Compensation Committees: What Board of Directors Should Know

According to the PwC 2021 Annual Corporate Directors Survey, about 82% of surveyed directors agree that the media criticize executive pay unfairly. At the same time, 58% of respondents agree that executives are overpaid. So how is the issue with executive compensation regulated? This is the area of compensation committee responsibilities. 

The compensation committee refers to the board of the company’s independent directors who set the level of the chief executive officer compensation and decide on the payment rate for other executives of the senior management. However, the roles and responsibilities of compensation committees are much more than that and may vary based on the type of organization. 

In this article, we will provide an overview of what a compensation committee is and discuss how it differs between nonprofit and for-profit organizations. Additionally, we’ll touch on the main functions of a compensation committee and explain who can become a member. So, without further ado, let’s dive in.

What is a compensation committee?

A compensation committee is a group of people within a corporation charged with defining and reviewing executive compensation. Essentially, this means the compensation committee determines the salary and other forms of compensation that company executives are to receive.

A compensation committee draws its authority from the corporation’s board of directors, by which it is appointed. Typically, compensation committees work both a managerial and a strategic function and are tasked not only with establishing and reviewing compensation packages but also with ensuring these fall within the broader set of corporate values and goals. 

That being said, let’s define three main functions of a board compensation committee: 

1. Advisory. The compensation committee stays abreast of all the industry best practices and guides the board and the whole organization based on them.
2. Strategic. Members of the compensation committee also ensure that the compensation strategy matches the overall company strategy and doesn’t discourage its execution.
3. Administrative. Another important role of the compensation committee is to ensure that the technics and approaches to the review of the compensation of the chief executive officer are disclosed and shared with the rest of the board. 

What does a compensation committee do?

Basically, the main purpose of the compensation committee is to ensure that the executive officer and other executive managers have fair and reasonable compensation that aligns with the company strategy and doesn’t prevent its execution. Committee members review and decide on executive pay and other means of compensation such as bonuses, vacation pay, benefits, and incentives.

The directors’ compensation committee develops compensation packages and defines ways to measure the success as a result of those strategies.  

Among the factors that could help the executive compensation committee to evaluate the results of implemented strategies are the following:

• KPIs for the executive performance 
• Actions that executives take to achieve set goals
• Results that can be directly measured and those that are a part of the larger company’s goals

Are compensation committees different in nonprofits?

If you are wondering whether there are any fundamental differences between a compensation committee nonprofit and a for-profit corporation, the answer is: some, but not much. 

While the main tenets of compensation are similar for nonprofits, nonprofit boards are commonly more closely regulated. There is an expectation that impartiality and fairness are to be the guiding principle, as much as possible.

In the US, for instance, a nonprofit must meet three requirements when establishing executive compensation to preserve its tax-exempt status. These requirements are:

• Compensation must be determined by a body within the corporation appointed especially to that end (the compensation committee). The members of this body must have no conflict of interest when they develop compensation packages. This means that, for example, the CEO cannot be a member of the committee.

• The committee must base its deliberations on relevant and reliable data. The recommendation here is that members of the committee should examine the standards set by other nonprofits acting under the same conditions (same region, industry, etc.) and determine compensation terms accordingly.

• The basis for the committee’s decisions and the committee’s deliberations must be well documented. This is important not only because of transparency reasons but also because of compliance requirements.

However, there may be special demands placed on publicly-traded companies. That is the case with corporations listed on the NASDAQ or the New York Stock Exchange (NYSE), which require and regulate the presence of compensation committees. 

For instance, the NYSE regulates the conditions under which a committee may hire an external compensation consultant or advisor, while also determining that a committee should feature two independent directors and requiring the committee to perform and publish annual evaluations of its effectiveness in keeping procedures and attaining strategic targets.

Most often, the above principles also apply to for-profit organizations. The key difference is that, for nonprofits, they can be taken as a necessary legal requirement for maintaining their nonprofit status.

Compensation committee components of a compensation plan

As it was mentioned above, the responsibility of compensation committee is much more than pure salary figures. The compensation committee oversees the whole compensation package, which usually includes the following components:

• The basic salary range of the chief executive officer
• Long-term goals-based bonuses (often come with corporate equity)
• Short-term goals-based bonuses (usually cash-based incentives) 
• Different benefits (vacation pay, parental leave, retirement plan, medical insurance)
• The privilege of access to company property such as phones, laptops, cars, etc.

For example, the infographic below shows how the pay for the top financial officer is made up in different countries based on the key compensation components.

Source: Willis Towers Watson

Who determines the board of directors’ compensation and who serves on a compensation committee

The compensation committee usually consists of independent board members who are elected by the board. Appointed members should have the expertise and required skills to be able to address all the compensation committee’s duties. Additionally, appointed committee members should be carefully assessed for biases before appointment to ensure the fairness of the compensation review process. 

It’s also worth noting that the compensation committees are also responsible for setting the compensation for board members. The board of directors compensation committee is usually a separate body that also consists of independent members who address the compensation for the board of directors. Also, organizations often opt for assistance from outside compensation consulting firms.

Who can take part in a compensation committee?

More often than not, compensation committees include members of the board of directors. However, the process of forming a compensation committee needs to take several other criteria into account. Specifically, compensation committee members should have a reason for being there. Factors often taken into account for the selection process are:

• Previous experience. Members should have a skill set and expertise relevant to the responsibilities and duties of the committee. Things like a background as a corporate financial advisor or a solid knowledge of industry standards can make someone a valuable addition to the team.
• No conflict of interest. As mentioned in the previous section, it makes more sense not to include committee board members who are affected by the compensation package decisions.
• Strategic and managerial ability. As we’ll see below, there is a lot that goes into determining executive compensation. It’s a good idea to select compensation committee members who are sure to be effective in this area.

Of course, these are just broad guidelines to follow. There will be other aspects to keep in mind — more self-evident, but just as important, such as leadership skills, compatibility between members across the committee, and so on.

Compensation committee responsibilities

Key compensation committee duties and responsibilities are outlined in the requirements of such regulatory bodies as the U.S. Securities and Exchange Commission (SEC), NASDAQ Stock Market, and NYSE. Obviously, the range of compensation committee requirements is extended depending on the organization it serves to. 

Besides the obvious task of determining the company’s compensation programs, many other elements fall under the purview of the compensation committee directors. The duties and responsibilities attributed to compensation committees fall within different areas and can be divided into several categories.

Overall compensation philosophy

One of the main compensation committee’s tasks is to develop the general compensation philosophy of the organization. It should correlate with the organization’s strategic plans as well as mission and values. 

The finance committee does a compensation plan that incorporates the ratio of salary and benefits, its competitiveness, correlation to business strategy, and factors that could drive the salary increase. Additionally, compensation board committees oversee the way compensation philosophy affects employees’ job satisfaction.

Compensation of executive officers

Through careful evaluation of industry standards and the corporation’s own goals, the committee is tasked with drawing a well-documented and holistic compensation plan that is then to be recommended to the board of directors. A robust compensation plan should be reviewed periodically and can include:

• Executive salary
• Short- and long-term incentives and other bonuses
• Health, dental, and life insurance benefits
• Vacation and personal days
• Company-established savings/investment funds or retirement plans, such as a 401(k)
• Other perquisites such as company-leased vehicles, accommodations, or devices

Among the factors that can impact the executive compensation decisions are the organization’s financial realities, current market indicators, and company’s risk appetite.

Compensation of board members and company’s employees

Except for the compensation of the CEO and other executive officers, independent compensation committees are also often responsible for setting and reviewing the compensation rates for board members and employee compensation. 

Compliance

The committee should ensure that everything is done in accordance with company bylaws and the committee’s own charter. Decisions should also conform with industry best compensation practices and ethical standards and, if relevant, with any external requirements, such as by an IRA or NYSE mentioned above.

Documentation

This naturally follows the previous point. Just like all other board committees, a compensation committee director should present certain documentation to the board. However, besides the initial task of drawing a compensation charter and a compensation committee report, it is also essential that any deliberations, decisions, and recommendations made to the board of directors should all be clearly documented.   

Evaluation

The committee should have an established mechanism through which to assess its success in achieving goals, fostering growth, fulfilling ethical standards, and keeping with the company’s strategic vision.

Other 

For many companies, the compensation committee plays a key advisory role, helping determine where compensation plans fit within the broader landscape of industry goals and corporate values.

Compensation committee best practices

Having an independent compensation committee selected leads to establishing certain guidelines that ensure the effective performance of compensation committee members. 

The board compensation best practices for the effective compensation committee governance include:

• Disclosure. The range of executive compensation is highly relative. That’s why a compensation committee should ensure a compensation disclosure by selecting a peer group. A company’s proxy statement should include information on how the peer group was selected and describe where the company falls within that peer group. 

• Engagement. The compensation committee developing a productive engagement with shareholders on the matter of executive director compensation rates is a must for the compensation committee members.

• Consulting. It’s often advisable for compensation committee members to hire compensation consultants or an independent legal counsel. These specialists can advise the committee on the peer group selection process, incentive design, and market peculiarities of compensation management.

• Data. To form a robust compensation plan and ensure fair and reasonable compensation pay, the compensation committee should have access to the right data. It includes the data investors have access to and tools for peer group modeling. 

• Independence. It’s essential for a compensation committee to stay unbiased, that’s why all compensation committee members should function independently of the board and be rotated regularly.

• Reporting. To ensure that the compensation committee operates legally, ethically, and in the best organization’s interest, they should regularly report to the board.

How board portals can help

A board portal is a universal solution for corporate governance. With the help of an organized board management tool, the compensation committee can improve its performance and facilitate decision-making. Board portals allow for secure document storage and distribution, effective collaboration within the committee, and online board meetings. 

Additionally, many board portals offer templates for the majority of corporate documents, such as a committee charter or meeting minutes. Choose the board portal that meets your needs the best on our main page.

Conclusion

As you can see, compensation committees are integral to ensuring transparency and fairness in internal corporate transactions, as well as preventing potential disruptions caused by conflicts of interest. 

Besides the job of researching and determining executive compensation plans, compensation committees are also instrumental as an advisor body for the larger context of a corporation’s place in the market, its mission, and long-term objectives. As such, their place in the structure of any major corporation cannot be underestimated.

FAQ

How many nonprofit organizations have a compensation committee?

Compensation committees are common primarily in large, well-staffed organizations. In other cases, their tasks are fulfilled by an executive committee or an especially assigned task force. 

How often does a compensation committee meet?

A compensation committee traditionally meets on a quarterly basis. Each quarter focuses on specific areas of the organization’s compensation planning. This way, a Q1 meeting centers on reviewing last year’s metrics, while a Q4 meeting decides on the benchmarks and policies for the upcoming year.

Is the compensation committee required?

Compensation committees are a must for corporations that went public and are generally recommended for all large organizations, including non-profits.

How are board members compensated? 

Board members are compensated through cash and stock awards that include meeting attendance fees and retainers. The rate of compensation for board members is usually set and reviewed by the independent compensation committee.