March 20, 2017
Discussion around the nuances of executive compensation are well-worn, while far less time has been spent on the analysis of director remuneration. This may be in part due to the difficulty in determining a uniform role across director positions, and thus the difficulty of comparing it apples to apples across companies.1 In addition, because board members set their own pay, they have to contend with the fact that their decisions can be viewed as “self-dealing.” Therefore, they must be careful of how they award pay, and since it is not typically aligned directly with performance, there is less analysis on forms of director award practices as seen with executive pay.
Though compensation is not awarded as an incentive toward driving company performance, shareholders want directors to have “skin in the game,” and equity compensation has been used to align independent directors to intervene in the shareholder’s best interest when working with management. Whether a board functions as a monitor, advisor, or some mix of the two, equity provides a counter-balance to the incentive to comply rather than provide contestation. For this reason equity now represents more than 50% of annual compensation and typically grows to dwarf a directors’ cash retainer over their years of service.2
The proportion of equity in director compensation is noticeably different between particular sectors in the S&P 500. For example, the amount paid in cash, as compared to the total value of a directors’ total compensation, fluctuates between approximately 35% (the average in the healthcare sector) and 50% (the average in utilities). These two proportions are outside the range of average cash compensation for the remaining six sectors, which ranges between 42% and 47%. For the S&P 500 overall, directors were awarded 42.3% of compensation in cash on average.
Noticeable differences exist between particular sectors in how they choose to construct director compensation, and it is difficult to parse out the exact cause of this variation. However, it is clear that if the rationale behind the use of equity as a significant portion of compensation is its ability to unite incentives, then there would be little reason for any particular sector to rely more heavily upon equity than another.
Possible causes of variations may simply track the rate at which some sectors adopt changes in corporate governance, and the fact that certain sectors may face additional scrutiny on these matters. Another reason could be that certain sectors comprise more recently established firms that are prone to higher short-term growth and thus construct their compensation to reflect this growth and their limited capital. It is still unclear the motivating cause behind every divergence, so more analysis in the future will likely yield additional factors by which to parse out the chief determinants in how director compensation is structured.
1Peter D. Hahn and Meziane Lasfer, “The Compensation of Non-executive Directors: Rationale, Form, and Findings,” Journal of Management and Governance 15 (2010), doi:10.1007/s10997-010-9134-5.
2David Yermack, “Remuneration, Retention, and Reputation Incentives for Outside Directors,” The Journal of Finance 59 (2004), 2281-2308.
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