A recent survey of internal auditors suggests that the profession may not be giving executive compensation the scrutiny it deserves, despite mounting pressure from regulators, Congress, and the public to reign in bloated pay packages.
The study of nearly 200 internal audit professionals, conducted by the Institute of Internal Auditors, asked whether companies conduct a holistic review of executive pay and benefits. Forty-nine percent of respondents answered with a firm “no.” Another 45 percent said that they did conduct such audits—but within that group, only one-third of them said the internal audit team led those reviews.
Those results appear alarming at first glance, especially since both the Dodd-Frank Act and the Securities and Exchange Commission’s new proxy disclosure rules order public companies to align executive compensation practices with their business strategies and risks. Implicit in those mandates is the need for companies to understand what their pay policies, and the risks those policies create, actually are.
Jameson
A closer look at the results, however, also indicates that perhaps internal auditors are tackling the problem in a more piecemeal approach. Steve Jameson, chief internal audit and risk officer at Community Trust Bancorp, says internal auditors may look at components of executive compensation as part of a broader audit of payroll practices or benefits administration, for example, “but not as a comprehensive unit where they would have looked at all aspects of it.”
When respondents were asked which parts of executive compensation they review most closely, overall plan design and cash compensation tied for first place, each at 56 percent. The other top areas were stock-based compensation (37.4 percent), deferred compensation (31.9 percent), and pension and other retirement contributions (25.3 percent).
Of the group who said their company does review executive compensation, a plurality (46.2 percent) said the human resources department leads that review. In second place was the internal audit department (33 percent), followed by the legal department (20.9 percent). Fifty-nine percent said they share those results with the compensation committee; 38.8 percent said they share the results with the audit committee.
Morley
“Every chief audit executive needs to look at the risks before deciding if an audit is warranted. I wouldn’t spend the time and money doing [an audit] if the risks don’t warrant it.”
—Lynn Morley,
Former President,
Institute of Internal Auditors
So the HR department is more likely to lead a holistic review of executive pay than the internal audit department—is that a bad idea unto itself? Not necessarily, audit experts say. Yes, the internal audit department should always lead the charge when an actual audit is necessary, but “whether an audit needs to be done is something different,” says Lynn Morley, an internal auditing consultant and author of an IIA practice guide on executive compensation.
“Every chief audit executive needs to look at the risks before deciding if an audit is warranted,” she explains. “I wouldn’t spend the time and money doing [an audit] if the risks don’t warrant it.”
Hirth
Bob Hirth, executive vice president of global internal audit at Protiviti, agrees. If the company’s residual risks are low, or other functions of the company (such as the HR team or the compensation committee) already do a good job of vetting compensation plans, a full internal audit may not be needed, he says. Internal auditors always have plenty to do, and not enough resources complete all tasks. If your C-suite is paid a total of $4 million and the company has a union agreement totaling $800 million, “which are you going to pay more attention to?” Hirth asks.
ANY ECB REVIEW?
Does your organization conduct a review of its executive compensation and benefits (ECB) program?
Response
Frequency
Count
Yes
45.3%
87
No, but planning to this year
5.7%
11
No
49.0%
94
Source
IIA Exec Comp and Benefits Review (June 28, 2010).
Internal auditors have a lot of knowledge, Jameson says, but not necessarily all the expertise to examine every aspect of every program—so sometimes they have to call on other resources in the company, he says.
Hirth further stresses that executive compensation doesn’t always end at the C-suite. Current SEC rules require companies to disclose the pay of their five highest paid executive officers—not necessarily the top five highest-paid people. The top sales person, for instance, may make more than one of those executives.
Weighing the Risks
Still, the overall results indicate that fewer than half of the organizations surveyed consider the whole picture of executive pay to determine whether they should give it an audit. Some companies audit different departments on different days, while others look at a different system every year, but “they don’t tie it all together,” Morley says.
WHO’S IN CHARGE?
Who has responsibilities for performing the ECB program review (choose all that apply)?
Response
Frequency
Count
External auditors
12.1%
11
Human resources
46.2%
42
General counsel/legal
20.9%
19
Compliance
4.4%
4
Internal Audit
33.0%
30
Other
33.0%
30
Source
IIA Exec Comp and Benefits Review (June 28, 2010).
The survey results “lead you to think nobody is doing audits of executive compensation and benefits,” she says. In truth, while companies may not be auditing that subject, per se, they are likely auditing “bits and pieces of it.”
This lack of a holistic approach to reviewing executive compensation comes with some risk, depending on the company, Morley says. Survey respondents agree. Reputation risk is cited most often (41.9 percent) as the reason for conducting such a review.
It’s important to assess whether your program is designed to “actually incent the wrong behaviors,” Morley says. “A lot of them are. They’re very short-sighted, rather than having a balance between short-term reward and long-term reward.”
She warns that in some years, executives can commit outlandish behavior and go unnoticed; in other years, that same behavior lands the company in unwanted headlines, such as “flying the guys on the corporate jet when you’re begging for money,” she quips—a reference to the CEOs of Detroit’s Big 3 automakers flying to Congress in 2009 to ask for a federal bailout.
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