February 9, 2011

When Familiarity Breeds Complacency: Factors to Consider When Selecting a Compensation Consultant

This article originally appeared on Robin A. Ferracone’s “Executive Pay Watch” blog on Forbes.com.

As the first quarter of 2011 is in full swing, and proxy season is around the corner, many compensation committees are considering whether they should take another look at who their compensation consulting advisor should be.  And rightly so.  In the wake of heightened concern about independence and conflict of interest, three of the top five executive compensation consulting firms to the top 1000 companies are still the integrated firms, which offer a variety of services primarily to management.

So, why do compensation committees stick with these companies when there is pressure to prove impartiality and independence of the board’s advisors?  Some committees say that they trust their advisors, despite the corporate package that they come in.  Others say that they rely on the reputation and name recognition of the integrated firm.  So, what’s in a name?  As it turns out, maybe too much.

This “safety in familiarity” approach, while perhaps comforting to Directors, appears at odds with the pressures facing Compensation Committees to identify and retain a compensation consultant who is both independent and whose capabilities extend beyond the collection and analysis of competitive pay data.  In particular, the consultant’s knowledge and expertise ideally should encompass an in-depth understanding of performance measurement and goal-setting, the capacity to relate compensation to various performance outcomes, and the research base needed to identify potential misalignment between pay and performance before it becomes an issue.

In selecting a compensation consultant, Boards and Compensation Committees ideally should examine a wide variety of factors.  Failure to do so may result in less than optimal results in terms of the quality of advice or the perception of external investors regarding the counsel received.  Some things to consider include:

  • While Dodd-Frank does not require the outside advisors to the Compensation Committee to be independent of the company, it does require the company to disclose how the committee considers factors that affect the independence of the advisors.  (The SEC is expected to provide greater clarity on the factors that they deem affect independence.)  And of course, there is still the requirement to disclose services in excess of $120,000 that are provided to the company by the board advisors.  I’ve heard some boards say that in hiring an integrated firm to do their executive compensation consulting, they will disqualify these firms from consulting to management.  However, these firms are good at things like benefits consulting and one has to ask whether taking a major competitor out of the bidding for these other activities is doing more harm than good.
  • At this point, the emphasis on independence has resulted in a spate of spin-offs of the executive compensation consulting businesses from the large integrated firms.  But what also has happened as a result of, and prior to, this “spin cycle” is that many of the best compensation consultants no longer work for the integrated firms.  It is inevitable that compensation committees will need to acknowledge this trend and at some point, explore what the smaller firms have to offer.
  • Data on competitive pay practices has essentially become a commodity, with size and industry-specific data being accessible to most consultants, not to mention the fact that a tremendous amount of data can be gleaned from proxy reports.  In the end, it is how the pay data is analyzed, interpreted, and used for decision-support, rather than access to the data itself, that has become a key issue in providing high quality, independent advice.
  • While specific industry knowledge can be an asset, it also can result in failure to sufficiently consider other approaches to incentive design and performance measurement that may better fit the strategy of the company.  In fact, the comfort of conforming to industry practices can result in sub-optimal decisions in compensation design.  As a case in point, one has to look no further than financial services to see the impact of destructive and imitative pay practices.
  • Due in part to increased investor scrutiny on the alignment between pay and performance, consulting on pay, and in particular, on executive compensation, the world around consulting has become more complex.  As such, the traditional approach to compensation consulting around “how much pay” rather than “how to pay” is no longer sufficient.  Instead, experience in the strategic aspects of compensation, including performance measurement, peer group selection, and methods of aligning pay and performance in incentive design, have become much more important in providing sound compensation advice.

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With significant changes in the compensation consulting landscape, the time when Compensation Committees can take comfort in “name recognition” to select their pay consultant has passed.  In fact, Compensation Committees will benefit by adopting a more open and inquisitive approach to selecting a consultant that factors in independence, expertise in performance measurement, and strategic capabilities.  Such due diligence by no means precludes retaining a “name” firm, but rather, provides Committees the opportunity to better understand the resources that are available and to ensure that they have selected the best firm to meet their needs.  The results may be surprising.

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Robin A. Ferracone is the Executive Chair of Farient Advisors, LLC, an independent executive compensation and performance advisory firm which helps clients make performance-enhancing, defensible decisions that are in the best interests of their shareholders.  Robin Ferracone is the author of a recently published book entitled Fair Pay, Fair Play: Aligning Executive Performance and Pay, which explores how companies can achieve better performance and pay alignment. Robin can be contacted at robin.ferracone@farient.com.

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