The best ways to pay directors.

• Author: McLaughlin, David J.
• Position: Corporate directors

Companies are casting about for innovative ways to compensate quality directors for their labors. Here is a panoply of ideas for consideration.

DIRECTORS & BOARDS enlisted five specialists in board organization and compensation for their best ideas on fashioning a forward-thinking pay and benefits program for directors and on enhancing the director pay/performance link. Here are their recommendations.

Make a Meaningful Commitment

David J. McLaughlin is President of McLaughlin and Co. Inc., a consulting firm in Essex, Conn. He serves as the chairman of the compensation and human resources committees of three public-company boards: Scientific-Atlanta Inc., Exide Electronics Group Inc., and Smart & Final Inc. He is also a management advisor to several multinational corporations in the United States and Europe; Executive Director of the Senior Personnel Executives Forum (a nonprofit association); and Publisher of The Organization Frontier, a new management journal.

An old English proverb says, "Some men go through a forest and see no firewood." The proliferation of data and opinion on director pay levels and practices may be diverting us from the real issue: How can we make our boards as effective as possible? The challenge is not how to pay directors. If we start with that question, the answer will look a lot like the executive compensation scenarios of the 1980s: Keep paying more. The real question is, can remuneration be used to make boards more effective?

In my opinion, there are four major obstacles to board effectiveness:

-- The mix and level of commitment of board members;

-- The organization structure prevalent in most boards;

-- The time span on which boards are focused; and

-- The tendency of boards to work as clubs rather than teams.

Remuneration can play some role in overcoming these obstacles.

Compensation is supposed to help attract and retain talented people. While board retainers have increased about 60% in the last five years, anyone involved in director selection can tell you that it is easy to fill the job with well-credentialed individuals but hard to get the right combination of committed people. Most boards do not have enough women, for example; or they have too many members with domestic rather than global business experience. A high level of commitment is necessary for effective participation, and many able candidates (particularly other CEOs) simply do not have the time.

More aggressive forays, often with the help of an executive search firm, are turning up better candidates, and independent nominating committees have raised the selection standard, but more attention also needs to be given to the remuneration package.

Average board compensation, particularly below the top several hundred companies, is a pittance for a CEO or successful professional but a true attraction for those coming from other sectors. To enhance the appeal to all types of candidates, I believe companies should offer recruiting bonuses in the form of restricted stock, with gross-up payments on the taxes due, or sizeable, front-end-loaded stock option grants.

Boards need to be more flexible than the traditional structure (meetings of the whole and standing committees) allows. I see boards using ad-hoc groups more extensively, particularly to address major strategic questions or handle top-level succession; resorting to conference calls more frequently; and stepping up the flow of information. Most companies have been slow to tie directors into their voice mail systems and online data networks, but it is clearly coming. In this unfolding world, the meeting fee may become an antiquated device. For this reason, director remuneration should be simplified to a sizeable retainer and ongoing stock options.

Some have argued that director compensation should fluctuate with bottom-line results, but I am dubious both about the appropriateness of any fixed formula and about the short-term orientation encouraged by such methods. The strongest incentive for directors to do their jobs well is to have a sizeable stake in the enterprise. I believe board members should be expected to make a meaningful stock commitment upon joining a board. A significant portion of director fees -- at least 25% -- should be paid in stock. Stock option vesting should extend over five years, not shorter periods, and there should be a threshold level of corporate performance required before options can be exercised. Further, directors should be expected to retain at least half of the stock they acquire through option grants and, over time, own stock with a market value of at least five times their annual retainer.

Maintaining an effective board also requires that more attention be paid to the performance of board members. The initial term of a board member should be a trial period, with a formal assessment at the end of a two- or three-year term by both the incumbent and a committee of outside directors charged with overall board governance.

Board charters should establish parameters for the retirement of board members. A common practice has been to set an "outside" date for retirement, such as age 68, but this may be too early for some and too late for others. An alternative would be to adopt a process under which the governance committee reviews all directors automatically. The committee could then recommend extended terms of service (an additional three years, for example) on a case-by-case basis. This would formalize a practice now followed by well managed boards. There should also be a director's retirement program that enables the company to transit with dignity individuals who have made a significant contribution in the past but are no longer active in business. Board members should be intensely interested in the company's business: while being a director is a part-time role, it is not a part-time commitment.

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