Companies should give CEOs share units less often and stop paying them with stock options to motivate better long-term performance and minimize the role of luck in compensation payouts, a new report argues.
The Quebec-based Institute for Governance of Private and Public Organizations has proposed revamping the model for executive pay in Canada, saying companies have to move away from a standardized approach that sees most CEOs paid with virtually identical compensation structures. Instead, it says pay structures need to be tailored for the unique business model or each company and the time horizons of its strategies.
As a first step, the institute's new report says companies should abandon the idea of setting CEO pay based on comparisons to a peer group of companies, saying it is the main factor driving pay higher.
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"Each company is somewhat different in its particular issues and challenges, and industries are different, and we should not have this standardized process," Institute executive chair Yvan Allaire said in an interview. "Boards should design the compensation for their own particular needs and requirements."
Mr. Allaire headed the seven-member working group behind the new report, which also included Laurentian Bank chair Isabelle Courville and veteran directors Robert Parizeau and Guylaine Saucier.
The report said CEOs at Canada's largest companies in the S&P/TSX 60 index earned a median of $8-million in total compensation in 2016, down slightly from $8.5-million in 2015, based on the grant date value of the pay elements.
Total pay levels have remained fairly stable since 2010, but the report said the appearance that pay is moderating is misleading.
That's because companies are granting CEOs more pay in the form of share units – which track the value of shares, but pay out in cash – and are granting much less value in stock options. Share units are less risky and more likely to retain at least some value, the report said, so the result is that executives have traded upfront value for greater payout certainty down the road.
"That's a big change over the last several years, and it accounts for the levelling off of compensation," Mr. Allaire said. "For an executive, the assurance of getting the money is much higher, or there's less risk of not getting the money."
While stock-option use has been declining over the past decade – accounting for 19 per cent of CEO's median compensation value in 2016 – the report recommends companies should not grant stock options at all, and should also abandon the "ritual" of granting new share units to CEOs every year.
Instead, it says new grants of share units should only occur when an executive is hired or promoted, and the total should be reviewed every three years as the share units become exercisable.
While share units typically pay out after a three-year term, their terms should be extended further to match the investment or management cycle of the company, which could make them exercisable anywhere from one to 10 years, the report said. To accomplish that, however, the report said federal tax rules need to be revised to allow share units paid out in cash to have terms greater than three years.
"The current system in our view is not inciting a long-term approach to management, unless three years is considered long-term," Mr. Allaire said.
The report says boards should also move away from primarily using share-price metrics to determine payments – such as basing share-unit payouts on total shareholder return – because too many external factors can influence shares, making luck too much of a component of pay.
It also recommends that if there is a change in control of a company, executive stock options and share units should pay out at the price of the company's shares 90 days before the bid was publicly announced. That removes any incentive for management to support deals because of the large windfall they will reap from a spike in the value of their equity holdings.
Executives should not benefit from the increase in the value of options or share units that comes from "financial engineering" measures, such as share buybacks, the report said.
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The report said the chairs of Canada's largest boards, and heads of their compensation committees, should hold a forum to discuss compensation ideas and find ideas that receive broad support. Large institutional investors should also clarify what they want to see in long-term compensation practices, saying current guidance is too broad and vague.