Compensation Experts Exchange Insights on ESG, Planning Amid Turbulence

Each February, board compensation committees typically evaluate the prior year’s business performance and individual executive contributions. Up for review are whether or not targets were hit and how executive compensation compares to peers. What better time to bring together a group of compensation experts to discuss the latest trends in the pay arena?

NACD hosted a virtual panel of such experts and board members, moderated by Christopher Y. Clark, NACD publisher and senior director of partner relations, on Feb. 25 to do just that. The panel comprised the following speakers: Karen A. Smith Bogart, a director at Mohawk Industries, Michelman, Fielding Graduate University, and the NACD Pacific Southwest Chapter, who has chaired both the compensation and nominating and governance committees at Mohawk and the executive leadership and compensation committee at Michelman; Robin A. Ferracone, founder and CEO at Farient Advisors and a director at Trupanion, where she chairs the compensation committee, WildAid, where she chairs the board, and 50/50 Women on Boards; Thomas C. Leppert, chair of Austin Industries and a director at Fluor Corp., View, Dallas Theological Seminary, and the NACD North Texas Chapter; Kelly Malafis, founding partner at Compensation Advisory Partners; and Aalap H. Shah, managing director in the New York office at Pearl Meyer. Below, we offer answers to some of the more provocative questions.

In 2020, what fundamental flaws in compensation plans were exposed?

Aalap H. Shah: I would classify 2020 as a year of extreme thoughtfulness, by management and by the board. There was an initial knee-jerk reaction and a desire to potentially change a lot of things about incentive programs, but what compensation committees ended up doing instead was very frequent check-ins [on the set plans]. Many said, “We have adopted a process to exercise discretion, but we don’t necessarily need to apply that until the year pans out. But learning from 2020, we need to rethink incentive programs.” Every time we are faced with a crisis of some nature—whether it’s COVID-19; the financial crisis, which impacted all industries; or 9/11, which primarily impacted insurance and reinsurance—there is always this reaction to say, “Let’s elongate the leverage curve of the incentive program. Let’s think about adopting ranges, rather than pinpointing numbers for threshold targets or superior. Let’s look at relative performance versus absolute performance, because we’re having forecasting issues.” Incentive plans are broken because these should not be responsive changes to an event; they should be programmatically considered as part of the incentive design. For example, why not from a programmatic basis establish ranges at threshold target and superior? Ranges don’t necessarily mean that your performance goals will be easier, they provide flexibility within the system. This is the type of thoughtfulness that is required, regardless of external events.

Should the compensation committee and the nominating and governance committee combine into one?

Karen A. Smith Bogart: A company has one business strategy that includes opportunities, risks, key drivers, and needed organizational capabilities. There is also one company human resources strategy. Accordingly, the focus of the compensation and nominating and governance committees must be to develop the desired competencies and performance required to achieve the business strategy. The committees have different emphases, but their philosophies, policies, and programs have to be integrated to shape those desired outcomes.

Having shared membership on the committees can help with communication and alignment of work. I currently chair the nominating and governance committee at a firm and serve on the compensation committee, but a year ago, I chaired the compensation committee and served on the nominating and governance committee. The committee chairs must communicate regularly to ensure shared priorities. Public firms currently require the two separate committees to ensure appropriate focus—and both have full slates! However, at private companies, particularly smaller ones, there is the opportunity to have the nominating, governance, and compensation work done in one committee. Regardless of committee organization, ongoing communication and work coordination can ensure policy development, philosophy, and program design that enable organizational capabilities and success.

How should environmental, social, and governance (ESG) and diversity, equity, and inclusion (DE&I) issues be included in compensation plans?

Kelly Malafis: When we look at DE&I data specifically, the practices are mixed. About a third of companies are using metrics in incentive plans. Most companies use them in the short-term plan, and they tend to be a smaller weighting; the financials tend to be the majority of the weighting. They’re sometimes built into a qualitative, individual, or strategic component.

Part of that is that companies don’t know how to measure DE&I. For others, since it’s a marathon, not a sprint, do they want to get into the details of disclosure annually? Should these metrics be in the long-term plan because there is not an overnight fix? We’re seeing less of that, but Starbucks Corp. and Prudential Financial are two companies that actually did put it in as a modifier to their long-term plans. Each company should be having this conversation. Then, boards need to look at the measures, because many companies will default to representation, and that’s not a bad place to start because we’re trying to get the numbers up. But DE&I has been a part of many organizations’ strategies if you go back 20 years—so why didn’t it happen? Should we be looking more at hiring practices, training, and our mentoring practices? It’s not just something that should be automatically added to an incentive plan, it has to be very thoughtful.

Thomas C. Leppert: Companies are moving to include diversity and inclusion in their compensation plans, which is a positive. Unfortunately, at the levels being discussed, the motivation has more to do with individual and corporate visibility than meaningful substance. For instance, several companies are saying that 10 percent of some element of incentive pay is going to be tied to diversity. In reality, that is not meaningful, it lacks real substance. It is simply an “add-on” or a number at the margin that is not a significant factor in behavior or pay. This is especially the case when you further analyze the impact on total compensation and the qualitative judgments that determine this element.

People are grasping now to try to come up with numbers. So, they’ll measure how many people of a given ethnicity have joined the company or joined senior management. That doesn’t ensure diversity at all. What you really want to measure goes back to cultural issues: Do employees really have a voice in the company, and do they feel that they have a voice? Are they helping to drive the company’s views and opinions? Are they making a difference in management decisions? That’s what you really want to get to. Diversity is not just a set of numbers. And it needs to be longer term. You can manipulate metrics to try to demonstrate progress, but the depth and breadth of diversity and inclusion must be much deeper to be meaningful. These are important issues, and they’re so important that they need to be done right.

What will be the Biden administration’s effect on what’s left to implement of Dodd-Frank?

Robin A. Ferracone: We’ve got two outstanding Dodd-Frank issues pertaining to compensation. One is the pay-for-performance disclosure, on which we probably will get some uptake [from the administration]. The other is finalization of the clawback provision. For clawbacks, we have some preliminary rules that we’ve been sitting on for five years now. But I do not think that finalizing these two provisions is going to create a lot of change. Companies are already looking at pay for performance, and they’re already way ahead on clawbacks by including reputational risk in clawbacks. Another change is that the US Securities and Exchange Commission (SEC) has said that companies should discuss their human capital practices in their 10-Ks if they think such disclosures will be informative to shareholders. That opens the floodgates for more discussion on human capital, which is a good thing. In addition, there will be more attention from the SEC on standards around ESG and DE&I reporting.