Director pay: what makes sense today; Compensation received should reflect the work done. Here is a model for the new corporate governance era.

• Author: Poster, Claudia Zeitz
• Position: DIRECTOR COMPENSATION

OUTSIDE DIRECTOR COMPENSATION has increased significantly over the last few years in response to increased visibility and accountability around the directors' role in safeguarding shareholders. However, during this time there has been very little discussion about the structure of director compensation--that is, until Coca-Cola shook things up in April 2006 with its announced new director pay plan. Given the importance of the role of directors to corporate governance and shareholder value creation and the difficulty of recruiting top talent to play this increasingly difficult role, we believe a review and assessment of director pay is in order.

First, a word about Coke's new plan. The plan will pay the same amount (initially $175,000) to all directors regardless of their individual roles, in stock, based on the company's achievement of a specified three-year EPS growth target. If the target is not achieved, the directors are paid nothing.

While we applaud the Coke board for originality, commitment, and boldness, and for inspiring a discussion that is long overdue, we do not believe the plan is appropriate for many companies, primarily because it blurs the line between management accountability and board accountability. More on that below.

In this article we will not address the amount of director pay (which for the largest 250 publicly traded companies is surprisingly tightly clustered around a median of $170,000). Rather, combining our experience working with boards on director and executive pay with an analysis of trends over the last five years among the 250 largest publicly traded companies and interviews with a number of directors about their roles and pay plans, we will explore the structure of director pay plans in the context of directors' role and work processes. Over the last few years we have noticed, and confirmed statistically, a quiet but inexorable shift away from meeting fees toward board/committee retainers of varying amounts. We will address the question of whether meeting fees still make sense or whether retainers should be the primary mode for delivering pay, as well as other basic questions: How should "pay for performance" be structured, if at all? Does equity provide the right alignment with shareholders? What is the right mix of cash and equity?

Mix of elements and structure

The accompanying sidebar, "Watchdog/Helpdog: What Directors Told Us," addresses the issue of director pay in the context of changing work processes to support good governance, due diligence, and shareholder alignment. It is appropriate to look critically at the structure of outside director pay in this context to ensure that it compensates directors for being effectively engaged in today's corporate governance environment.

Generally, there are six elements of director compensation that can be paid in some combination of cash and stock. (Perquisites that serve no business purpose, such as pensions, have been eliminated.)

-- Board retainers,

-- Board meeting fees,

-- Committee retainers,

-- Committee meeting fees,

-- Committee chair retainers, and

-- Committee chair meeting fees.

These six elements, which can be paid in cash or stock, are combined in three basic ways:

1. Retainers and meeting fees: This is the most common and traditional structure for outside director pay. Under this format, some combination of a flat retainer and per-meeting fee is established for the board and for some or all committees and/or committee chairs.

2. Multiple retainers, no meeting fees: This is the next most common structure. There is a retainer for board service and some combination of a standard or variable retainer for service on some or all committees plus a retainer for the committee chair.

3. Single retainer: This is the simplest yet least common structure, more typical of small boards with an even distribution of committee service among directors. All directors receive the same retainer regardless of their role and committee memberships.

Our analysis of director pay plans in the 250 largest publicly traded companies in 1999 and 2004 shows a shift from the first model above (retainers and meeting fees) to the second and third (all retainers). In 1999, 28% of the largest companies had retainer-only compensation structures (multiple or single). By 2004 that number grew to 40%, including nine of the largest 10 companies. At the same time, the newest form of compensation, extra pay for chairing certain committees (such as audit and compensation), is almost exclusively in the form of a retainer, with no extra meeting fee. Interestingly, in 2004 one of the most prevalent pay structures in our large company sample included only two components: a board retainer and committee chair retainer.

The addition of committee chair compensation is understandable in the context of the extra workload that position has taken on in recent years. But how can the trend away from meeting fees be explained in the...