Wednesday, April 12, 2006

'Independent' Compensation consultants? Article about Verizon

Came across an interesting article about outside compensation consultants and their incentives. It discusses the relationship between Verizon and its pay consultant Hewitt, whose relationship may go deeper than is desired for a truly independent pay consultant assessment.

"Hewitt does much more for Verizon than advise it on compensation matters. Verizon is one of Hewitt's biggest customers in the far more profitable businesses of running the company's employee benefit plans, providing actuarial services to its pension plans and advising it on human resources management. According to a former executive of the firm who declined to be identified out of concern about affecting his business, Hewitt has received more than half a billion dollars in revenue from Verizon and its predecessor companies since 1997.

In other words, the very firm that helps Verizon's directors decide what to pay its executives has a long and lucrative relationship with the company, maintained at the behest of the executives whose pay it recommends. "
(emphasis is mine)

Though reams has been written about poorly designed executive pay packages, not enough attention has been focused on how these packages are determined.
The above article may come as no surprise to Dr.Lucian Bebchuk and Dr. Jesse Fried of Harvard and Berkeley respectively, who discussed the problem of linked consultants among other issues in their 2003 paper :

"Compensation consultants have strong incentives to use their discretion to benefit the CEO. Even if the CEO is not formally involved in the selection of the
compensation consultant, the consultant is usually hired by the firm’s human resources department, which is subordinate to the CEO. Providing advice that hurts
the CEO’s pocketbook is hardly a way to enhance the consultant’s chances of being
hired in the future by this firm or, indeed, by any other firms. Moreover, executive pay specialists often work for consulting firms that have other, larger assignments with the hiring company, which further distorts their incentives.

Gillan(2001) documents a panel discussion with several compensation consultants, board members and other interested parties and brings up two other interesting issues.

First is the issue of outside directors on the board. Now this is commonly considered a GOOD thing for executive compensation, but this paper documents that it may have a downside.

"The public company board model places an emphasis on independent outside directors... (and) ensures general accountability to shareholders, but it can result in an imbalance in the pay-setting process. Highpowered executives may end up negotiating for pay with part-time directors who have difficulty valuing the job of the CEO, which can create a dynamic favoring CEOs, if not creating a systematic bias toward management.

The second issue mentioned in this connection is the use of industry surveys in setting pay. Again, this may at first glance appear to be a good normalization, but not if the industry isn't quite 'normal' in its pay practices.

"..a reliance on surveys in setting pay may also lead to higher compensation. Surveys lead to asymmetry in compensation practices, emphasizing pay for performance when companies are performing well, and offering peer group pay norms when companies are not performing well.
(Thus) strong-performing companies tend to link pay to performance, while weaker performing companies rely on surveys. The result is that the pay-to-performance link is weakened, and pay levels ratchet ever upward.

What, then, are good pay practices? More on that coming up.

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