What is a CEO worth?

(March 24, 2005) In many public companies, maybe yours and definitely ones in your clients’ portfolios, boards are juggling the sticky and increasingly complex question of what management is worth — and how to dole out compensation without those decisions coming back to haunt share prices.

On Thursday, Watson Wyatt Worldwide released its fourth annual Canadian CEO Pay study, analyzing the compensation practices of more than 200 companies in the S&P/TSX Composite Index. At a Toronto breakfast meeting attended by many of those executives, Ray Murrill, Watson Wyatt’s practice director of executive compensation, discussed the risks and growing complexities that companies face when trying to strike a balance in developing effective pay packages that will retain good management and still pass scrutiny from shareholders and governance officials.

According to the study, many boards in Canada are becoming more assertive in linking executive compensation to company financial performance. Those that paid bonuses to their CEOs typically outperformed those that did not pay bonuses. Of the 214 companies surveyed, 176 paid bonuses in 2003. Those companies generated a median total return to shareholders of 30.6%, compared to 6% returned by the 39 companies that did not pay bonuses.

“Pay for performance is taking hold and having a real impact on executives in Canada,” says Murrill. “Because companies are increasingly tying executive compensation to financial performance goals, CEO pay is increasing at what can be considered a reasonable rate in relation to the economic value executives help to create.”

The challenge for boards, he says, is creating long-term incentive plans and performance criteria that are justifiable if and when the details become public. The committee that makes such decisions needs to be comprised of independent directors, but at the same time, directors need to be in touch enough that they are able to fully grasp the implications of their decisions. “The compensation committee is one of the toughest committees to be on,” Murrill told his audience. “Do directors really understand the business? You rely on them to have a good grasp on the business. If they don’t, it doesn’t matter how independent they are.”

After understanding the company, the second challenge is understanding the wide variety of compensation options outside of “plain vanilla” stock options. The third is conveying to shareholders how those options plans work once they are in place.

Stock options are still the most popular form of long-term incentive plans. In 2003, 98.6% of the companies surveyed had stock option plans and use of the plans stabilized during the year, but pay packages are getting more complex, and disclosure is becoming more of an issue with investors. Institutional investors in particular are getting more detailed in their analysis of CEO pay and how it is related to total return to shareholders.

Compensation disclosure, whether voluntary or regulated, appears to be improving. In 2003, 80% of TSX-listed companies provided some insights in their reports on executive compensation to inform shareholders about incentives for executives. In 2002, only 52% of companies surveyed provided the information. The disclosure is required by regulators. Reporting the outcome of proxy votes and the actuarial value of executives’ pension plans are also on the radar for securities commissions.

Despite additional disclosure requirements, Peter Chapman, executive director of the Shareholder Association for Research and Education (SHARE), says the quality of information available in Canadian proxy circulars “varies enormously.”

“Some companies are producing excellent information for shareholders, but it’s not the norm and it’s not consistent,” he says. “Executive compensation is a complex area and reporting on compensation is a complex area. In general much work needs to be done in raising the level of clarity in the reporting of executive compensation. “Pay for performance, description of pay for performance arrangements are often vague. If shareholders want to make sure that compensation arrangements align the interests of senior management with their interests as long-term owners of companies, then it is important that they understand clearly what is being measured in pay for performance.”

Filed by Kate McCaffery Advisor.ca, kate.mccaffery@advisor.rogers.com