Equity awards likely to constitute major part of future pay packages.
There’s good news and bad news for directors when it comes to compensation. The good news is that a number of factors could cause director compensation to make significant percentage gains in the next few years. The bad news is that directors will have to work much harder and endure higher scrutiny than ever before to earn it.
Directors are facing higher scrutiny due to shareholder angst over the failure of corporate boards to keep financial firms from taking risks on the toxic securities that sparked the 2008 economic crisis. Add to that the growing concern over the constant approval of multi-million-dollar bonuses and pay increases for top executives even as company performance has waned and you have an environment that is beginning to demand more attention be drawn to the role directors play in preventing such things from happening.
Directors can no longer sit on a board just for profit and prestige – they must bring critical skill sets that can contribute to the future growth of the company. They must also be critical thinkers who can provide real guidance that can prevent management from making poor decisions. This means directors must be prepared to put in more time and be better prepared to meet their fiduciary duties.
‘If you walked into a boardroom today, you would be hard pressed to figure out who the executives are and who the board members are,’ says Randy Ramirez, pictured left, a compensation and benefits director at BDO and author of the ‘BDO 600’, a 2011 survey of board compensation practices. ‘Board members are playing such an active role that they know a lot of details of the company, they think like executives and they are participating in meetings like executives. These are not the old board members of 10 years ago.’
‘Shareholders want board members to become more involved, not less, so if you argue for them to do more work, you can’t argue with increasing their pay,’ says James Reda, founder and managing director of executive compensation consulting firm James F Reda & Associates.
In fact, there hasn’t been much complaining about director pay recently, mainly because it has been mostly flat since the 2008 financial crisis. Since a 7 percent increase in 2010, however, there are indications director pay will be trending upward, and once director pay increases substantially, some believe shareholders and regulators may begin focusing on it just as they have focused on executive pay for this coming proxy season.
Expect pay to trend higher
Gerard Leider, a partner at Meridian Compensation Partners, highlights the key issues expected to drive director compensation higher in the future:
– Greater time demand on directors: directors spend more time ever before preparing for and attending actual meetings so they can be actively engaged in discussions and make informed decisions
– Increased personal liability: with increased scrutiny, the exposure potential for directors has increased dramatically. Fewer people want to take on the risk
– Demand for expert knowledge: the issues boards and committee members face today are more technical and complex than in prior years
– Fewer qualified candidates: the perception is that the pool of potential candidates capable of dealing with the increasing responsibilities of directors is shrinking. Policies that impose a mandatory age 72 retirement and limit the number of boards an active CEO can serve on has taken many capable people out of consideration.
Additionally, candidates who actually fit the optimal criteria for new board members are often lured away by more lucrative job opportunities, which means higher compensation will be needed to compete for the highest-quality directors. All of these issues can be used to justify increases in director compensation.
Leider also notes that director pay may increase in the near term because ‘as the market and stock prices have recovered, that has bumped up some of the equity [award] values’, which translates into higher overall director pay once the value of stock grants are calculated.
Even with all of these reasons for director pay trending higher, few experts believe it will create a problem right now. Leider says the total fees directors currently receive average out to roughly 3 percent of what CEOs are paid.
The BDO study of 600 companies ranging in size of revenues from $25 million to $1 billion finds the average annual compensation paid to board members for fiscal year 2010 is $110, 155, a 7 percent increase over the $102,809 paid in 2009. Director compensation in 2010 comprises an average of $42,840 in board retainer fees, $7,882 in committee retainers and fees, $39,591 in full-value stock awards and $19,842 in stock options.
Simplifying and bundling pay
As little as five years ago, there were so many different ways directors could be compensated that it was hard to determine what the right amount of compensation for the director’s role should be. Directors could receive an overall retainer for sitting on the board, plus meeting fees for each board meeting, meeting fees for each committee meeting, additional fees for serving as committee chairman, stock grants, stock options and perks too numerous to name. Some directors were even given retirement and pension plans until shareholder concerns ended that practice about 15 years ago.
In the past, a director’s pay was mostly determined by the number of meetings in which he or she participated. Similar-sized companies could have board members paid vastly different amounts based on the number of board meetings each company had in a particular year. Today, companies are simplifying how directors are paid, bundling fees together so there is one pay level for all.
‘You are seeing a continued movement away from a per-meeting structure to a more fixed retainer type aspect, and those retainers will be paid in some form of cash and equities,’ says Leider.
Companies are opting to pay a specified amount of cash and equities for sitting on the board, and then enhanced fees are paid to committee chairs and the lead chair for the extra work that comes with those positions. The enhanced fees paid to committee chairs can range anywhere from $75,000 to $150,000 a year or more. Some experts suggest non-executive chairs could be paid as much as $500,000 in some cases because they do even more than a lead director.
In the future, Leider says we are likely to see an increased use of equity as the primary vehicle to deliver compensation to directors. While there will definitely be a decrease in the use of stock options, the use of full-value shares as stock grants, restricted stock or preferred stock will increase because it better aligns with the interests of shareholders. ‘You basically have equity, like shareholders, that moves in an appropriate fashion, rather than stock options,’ he notes.
Leider also predicts that the use of more equity for directors will result in companies offering more equity deferral plans because, with higher tax rates on the horizon, they provide ‘a tax-effective way to potentially provide compensation to directors by allowing them to defer [stock gains] and let them grow on a pre-tax basis.’
Higher pay sparks governance concerns
The point at which director pay begins reaching higher levels is when concerns about governance are raised. Concerns over directors making small fortunes by sitting on multiple boards simultaneously but not being able to fulfill their obligations led companies to make major policy changes just a few years ago.
‘There were people sitting on seven or eight boards, and that was too many,’ says Ira Kay, managing partner at Pay Governance. ‘A lot of corporate governance policies were adjusted to say that directors could not sit on more than one other major board, or at most two other boards.’
This proxy season, the primary governance concern is over executive pay. Mandatory say-on-pay votes and new requirements that companies explain in detail how their pay plans are aligned with company performance have directors busy making sure their companies can justify the pay schemes of their CEOs and other top executives.
‘Now that companies have adapted their compensation practices in light of say on pay and pay for performance, we think pay for performance will be directed toward board members,’ says Ramirez. He notes that there is no tie to pay for performance when it comes to director pay, and he believes that, in the current climate, that won’t last for long. ‘Over time, the expectation will be that board members must also be held accountable for the company’s performance, and this focus will start during the 2012 proxy season,‘ he predicts.
Ramirez also believes corporate boards will soon be viewed as one unit that should have its pay tied to the performance of the company, just like the CEO’s pay should be tied to company performance. Companies may begin focusing on the compensation of the entire board as an expense that should bring shareholder value. ‘If we’re just looking at $130,000 per board member, and you multiply that by 10, a company is basically guaranteeing $1.3 million in compensation with no performance ties to board members,’ Ramirez explains.
There are other governance concerns about director pay that appear to be gaining momentum. ‘At least one company I know about had a shareholder proposal for an advisory vote on director compensation last year,’ says Jonathan Ocker, partner and chairman of the compensation and benefits group at global law firm Orrick Herrington & Sutcliffe. In the future he says he ‘wouldn’t be surprised if Congress enacted and voted to expand management advisory votes on say on pay for executives and extended them to directors.’
In fact, even before Congress gets involved, Ocker says proxy advisory firms ISS and Glass Lewis may begin to exert pressure on companies where director pay is out of bounds. ‘You could have a situation where the shareholder advisory firms recommend that top board members not be reelected if their pay is too high relative to what’s going on,’ he says.
The importance of being reasonable
Since directors have a hand in setting their own pay, the issue of determining director pay is always a very sensitive matter. Director pay is generally set every two or three years, because voting an increase every year would not appear to be exercising good governance. That means that when director pay is established, it has to be right.
‘That’s why it’s important that companies benchmark their pay levels against similar-sized companies,’ says Reda. ‘This benchmark should include all types of compensation. Shareholders are not critical of director pay within reason.’
It will be interesting to see what boards consider reasonable pay in the future. Kay says boards tend to focus on the percentile rankings of where their pay falls in relation to others in their industry, and that they aim to set director pay in the 70th percentile of their group. But they will accept winding up in the 60th percentile because ‘they know that the market changes and they figure if we are 4 percent or 5 percent above the median, the market will catch up in a year or two, and that’s okay because then we can revisit it. What you’ll see is a lot of companies out there increasing their director fees slightly above the median.’
Since no company is likely to think its directors aren’t worth raising fees slightly above the median, such practices are sure to make director pay creep up more quickly than some might expect. Shareholders will be on the lookout for directors they feel are not earning their keep.
Ocker notes that already shareholders are working to get companies to eliminate staggered voting and move to annual voting to help police bad director decision making. As another way of making sure pay is aligned with performance in accordance with new governance rules, he says, ‘It wouldn’t surprise me if, when the company isn’t performing well, director pay would be reduced for the year in which you are not performing well.’
That would definitely be a positive for governance, but Ocker concedes a development like that will not happen any time soon. ‘It’s in the air,’ he says. ‘I think the next logical step is a referendum on director pay versus poor performance.’
Director pay breakdown
In the past:
Non-retainer equity 48%
Cash retainer 37%
Committee fees 9%
Board meeting fees 6%
In the future:
Outright stock grants 50%
Cash retainer 35%
Cash role premium 15%
Source: Meridian Compensation Partners
Average director pay, by industry:
Energy $139,930
Financial services: banking $50,824
Financial services: non-banking $77,022
Healthcare $137,601
Manufacturing $107,383
Real estate $119,686
Retail $99,370
Technology $149,427
Source: 2011 BDO 600 survey
