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Article | Executive Pay Matters

Compensation committees, a practical solution for human capital management oversight

Executive Compensation|Governance Advisory Services
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By Ryan Resch | July 2, 2019

A new, cutting-edge concept is changing the way that boards are envisioning compensation committees, driven by forces that include investor expectations.

Compensation committees (CCs) are at a crossroads: traditional fiduciary responsibilities are their chief remit, but a greater role in overseeing human capital management (HCM) and strategies could fit in nicely with their current function.

We continue to see evidence of this reevaluation and have regularly commented on it of late in editorial pieces such as “What steps should compensation committees take as HR becomes part of their expanding responsibilities?Executive Pay Matters, November 13, 2018.

How companies’ boards of directors decide this issue will be determined by a number of powerful forces that organizations currently face:

Investor pressures

Investors continue to ask boards to oversee human capital within their organizations as they recognize the potential risks that can arise from a poor company culture and ineffective human resource policies. They also understand human capital drives company performance, and strong company cultures and human resource practices can be a market differentiator that supports attraction, retention and engagement of the right talent required to deliver upon rapidly changing strategic priorities. This is more clearly articulated by the Human Capital Management Coalition in its SEC petition for greater disclosure of HCM.

Treat human capital like financial capital

“Information about human capital needs to be treated with similar rigor and accountability as is afforded to financial capital,” 1 the International Integrated Reporting Council (IIRC) has indicated. Such treatment may be more important as intangible assets as a percentage of market value have increased from 17% in 1975 to 84% in 2015.2 This increased focus on intangible assets suggests that business models increasingly rely upon people as key drivers of intellectual capital and brand development, and that people can quickly destroy value through reputational risks and challenges.

Partially in response to investor feedback, the Securities and Exchange Commission’s (SEC’s) Investor Advisory Committee recommended some form of HCM disclosure, but it did not advocate a specific approach as detailed in “Executive Compensation Bulletin: SEC Advisory Committee Recommends Expanded Disclosures on Human Capital Management,” Executive Pay Matters, April 5, 2019. At this point in time, there does not appear to be any standard approach as a variety of organizations have provided suggested HCM metrics that companies should disclose. More work is necessary to balance the need for standardization and comparability with different industries and business dynamics.

The board’s role

Boards need to be prepared to address potential questions about their organizations’ HCM programs and practices, and we are seeing expanded CC responsibilities as one way for boards to accomplish this end. Key steps include:

  • Communicate with investors to understand their priorities. The investor focus on HCM is not homogenous, and different investors have different HCM priorities and approaches to aligning HCM with overall company valuations. Some are focused on gender diversity or other narrow factors (e.g., compensation design and organizational culture), while others take a broader perspective when they want to understand their organization’s HCM strategy and how it will flex with business strategies and changing market dynamics.
  • Work with management to clarify the CC’s role. Collaboration would typically include a review and approval of HCM strategies and regular updates on the strategies’ execution and effectiveness. We would anticipate a greater level of granularity on key talent (regardless of level) and leaders (one to two levels below CEO), while the broader employee base would be managed in aggregate or by major segment/group. In addition to the responsibility matrix, the board will need to specifically define the broad topic of HCM covering the entire employee lifecycle from recruitment and onboarding to talent development and succession. We suggest that a broad approach is likely required to address the full value of human capital throughout the organization. The investments that are made in support of this “asset base” will include the full employee experience and both monetary/nonmonetary programs. Management should retain the actual development of HCM policies and practices, and their implementation. The board should step in to oversee strategy and implementation, to ask the right questions and to fully vet unresolved issues.
  • Monitor and oversee. Increasingly we find CCs are working with management to develop “dashboards” that summarize material HCM metrics to track progress on a historical basis and/or relative to peers or other norms. As noted, there is no standardization on the types of metrics that should be reported; however, some of the key metrics include: turnover, employee health and safety, gender and other forms of diversity, talent management (e.g., time in role, promotions, bench strength, hiring rates and more). In addition to these “lagging indicators”, companies are looking at other “leading” measures such as culture assessments and engagement scores. From a risk perspective, compliance breaches and other reported incidents are also summarized. Finally, it is important to tie overall costs of the various human capital programs to productivity (total compensation costs as a percent of revenue or profits) and establish a potential connection to financial performance to demonstrate human capital’s return on investment.
  • Independent advice. HCM policies and practices will vary by industry and by company as they need to reflect and align with the overall purpose and strategy of the organization. This makes it difficult to standardize HCM with generic templates that CCs can review. The wide degree of latitude also puts increased pressure on CCs to ask the right questions, address material issues and have the required information to effectively fulfill their oversight responsibilities. Audit committees rely on external auditors to provide guidance in the review and oversight of the organization’s financials, and CCs will likely need to rely more on independent advisors that can provide subject matter expertise and an independent point of view on the organization’s HCM policies and practices.

A cutting-edge concept

This area is in its infancy, and CCs continue to develop and refine their approaches to effective HCM oversight. We anticipate that a variety of governance models will evolve that allow CCs to leverage their experience and expertise to provide strategic oversight with greater standardization and consistency in how human capital assets are valued, managed and reported.

1The Value of Human Capital Reporting (http://integratedreporting.org/wp-content/uploads/2017/05/CreatingValueHumanCapitalK1.pdf)
2Intangible Market Value Study, 2017 (https://www.oceantomo.com/intangible-asset-market-value-study/)