Peer pres­sures

Use of CEO com­pen­sa­tion com­par­isons draws height­ened scru­tiny

Modern Healthcare - - GOVERNANCE -

As chief ex­ec­u­tive pay con­tin­ues to draw height­ened scru­tiny in the wake of the Great Re­ces­sion, com­pen­sa­tion com­par­isons used by gov­ern­ing boards to jus­tify the pay­outs to share­hold­ers and reg­u­la­tors are com­ing un­der fire from crit­ics.

The prac­tice, com­mon in the health­care sec­tor, has drawn fire for years. Crit­ics claim re­liance on peer group anal­y­sis is flawed and ar­ti­fi­cially in­flates salaries and bonuses.

Their com­plaints are be­gin­ning to be heard, in­clud­ing by the health­care sec­tor. One of the largest pub­licly traded health sys­tems has re­vised its ex­ec­u­tive com­pen­sa­tion peer group, which con­sid­ers the mar­ket in which com­pa­nies must com­pete on pay to re­cruit and re­tain top tal­ent.

The In­ter­nal Rev­enue Ser­vice also is be­gin­ning to ex­am­ine CEO pay at big not-for-prof­its, which are the dom­i­nant play­ers in much of health­care. An IRS ex­am­i­na­tion re­leased last month found one out of five tax-ex­empt or­ga­ni­za­tions used com­par­isons from in­sti­tu­tions that were so dif­fer­ent in size or other char­ac­ter­is­tics that reg­u­la­tors deemed them “not com­pa­ra­ble.” The in­com­pat­i­ble com­pen­sa­tion data in­cluded too many highly paid ex­ec­u­tives, ac­cord­ing to the re­port.

“It shows a high level of in­ter­est and an in­creas­ing level of so­phis­ti­ca­tion” by reg­u­la­tors in the tax-ex­empt sec­tor, says Ralph DeJong, a part­ner with McDer­mott, Will & Emery in Chicago.

The IRS ex­am­i­na­tion looked ex­clu­sively at col­leges and uni­ver­si­ties, but its find­ings can be ap­plied to tax-ex­empt hos­pi­tals and health sys­tems, which are sub­ject to the same reg­u­la­tions and scru­tiny, DeJong says. The find­ings sug­gest reg­u­la­tors will be more com­pre­hen­sive as they re­view which or­ga­ni­za­tions may be con­sid­ered com­pa­ra­ble for the pur­pose of de­ter­min­ing the mar­ket rate for chief ex­ec­u­tive com­pen­sa­tion, he says.

Crit­ics con­tend those mar­ket rates are an il­lu­sion based on un­likely com­par­isons across mul­ti­ple in­dus­tries where the CEO isn’t a true peer. Most top ex­ec­u­tives have knowl­edge and ex­pe­ri­ence that is spe­cific to their em­ploy­ers, and, there­fore, is not trans­fer­able to other com­pa­nies. “It’s very clearly fic­tional,” says Craig Fer­rere, a fel­low in cor­po­rate gov­er­nance at the Wein­berg Cen­ter for Cor­po­rate Gov­er­nance at the Univer­sity of Delaware, who co-au­thored a work­ing pa­per with Charles El­son, di­rec­tor of the cen­ter and a fi­nance pro­fes­sor at the univer­sity. that crit­i­cized peer groups.

Ris­ing ex­ec­u­tive pay has long been a flash­point in the pub­lic de­bate over the na­tion’s widen­ing in­come gap. The sting of as­tro­nom­i­cal pay­outs to CEOs was height­ened by the re­ces­sion. While aver­age cit­i­zens mea­sure the tepid U.S. eco­nomic re­cov­ery by how much lost ground they have made up in the job mar­ket, hous­ing prices and fam­ily in­come, they can’t help but no­tice that chief ex­ec­u­tives barely got dented by the down­turn. Pay­checks for top ex­ec­u­tives re­bounded quickly, sep­a­rate analy­ses by the As­so­ci­ated Press and USA To­day found, even as house­holds con­tinue to strug­gle.

This has ex­ac­er­bated the long-term trend of top cor­po­rate of­fi­cials in­creas­ing the pay gap be­tween them­selves and the rest of so­ci­ety. CEOs in the Stan­dard & Poor’s 500 saw the gap be­tween their com­pen­sa­tion and salaries paid to their work­force in­crease 20% be­tween 2009 and 2011, when chief ex­ec­u­tives re­ceived 204 times more than the aver­age worker, ac­cord­ing to a Bloomberg anal­y­sis.

The use of peer groups by board com­pen­sa­tion com­mit­tees in de­ter­min­ing CEO pay has played a ma­jor role in driv­ing those salaries up­ward, crit­ics con­tend. Ira Kay, a com­pen­sa­tion con­sul­tant and pro­po­nent of their use, says ex­ec­u­tives op­er­ate in a com­pet­i­tive mar­ket for top tal­ent and in­cen­tives such as stock op­tions, bonuses and gen­er­ous re­tire­ment pack­ages have suc­cess­fully re­tained highly mo­bile ex­ec­u­tives.

Kay, a man­ag­ing part­ner with con­sul­tant Pay Gov­er­nance, says the con­tention that CEO com­pen­sa­tion is too high isn’t one that can be ad­dressed by at­tack­ing the use of peer groups, which merely re­flect the mar­ket. “That’s not a peer group prob­lem, that’s a so­cial prob­lem,” he says.

Fi­nan­cial re­forms en­acted in the wake of the 2008 fi­nan­cial cri­sis sought to give share­hold­ers a voice—though not the au­thor­ity—to curb ris­ing ex­ec­u­tive com­pen­sa­tion. Fer­rere and El­son ar­gue in their 2012 pa­per that that will not be enough to over­come the more sys­temic flaws in com­pen­sa­tion poli­cies that rely on peer groups to de­ter­mine com­pen­sa­tion.

Stel­lar per­for­mance—and com­pen­sa­tion to match—for a few stand­out ex­ec­u­tives within a peer group skew the com­pen­sa­tion com­par­isons, they ar­gue. That un­fairly re­wards more aver­age or lack­lus­ter CEOs as boards seek to match the ris­ing com­pen­sa­tion

at other firms, which some­times aren’t even in the same in­dus­try.

It can be­come a vi­cious cir­cle. As gov­ern­ing boards of di­rec­tors or trus­tees award raises to match the me­dian pay at other firms, the other boards re­spond in kind, they wrote. Boards of­ten feel pres­sure to award com­pen­sa­tion at or above the me­dian as a pub­lic en­dorse­ment of CEO per­for­mance, they wrote.

Some firms are clearly sen­si­tive to the is­sue. Unit­edHealth Group, the na­tion’s largest health in­surer, last month as­sured share­hold­ers that the be­low-me­dian com­pen­sa­tion for Pres­i­dent and CEO Stephen Hem­s­ley was not a re­flec­tion of his per­for­mance. The com­pany’s di­rec­tors praised Hem­s­ley’s lead­er­ship as “out­stand­ing” in the in­sur­ers’ an­nual proxy to in­vestors even as it noted his roughly $13.9 mil­lion pack­age of cash, in­cen­tives, eq­uity awards and other pay­outs was “well be­low” the me­dian for peers at a di­verse group of com­pa­nies, in­clud­ing eBay, Cit­i­group, Coca-Cola and a few man­aged-care gi­ants.

The broad group by which Unit­edHealth com­pares CEO pay was vet­ted to ex­clude in­dus­tries that would be un­likely as a source of new re­cruits, such aero­space, oil and com­pa­nies that fo­cus ex­clu­sively on one busi­ness line, the proxy says. The group re­flects the in­sur­ers’ size and com­plex­ity, the com­pany con­tin­ued, and also takes into ac­count po­ten­tial com­peti­tors for top ex­ec­u­tives that op­er­ate in the same ge­o­graphic lo­ca­tion as Unit­edHealth’s man­age­ment. Hem­s­ley, the com­pany says, be­lieves the pay pack­age “is suf­fi­cient to re­tain and mo­ti­vate him.”

Kay of Pay Per­for­mance con­tends crit­ics’ in­fla­tion ar­gu­ment is “over­stated” and points to data that show ex­ec­u­tive com­pen­sa­tion rises and falls with stock per­for­mance.

Fer­rere and El­son ar­gue that top ex­ec­u­tives are not so eas­ily swapped be­cause the de­tailed knowl­edge of their own com­pany needed to run the busi­ness has no value else­where. That weak­ens the ar­gu­ment that com­pen­sa­tion must be com­pa­ra­ble to pre­vent ex­ec­u­tives from bolt­ing for an­other, more lu­cra­tive job.

Good gov­ern­ing boards are sen­si­tive to the dy­namic cre­ated by peer groups that can in­flate com­pen­sa­tion, says Ron Seifert, vice pres­i­dent and leader of ex­ec­u­tive com­pen­sa­tion at the Hay Group.

The ques­tion of how much to pay is not solely an­swered by blindly match­ing ev­ery move the mar­ket makes, he says. Boards that have grown more so­phis­ti­cated may also re­fer to com­pen­sa­tion awarded among its own ex­ec­u­tives and the po­ten­tial value of pay­outs based on a range of stock prices as they con­sider how much to pay. Com­pen­sa­tion is also in­flu­enced by per­for­mance goals tied to in­cen­tive pay­outs and how those in­cen­tives are struc­tured, he says.

At pub­licly traded com­pa­nies, out­side share­holder ad­vi­sory ser­vices are look­ing closely at the com­po­si­tion of peer groups. For in­stance, In­sti­tu­tional Share­holder Ser­vices crit­i­cized Com­mu­nity Health Sys­tems’ peer groups ahead of last year’s vote as “as­pi­ra­tional” and de­scribed Chair­man, pres­i­dent and CEO Wayne Smith’s pay as “con­sid­er­ably higher” than the me­dian of his peer group and tied to “seem­ingly un­chal­leng­ing per­for­mance goals.”

In­sti­tu­tional Share­holder Ser­vices and proxy ad­viser Glass Lewis urged share­hold­ers to vote down the 2012 com­pen­sa­tion pack­age. They did. CHS last month said the board re­vised its peer group af­ter two-thirds of share­hold­ers re­jected the health sys­tem’s 2012 ex­ec­u­tive com­pen­sa­tion in an ad­vi­sory vote.

“That’s not a peer group prob­lem, that’s a so­cial prob­lem.”

—Ira Kay, man­ag­ing part­ner with con­sul­tancy Pay Gov­er­nance, on con­cerns over highly com­pen­sated CEOs

CHS said it would no longer set com­pen­sa­tion for top ex­ec­u­tives us­ing pay from com­pa­nies out­side of health­care, such as Sara Lee, Whirlpool and ConA­gra. In­stead, Com­mu­nity Health Sys­tems will rely on pay at 20 health­care com­pa­nies to set all top ex­ec­u­tive com­pen­sa­tion. The group was se­lected based on mar­ket cap­i­tal­iza­tion, en­ter­prise value, work­force and rev­enue. Com­mu­nity Health Sys­tems’ rev­enue is “just above” the group’s me­dian.

ISS de­scribed the changes as “sig­nif­i­cant.” How­ever, the health sys­tem’s prac­tice of bench­mark­ing cash in­cen­tives to the 75th per­centile was a con­tin­ued source of con­cern for the share­holder group.

The vote against CHS’ CEO pay pack­age was a rar­ity. Few com­pa­nies have “suf­fered the em­bar­rass­ment” of share­hold­ers who ob­jected to ex­ec­u­tive com­pen­sa­tion in ad­vi­sory votes re­quired at pub­licly traded com­pa­nies un­der the 2010 Dodd-Frank Wall Street Re­form and Con­sumer Pro­tec­tion Act, re­searchers wrote in a Van­der­bilt Univer­sity Law School work­ing pa­per pub­lished in Fe­bru­ary.

Mean­while, for tax-ex­empt hos­pi­tals and health sys­tems, reg­u­la­tors have laid out steps nec­es­sary to demon­strate that gov­ern­ing boards have sought to avoid over­pay­ing ex­ec­u­tives. One of those steps is to use com­pa­ra­ble com­pen­sa­tion data to jus­tify CEO pay­ment. Not­for-prof­its who wish to meet reg­u­la­tory stan- dards to demon­strate good gov­er­nance must use pay com­par­isons.

But DeJong of McDer­mott, Will & Emory says it may be in­creas­ingly dif­fi­cult to iden­tify com­pa­ra­ble or­ga­ni­za­tions if the IRS broadly ap­plies new stan­dards for com­par­isons fol­low­ing its re­view of col­leges and uni­ver­si­ties. That could leave com­par­isons more eas­ily in­flu­enced by a sin­gle large pay­out. “There’s a value in hav­ing a more ro­bust set of peers, even if they’re not quite as tightly com­pa­ra­ble, but re­sult in stronger, more ro­bust data upon which to rely that not as in­flu­enced by out­liers,” he says.

At the Mayo Clinic, a search is un­der­way to fill the spot when Shirley Weis, Mayo’s vice pres­i­dent and chief ad­min­is­tra­tive of­fi­cer, re­tires at the end of the year. The Rochester, Minn.-based health sys­tem cul­ti­vates po­ten­tial ex­ec­u­tives within its own ranks be­cause of Mayo’s cul­ture and size, says John Bier­mann, the Mayo Clinic’s di­rec­tor of physi­cian and ex­ec­u­tive com­pen­sa­tion.

The sys­tem’s scope of op­er­a­tions makes it dif­fi­cult to find some­one out­side the or­ga­ni­za­tion with nec­es­sary ex­pe­ri­ence to fill top va­can­cies, he says. Mayo’s un­usual man­age­ment struc­ture—which pairs physi­cians and ad­min­is­tra­tors as joint man­agers—also com­pli­cates ef­forts to re­cruit ex­ter­nally for the health sys­tem’s ex­ec­u­tive jobs. “That doesn’t ex­ist (at) most places,” he said. “It’s pretty unique in health­care. It’s prob­a­bly non-ex­ist­ing in in­dus­try.”

Bier­mann says he re­views com­pen­sa­tion for nearly all Mayo em­ploy­ees to mon­i­tor dif­fer­ences in pay for in­equal­ity, but the mar­ket “gets in the way” of rop­ing top ex­ec­u­tives’ pay to that of man­agers. Mayo uses three sets of com­pa­ra­ble com­pen­sa­tion data, all of which are limited to academia or health sys­tems. The sys­tem’s top tal­ent pool may be largely in­ter­nal, but com­pen­sa­tion for top ex­ec­u­tives is “pure mar­ket pric­ing.”

As long as com­pen­sa­tion com­mit­tees con­tinue to be swayed by that logic, the wide dis­par­i­ties be­tween top ex­ec­u­tives and the com­pany’s work­force will con­tinue. And it comes at a price. They broadly un­der­mine morale, loy­alty and mo­ti­va­tion for lower-paid work­ers, the Univer­sity of Delaware schol­ars say.

It would boost pro­duc­tiv­ity if boards con­sid­ered bench­mark­ing ex­ec­u­tive com­pen­sa­tion to their own em­ploy­ees, whose pay and com­pen­sa­tion pack­ages more ac­cu­rately re­flect mar­ket con­di­tions than ill-matched peer groups of fel­low CEOs, ac­cord­ing to El­son.

“Board rat­i­fi­ca­tion of the ex­ec­u­tive’s con­tract should not be viewed sin­gu­larly,” Fer­rere and El­son wrote. “It is an im­plicit ex­am­i­na­tion and ap­proval of the en­tire or­ga­ni­za­tion’s wage and in­cen­tive struc­ture.”

CEO PAY AT LEAD­ING HOS­PI­TAL CHAINS

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