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Home > Corporate Governance Checklists > The Board’s Role in Executive Compensation

Corporate Governance Checklists

The Board’s Role in Executive Compensation


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Checklist Description

This checklist considers the various elements that comprise executive pay and benefits. It also looks at how the board can and should ensure that remuneration levels strike the right balance to attract and retain management talent while still representing value for shareholders.

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Definition

Salary is just one of many elements that collectively form executive compensation. Bonuses (sometimes performance-related or even guaranteed), stocks, stock options, pension contributions, medical provisions, and even the use of chauffeured cars all contribute toward the compensation that company executives enjoy.

Setting the appropriate level of compensation for executives can be a considerable challenge for the company board. Set the level too low, and key decision-makers could be tempted away by rival firms. Set the level too high, and the board is left open to the charge that executive performance has failed to deliver value for shareholders. So, in setting compensation levels, the company must seek to attract and retain executive talent while satisfying itself that management is delivering returns appropriate for the level of investment made in the company by stockholders.

Given the scope for executive mobility between firms, the levels of executive compensation in any one firm are frequently compared with those of other companies. Cultural factors play a role in the level of executive mobility between companies and society’s general acceptance of executive remuneration. In Japan, for example, executive compensation is typically a more modest multiple of average salaries than in countries such as the United States, where executive compensation, boosted dramatically by the impact of stock options, tends to tower far above the pay and benefits of the average worker.

As levels of executive compensation have risen sharply over recent years, particularly in the United States, pressure on company boards has resulted in increased use of independent parties to help set an appropriate level of remuneration. These typically take the form of a remuneration committee or an independent nonexecutive director charged with the responsibility of creating a “Chinese wall” between those deciding remuneration and those benefiting from it.

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Advantages

  • Linking executive pay to the achievement of clearly defined performance targets incentivizes managers while still delivering value for stockholders.

  • Establishing and supporting an impartial and independent remuneration committee ensures that the board cannot be accused of “feathering their own nests” by awarding themselves excessive benefits.

  • The board can delegate all responsibilities relating to pay and terms of employment for senior staff, freeing resources for other matters relating to the success of the business.

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Disadvantages

  • The correlation between improvement in a company’s overall performance and the precise contribution of any single executive can be difficult to quantify. This could result in an underperforming executive receiving excessive remuneration relative to better-performing colleagues.

  • Some chief executives take the view that they should retain the power to decide the level of remuneration of senior executives, arguing that they are in a strong position to judge individual contributions.

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Action Checklist

  • The remuneration committee should be a committee of the board composed of independent nonexecutive directors.

  • The board must ensure that the executive remuneration committee is widely acknowledged to be truly impartial and independent. Any doubts over the committee’s independence could cause damage to the firm’s reputation among the investment community.

  • The chairman of the board should ensure that the independent remuneration committee has access to external compensation expertise, such as independent benefits consultants. However, to avoid conflicts of interest, the committee should not use consultants with professional links to the board.

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Dos and Don’ts

Do

  • Disclose executive remuneration, as proper reporting improves accountability. Listed companies should detail directors’ compensation in the remuneration section of the company’s annual report.

  • Allocate space in the annual report for a statement from the remuneration committee to facilitate direct communication with stockholders on matters such as remuneration policies and service contracts.

Don’t

  • Don’t permit the chairman of the remuneration committee to be also the chairman of the pension fund trustees, as this could present potential conflicts of interest.

  • Don’t expect use of a remuneration committee to put an end to all criticism of executive pay.

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Further reading

Books:

  • Ellig, Bruce R. The Complete Guide to Executive Compensation. 2nd ed. New York: McGraw-Hill, 2007.
  • Reda, James F., Stewart Reifler, and Laura G. Thatcher. The Compensation Committee Handbook. 3rd ed. Hoboken, NJ: Wiley, 2007.

Articles:

  • Bruce, Alistair, Trevor William Buck, and Brian G. M. Main. “Top executive remuneration: A view from Europe.” Journal of Management Studies 42:7 (November 2005): 1493–1506. Online at: dx.doi.org/10.1111/j.1467-6486.2005.00553.x
  • Hill, Jennifer G. “Regulating executive remuneration: International developments in the post-scandal era.” European Company Law 3:2 (2006): 64–74.

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