CEO Compensation Trends

Pay for performance and investor scrutiny on the rise

Executive compensation has always been a hot topic in corporate America — and the retail industry is no exception. These days, two trends are upping the attention paid to pay at the top: the ongoing move to performance-based equity, and the scrutiny compensation packages are receiving from increased SEC regulations and shareholder involvement.

“Everything related to executive compensation is a more rigorous discussion and weighed more seriously than it was five years ago,” explained Cory Morrow, senior principal and executive compensation consultant, retail practice, Hay Group. The global management consulting firm is based in Dallas.

Retail CEO salaries generally hover around $1 million, and the majority of their executive compensation packages are in equity awards, according to Morrow.

“Now when organizations are talking about setting goals for performance-based compensation or what type of equity to grant, even adjustments to salary and what to offer external candidates, their decisions have repercussions that were not present before,” he said.

However, experts warn that to criticize compensation packages that appear inflated without delving deeper into the realities and rationales behind the compensation is a mistake. For instance, the $53.2 million recruitment package awarded to Ron Johnson when he took over as CEO of J.C. Penney Co. in 2011 has been widely critiqued. Compared with the total compensation packages for other CEOs included among the Top 20 U.S.-based public retail companies, Johnson’s package rocked the retail world.

In actuality, the bulk of that package, $52.6 million, was a stock award. The salary and non-equity incentive paid to Johnson was only slightly more than $600,000 — considerably less than the cash compensation of many retail CEOs.

Regardless of how it’s paid, $53 million is a staggering sum. But critics of Johnson’s compensation failed to acknowledge that recruiting talent in the competitive retail arena requires more than the promise of earnings potential at a new company; executives must be fairly compensated for any money left on the table of their previous employer. Certainly that was the case when Johnson left his leadership role at Apple to join J.C. Penney.

Devilish Details: Scrutiny, by definition, must look beyond the obvious to closely examine the minute details and decisions that ultimately comprise the total compensation of a retail executive.

As for astronomical sign-on packages, Morrow noted, “It’s always more costly for an organization to recruit talent from outside because executives are leaving a known quantity for an unknown. Sign-on packages that appear high are related to millions of dollars the executive may be leaving at his former company, which the hiring company has to make up.”

There is also a correlation between the size of a company, the type of retail sector it is in and executive pay levels.

“Different sectors of retail pay differently,” Morrow continued. “Dollar stores and food retailers are more conservative with executive compensation, while fashion retailers pay more.”

This observation is validated when the $17.6 million compensation package of Terry Lundgren, CEO of Macy’s, is compared with the $12 million compensation earned by David Dillon, CEO of The Kroger Co. Both executives assumed their current CEO roles in 2003, after being with their respective companies for several years. Macy’s 2011 revenues were $26.4 billion; Kroger topped $90 billion.

However, both companies appeared on target in their selection of peer companies for setting executive compensation. Macy’s peer group had 10 companies, primarily the largest U.S.-based fashion and department store retailers, plus Walmart and Target. Kroger’s peer group consisted of the eight largest, U.S.-based, publicly owned food and drug retailers, including Walmart and Target.

“After 40 years in the business, my experience has been that the vast majority of companies do a very good job of developing appropriate executive compensation packages,” said Don Lindner, executive compensation practice leader at World at Work, a global human resources association that provides certification in executive compensation. Founded in 1955, the not-for-profit organization has offices in Scottsdale, Ariz., and Washington, D.C.

Paid to Perform: What is appropriate clearly changes over time, and recognizing emergent trends enables retail organizations to establish compensation packages that are both competitive and reasonable.

The most pronounced trend, according to Lindner, and one that has been under way for several years, is the continued movement to performance-based equity.

Jack Zwingli, leader of Information Systems at Farient Advisors, an executive compensation consultant firm with offices in Los Angeles and New York City, described the trend as a shift from “pay for pulse” to “pay for performance.”

“Historically, equity awards and stock options were based on time; typically, option plans would vest over a three-year period regardless of a company’s performance,” Zwingli explained. “Now those options and stock awards are based on some measure of performance. Investors have no problem paying large sums to executives when the company is performing.”

Even directors’ compensation is tied to the company’s performance, with cash compensation reduced and stock awards increased. The objective, according to Zwingli, is to align directors’ interests with those of shareholders.

“Investors are not fixated on the last 12 months; They focus on performance over the last three to five years and increasingly benchmark the company’s success against the relative performance of peer organizations,” he added.

World at Work’s Lindner agreed with that assessment. But he noted that another trend is short-term bonus cycles, due largely to the unpredictable economy in recent years.

“Increasingly, retailers set short-term cycles, with performance goals defined for one year or even semi-annual goals because it is hard to set annual goals in such a volatile marketplace,” Lindner explained.

Whether performance goals are defined in months or years, another positive move is to establish metrics for each executive officer’s performance-based compensation that correlate directly to the business areas that he or she is responsible for and can influence. Chief executives are held accountable for the overall performance of the organization and, for the most part, are held to the tightest standards and greatest scrutiny.

Increased Scrutiny: One of the reasons that public companies are coming under increased scrutiny for compensation packages awarded to their named executive officers is largely due to expanded regulation under the Dodd-Frank Wall Street Reform Act, signed into law July 2010.

The overarching goal of expanded regulations and intensified reviews is twofold: one, to ensure earnings are more equitable; and perhaps even more important, to ensure that executives leading the company, particularly the CEO, have the same vested interests in long-term success as shareholders.

A number of actions and trends have emerged to foster that alignment, the most notable being Say on Pay, another requirement under the Dodd-Frank Act. Say on Pay gives shareholders the opportunity to vote on executive compensation packages, albeit the vote is non-binding. The companies must also allow shareholders to decide whether the Say on Pay vote is held annually, every two years or every three years. Even though the vote is non-binding, the fact that shareholders have this “say” has made public firms more responsive and has increased engagement between boards and shareholders. Through 2012, the Say on Pay requirement did not extend to everyone; but as of January 2013, all public companies will be required to hold a Say on Pay vote.

The natural byproduct of the Say on Pay requirement has been continued influence from proxy analysis firms, such as Institutional Shareholder Service (ISS). When ISS advises shareholders vote against a board’s recommendation, it makes an impression — and when retail companies fail a Say on Pay vote, it leaves a tainted image.

“In recent months, four retail companies failed the Say on Pay vote with their shareholders,” said Farient’s Zwingli. “At Farient, we agree with the shareholders on three of the companies that failed: Abercrombie & Fitch, American Eagle Outfitters and Big Lots. However, it’s our opinion that the fourth company, Best Buy, failed the Say on Pay vote due to the recent scandal with its CEO.”

Zwingli suggested that when investors have pushed back, it is often because peer companies that were used to benchmark comparative compensation packages appear to have been unfairly selected.

“Developing a peer group used to be a rubber-stamp exercise; now it’s a lengthy, critical process,” said Hay Group’s Morrow. “Generally, peer groups should include 15 to 20 organizations to be meaningful, and retailers should select peers from the companies they compete with for business as well as for talent.”

Compensation committees should identify peer companies that have a similar business model, and that are typically in the same industry, and are relatively close in size. The rule of thumb is that peers should be one-half to two times the size of the organization, with size most often defined by annual revenue, although number of employees, assets and market cap are also qualifiers.

Issues Resolved: As investors have gained both visibility and a voice into executive compensation, problematic payment practices have been addressed and progressive trends are emerging. For example, tax gross-ups that were a trend in the ’90s and 2000s, have been halted, and “change-in-control” compensation has been addressed.

Previously, when companies experienced a change in control, whether due to a merger, acquisition or for whatever reason, executive officers received severance compensation simply because of the change. That “single-trigger” policy has been replaced with a “double-trigger” process, which means if an executive officer is terminated following a change in control, he or she receives the appropriate severance package. But when executives remain in place, severance is not paid.

Additionally, there is increased focus and ongoing discussion around the practice of “clawbacks,” which allows the organization to reclaim compensation from past earnings if something negative comes to light about the executive’s conduct or payment. Essentially, the organization retains the right to “claw back” monies paid under questionable circumstances.

There is also a greater balance of equity between options, restricted stock and performance-based shares, according to Farient’s Zwingli.

“Over the last decade, we’ve seen some movement away from option awards to stock awards,” he said. With options, an executive is simply participating in the upside of stock growth. By comparison, stock awards have long-term benefits, which again, better aligns executives’ interests to those of shareholders.”

Connie Robbins Gentry is a contributing editor for Chain Store Age.

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