Agenda: With Spotlight on Director Pay, Caution Against Homogeneity

Agenda: With Spotlight on Director Pay, Caution Against Homogeneity – Director comp should be looked at on an individual level

March 18 2014

With Spotlight on Director Pay, Caution Against Homogeneityby Steven Hall Jr. and Michael Sherry

Once a background issue in the corporate governance world, director compensation is making its way to the forefront, and is likely to become a hot-button issue over the next few proxy seasons.

ISS is leading the charge on this issue. The influential proxy advisor recently introduced several new director-focused criteria to its proprietary QuickScore evaluation, including one which ranks director compensation on a relative basis, as reported by Agenda. The ISS evaluation measures average director pay as a multiple of the median pay of an ISS-selected peer group, as based on the director compensation table disclosed in the proxy.

In our view, this focus on relative ranking seems to treat directors similar to a commodity, where one director can easily be interchanged with another. The approach ignores many important factors that determine individual director pay levels, including the director’s level of responsibility. It also lacks any consideration for the size of the board or its aggregate cost to the company.

Based on a recent review, the typical S&P 500 board of directors consists of 10 non-employee directors and costs $2.4 million in aggregate. Under the assumption that directors work 250 to 300 hours a year, as estimated by executive search firm Korn/Ferry International, the average board will perform 2,500 to 3,000 hours of service in total, roughly equivalent to a full-time executive’s workload. Compared to the median S&P 500 CEO total compensation of $10.4 million, the 10-member board affords a company with the business experience and perspective of unique individuals who are selected for strategically important skill-sets, for less than one-quarter of the cost. Moreover, the median financial burden that aggregate director remuneration has on an organization equals just 0.03% of revenue and 0.02% of market capitalization.

While reviewing the compensation for the board in aggregate provides a compelling case for the overall value a company receives, it typically is not a practice used in determining a company’s director compensation program. Historically, the main influences on individual director compensation levels have been the industry and size of the company, similar to that of executive compensation levels.

Although organizational size continues to be an important factor, industry has become less of a differentiator as increased competition for directors has pressured companies in historically lower-paying industries to raise fees and attract needed talent. This competition is partly the result of recently adopted governance-based limits on the number of director seats one individual can hold. In our experience, compensation may be the deciding factor between two otherwise equal opportunities, although directors are traditionally far more focused on the challenges and responsibilities a specific directorship provides.

Additionally, larger companies typically have a higher total board cost than smaller companies. This is the result of paying higher fees per director and more paid directors. Meanwhile the differences between industries have closed in recent years.

It may be impossible to satisfy all the critics, but we believe the evidence, both empirical and anecdotal, supports the view that directors are one of the best buys in corporate America. In cases where individual director pay levels seem out of line with relatively situated companies, a total board cost analysis may help verify that amounts being paid are appropriate and justified. Additionally, companies are well served to conduct annual reviews of director compensation. This provides flexibility to make small annual adjustments to pay levels instead of larger sporadic increases, which may attract undesirable attention from shareholders and advisory groups.

Ultimately, pay levels should be considered both on an absolute basis and relative to the pay levels of company-identified peers. In light of the focus by advisory firms, it may also make sense to review compensation levels relative to the peer groups they construct. While consideration of these analyses may be prudent, companies should also remember that compensation is an important tool in attracting and retaining needed talent to an organization. It is this fact, rather than the views of the media or shareholder advisory firms, which should serve as the ultimate driver of all compensation-related decisions.