How corporate boards can set executive pay more fairly

One way to control sky-high C-suite pay packages is to base compensation on better metrics than just stock prices

Group of people in a boardroom

(Monty Rakusen/Getty)

Sky-high CEO compensation emerged as an issue again in 2015, after say-on-pay votes resulted in shareholders rejecting proposed compensation plans at both CIBC and Barrick Gold. “Executive pay is the greatest corporate governance problem yet to be solved,” says Richard Leblanc, a governance expert at York University.

Critics blame the problem largely on so-called peer benchmarking. Compensation consultants survey what CEOs of similar companies receive. That data is then used by compensation committees to set their executives’ pay. Since each board naturally believes their CEO is of above-average ability, the result is inflation over time. Additionally, the pay packages are often so complex that it’s hard to foresee the impact of provisions without actuarial expertise. “Directors admit to me privately that they don’t understand the terms,” says Leblanc. “Complexity is always a red flag for self-dealing and personal advantage.”

Rather than focusing on inter-company comparisons, comp committees should base pay on how executives build long-term value for the company, Leblanc and others argue. Currently, 90% of CEO pay is linked to company performance of three years or less and based largely on stock price, much of which owes more to market forces than management acumen. This structure motivates executives to prioritize short-term gains. Dominic Barton,global managing director of McKinsey & Co., recalls one CEO of a U.S. multinational admitting the inherent conflict of interest: “I could crank up my stock price dramatically over the next few years if I pulled back on R&D and training of my people. Personally, I would do very well, but my company would not be in existence.”

The answer, suggest institutional investors like Mark Wiseman, CEO of the Canadian Pension Plan Investment Board, is to align pay to longer industry and product cycles, and to use restricted stock units (rather than stock options) that vest over time—even after the CEO retires—pushing executives to think seriously about what happens after they’re gone. Wiseman commends Manulife for introducing restrictions this year that require executives to hold their stock options for at least five years before exercising them.

Importantly, pay should be tied to non-financial metrics, such as customer satisfaction, health and safety, and risk management. The board of Brazilian cosmetics maker Natura, for example, pays close attention to talent churn and cuts executives’ bonuses if such “health” numbers are poor. At PG&E, preventable accidents, customer satisfaction and other non-financial measures account for 40% of the CEO’s annual incentive pay. For several years, Cameco has tied compensation to environmental sustainability and worker safety, because “being in the uranium business, the company understands the importance of the social licence from the community,” says Nancy Hopkins, a lawyer who sits on several private- and public-sector boards, including Cameco’s. The result has been greater transparency and focus on these metrics, she reports. “The management brings up these issues at each board meeting.”

For all the criticism, many global companies have become much more rigorous in their compensation policies. Ken Hugessen, a Toronto-based compensation consultant, notes that the aggregate CEO pay for the TSX 60 was flat last year. “Much of the needed change has, in fact, occurred,” he argues. “This year, you’ve had quite a striking disconnect between troubles of the few and progress of the great majority.”

Barton also has noticed a significant shift in compensation approaches at many multinationals, but believes pay’s influence on executive mindsets is overstated. “To the extent compensation matters, it’s more about competitiveness [with other CEOs],” he says. “But people care about their reputation and legacy at the company.” The most important CEO motivator isn’t money, Barton suggests, but the fear of messing up, and boards would be smart to spend more time studying non-monetary drivers of executive behaviour.