pill” that makes it nearly impossible for anyone to buy the company, says Teachers' Gibson. “Just the cost of funding the existing SERPs amounts to more than 1% of Shaw's current market capitalization,” he adds. “Shareholders have no problem paying for good management, but when that pay gets to be way outside of normal bounds it is just a transfer of wealth and capital from shareholders to management.”

Shareholders had to swallow a bitter pill in 2003 when they tried to oust the management of Vector Aerospace Corp. (TSX: RNO), a tiny St. John's, Nfld.-based company. Management argued that it would not be in shareholders' interest to fire them since the change in control would force the company to fund a $30-million annuity to guarantee their pension and severance agreements. After a bitter proxy fight, the board ultimately voted the incumbent managers out; a legal fight over the SERPs continues to drag through the courts.

So what can directors do to avoid having their reputations — along with the balance sheets of the companies they are overseeing — destroyed by a poorly designed executive pension plan? Well, for one thing, they have to wake up and realize the value of pension arrangements they are approving, says Luis Navas, managing director of Toronto-based Executive Risk Governance Advisors. For most companies, he says, executive pensions were either an afterthought or a quick and under-the-radar way to increase compensation. “Let's be frank,” says Navas. “When the market took a downturn a few years ago and executives were not making as much on their stock options, pensions were seen as a way of boosting compensation without getting noticed.”

It is now common for executive pensions to include not just salary and bonuses (and, sometimes, long-term incentives), but also to allow execs to cherry-pick their highest bonus years to count as pensionable earnings, says Navas. Boards can limit their pension liability by putting caps on how much income is eligible to be included and ensuring that directors and execs understand the worth of the total pension plan. Unfortunately, most boards fail to take their pension arrangements for a test drive, says Gibson. “Boards often fail to look at extreme payouts where management does a really good job and gets a really big bonus that results in a hugely inflated pension cost.”

Canadian directors are now starting to get wise to the looming liability in their executive pension agreements. But for many companies, it may already be too late. Unlike other forms of executive compensation that can be revisited on an annual basis, it is almost impossible to make retroactive changes to pension agreements, says Gibson. That makes it even more important that directors get it right the first time. “SERPs are the gift that keeps on giving,” he says. “If you get it wrong, the company will be paying not only until the executive is dead, but until his spouse is dead as well.”