Honest questions needing honest answers: five straightforward queries that compensation committees should be asking...and answering.

• Author: Ferracone, Robin
• Position: Brief Article - Column

ALL EYES ARE ON the audit committee as a result of the recent spate of corporate fiascoes. But the truth is, compensation committees need more attention, too. These committees could be much more effective if they asked the following five questions:

1. Are we just giving lip service to pay-for-performance? Pay-for-performance is an overused, and abused, concept. Almost all companies claim to have it, but most don't dig deep enough to define and validate the link between executive compensation and shareholder value creation.

   How often do companies meet their earnings goals but fail to at least match industry total shareholder returns? Sure, below-market returns will affect option gains, but the last bull market proved that executives can be richly "rewarded" even if their company performs poorly. Directors need to understand which financial and operational measures truly drive value for their company, and the answer isn't always earnings per share.

   Demand evidence that your financial measures are appropriate (e.g., economic and statistical analysis of the link between financial performance and value). Tie annual bonuses to these measures and ensure that targets are meaningful.

2. Why are we targeting executive compensation above the market median? Inflation in executive pay levels over the past decade is due in part to aggressive market positioning (e.g., paying at the 75th percentile) and selective market definition (e.g., comparing only to a peer group of high performers or large companies), usually in the name of attracting and retaining executive talent. Far too often, this thinking goes unchallenged.

   Human capital needs to be evaluated for return on investment, the same as other inputs to the value-creation process. Avoid confusing the "quality" of people with the cold, hard value of their contributions. Compensation committees should define the market appropriately, set target pay at the median (absent a compelling rationale to the contrary, and there are precious few), and provide for exceptional actual pay when actual performance is exceptional. Do this and a superior executive team will be well rewarded.

3. Are we getting the most bang for our buck? Executive compensation programs are more than pay-delivery vehicles. They must motivate executives, improve decisionmaking, and reflect your company's culture. To get the most from your investment, your pay programs must reflect company goals and be fully valued by your executives.

   Many...