Executive Compensation – The Third Rail for Internal Audit?

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 activist investors.

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.