Outside/inside: peer group comparisons vs. internal pay system protocols.

• Author: Elson, Charles

Today, most boards justify their decision-making process for setting executive pay by referencing the pay of other "peer" company executives. In compensation disclosures most companies will use this "peer group" to explain that their particular executive is paid commensurately with others and that therefore the board has acted reasonably in setting compensation figures. However, now that they must publish the corresponding figure for median worker pay, companies will be forced to explain executive compensation decisions in a very different context. Rather than looking externally, to other executives, they will have to address the relation of pay to internal compensation dynamics.

Besides investors, a company's own employees are the most important consumer of proxy statements and annual reports. The information that is conveyed and the impression that is imparted have the potential to greatly affect how employees--whether middle management or assembly-line workers--view the company's mission, purpose and integrity. An employee's perception of these reports will affect their confidence in the enterprise long term. Done well, an annual report can help solidify employee commitment and facilitate a highly functioning organization. Done poorly, however, the reporting and the substance can become fodder for discontent and disillusion, creating broad-based dissension.

Employees will pay particular attention to this antagonistic pay-disparity ratio. Moreover, pay comparisons to other executives will not provide an adequate justification of board decision making as far as this important constituency is concerned. Such explanations will only inflame the pre-existing broad-based concerns about preferential treatment and meritless reward for executives. Peer group references to other executives will only serve to reinforce the common notion of a clubby and back-scratching boardroom culture.

Rather, boards and compensation committees will have to work closely with their human resources professionals to design and explain executive pay around internal company compensation system protocol. All employees understand that as one is successful and promoted within the enterprise, pay goes up concurrently. It must be communicated that...