A third rail is a
method of providing electric power to a railway train. The amount of
electric voltage it carries is often lethal for any living creature that comes
in contact with it. The guidance to railway workers and others and others is
simple: “Don’t touch it!”
From my experience, too many CAEs see
their organization's executive compensation practices as a figurative “third
rail” in their organizations, and consequently they “don’t touch it.” Indeed,
almost 70 percent of respondents to The IIA’s 2015 Global CBOK survey indicated
that they dedicate minimal to no effort in looking at executive compensation.
CAEs often indicate that they steer clear of executive compensation because of the
extraordinary sensitivity and perceived career risk of examining/questioning
their bosses’ pay. Unfortunately, avoiding executive compensation doesn’t make
it any less of a risk. In fact, executive compensation programs that are never
audited can become even greater risks over time.
Unease over executive compensation is gaining traction among
investors. Numerous recent reports have illuminated the growing divide between
how management and boards view executive pay compared with the general public’s
view, and the issue has evolved into a real risk at some organizations battling
The signs of investor and public unrest on the issue appear
to be everywhere. Willis Towers Watson, a global risk management, insurance
brokerage, and financial advisory company, recently reported an uptick in the
number of rejections on proposed compensation packages through Say on Pay votes.
Volkswagen succumbed to pressure from investors, unions, and
employees when it agreed to slash executive bonuses for 2015 by at least 30
percent in the aftermath of its emissions testing cheating scandal.
The Israeli parliament last month passed legislation capping
executive compensation for top executives of financial institutions at 2.5
million NIS (US$650,000).
But the growing concern over misaligned compensation doesn’t
appear to be getting across to those in control of the purse strings.
Compensation Advisory Partners reported earlier this year on 50 companies that
filed proxies between last November and February. Even though there were sharp
drops overall in a number of one-year performances measures (e.g., revenue
growth, earnings per share, total shareholder returns) in comparison to 2014,
the total mean CEO pay increased 13 percent at those companies.
There is little justification for executive compensation
that is not aligned with company performance, or board adoption of exorbitant
executive severance agreements. Such actions reflect a potentially unhealthy
corporate culture. The IIA has noted that executive compensation practices can
create compliance risks, financial reporting risks, and operating risks in
addition to reputational risks.
Focusing on the details of individual organizations can sometimes
offer reasonable explanations, but the potential damage and risk lie within the
collective impact of pervasive excessive executive compensation. All corporate
excesses ultimately undermine the credibility of boards, and negatively impact
the reputation of the corporate sector in society.
This apparent blind spot with management and the board poses
a challenge for internal audit. As is the case with many organizational risks,
internal audit is ideally suited to provide assurance to executive management,
the compensation committee, audit committee, and full board that the
organization’s executive compensation program and policies have been
effectively designed and implemented. Beyond that, internal auditors can
provide perspectives on how the organization’s executive pay plan compares with
industry peers, as well as warn of risks associated with being an outlier on
the high end. But the growing public outcry on pay suggest an organization’s executive
compensation may be seen as excessive even if it reflects what is happening
across the global corporate environment. This poses new reputational risks and
can make organizations vulnerable to activist investors.
The public’s disfavor and mistrust of the corporate sector is
easily understood when CEO-to-median-employee-compensation ratios of more than
200 to 1 are routine. That pay ratio will be a required disclosure under SEC
rules starting in 2018.
Equally troubling for me is a statistic reported by
compensation data firm Equilar earlier this month. The firm analyzed proxies of
the 100 largest companies by revenue that filed statements by April 1. It not
only found that more than two-thirds of companies in the group have combined
CEO-chairs, but that on average their compensation was about US$1 million more
than non-chair CEOs.
One analyst quoted in an Agenda Week article about the
Equilar findings could cite no reason for the discrepancy.
“From a philosophical point of view, there should be no
difference between the CEO-chair and the CEO on pay, because you’re not paying
for that chair [role],” Irv Becker, North American leader of Korn Ferry
Hay Group’s executive compensation practice, told Agenda Week.
From an internal audit perspective, a CEO who also serves as
board chairman diminishes the value of dual reporting lines that help protect
strong and independent internal audit functions. Data suggesting it also boosts
executive compensation unnecessarily only makes matters worse. It is time for
the members of the profession to join many corporate governance experts and take
a stand against combined CEO-chair positions, not just for the good of internal
audit, but for the good of the organization.
Even in the railway industry, the third rail is often
inspected/examined to ensure it is working effectively. Those who do so merely
ensure they use the right tools and deploy the correct expertise. I encourage
internal auditors to do the same with executive compensation. IIA members can
gain additional insight from The IIA's Practice Guide, Auditing
Executive Compensation and Benefits.
I welcome your thoughts as always.