Last week I wrote about corporate governance at the Royal Bank of Canada, and by happenstance, the next day the Bank found itself on Moody’s watch list for a possible credit downgrade. Since aligning executive compensation with sound risk management principles is one of the key policies relating to compensation at RBC, I have decided to look at the Bank’s compensation practices. Obviously, the Board believes that Gord Nixon, the CEO of the Bank, did a better than average job in respect of risk objectives for they gave him a bonus 15% above the target for his efforts.

Before I look at the compensation practices, I will set out my views and recommendations. I also add two caveats before I start. First, I am only picking on RBC because of convenience as I pointed out in my previous blog. I am sure that I would have similar criticisms for most other companies and their executive compensation practices. Second, no company is likely to ever adopt my recommendations because they set too high standards, and their adoption would expose the myth that all CEOs are exceptionally talented individuals. Ironically, senior executives who pride themselves on being risk takers, are anything but when it comes to their own compensation.

My proposals are quite simple and are motivated by two objectives – simplicity and reward for above average, relative performance.

All senior executives should be given fixed term contracts, preferably three to five years. Renewal would not be guaranteed. At the end of the contract term, the contract would either not be renewed, and in this case there would be no need for severance payments. Or a new contract would be offered. In this latter case, the company might have to bid for the services of the CEO or other senior executives. If there were competing bids, the Board would have to decide whether they should enter the contest, and if so, how large a re-signing bonus to offer. If a re-signing bonus were needed, it should be payable in two equal installments: the first upon re-signing; the second at the end of the contract, with payment conditional on the company outperforming (in terms of profit growth and/or increase in market value) its comparator group (i.e. the company’s performance would have to be in the top 25%).

Annual bonuses should be linked to the base salary and the relative performance of the company. No bonus would be payable unless the company outperformed its comparator group. If the company were in the top 40% in terms of performance, a bonus could be paid equal to 20% of the base salary. The bonus could increase as a multiple of the base salary by for example 20% for every 5% higher ranking. But an annual bonus should be paid out in equal installments over three years. The future installments would be payable only if the company outperformed its comparator group; that is, if the company’s performance placed it in the top 50%. Otherwise, the CEO would lose that year’s installment, and of course earn no bonus for that year as well.

Finally, at the signing of the first contract, and only this one time, the CEO should be granted stock options equal to 1% to 2% of the company’s outstanding shares. The options would vest after 10 years. The exercise price should be linked to an index of the share prices of the company’s comparator group. This would ensure that the options only would have value when the company’s share price rose by more than the average of the comparator group. CEOs should not benefit from a rising tide.

With my proposals, executive compensation should operate on autopilot with little input needed by the Board and their consultants after the signing of the contract.

How do the RBC compensation practices stack up? Badly!

First, there are no fixed term contracts – a serious mistake. Second annual bonuses are almost automatic regardless of the Bank’s relative performance. Moreover, there is wide scope for the Board to tinker with the annual awards. In other words, the fudge factor is very large.

By the way, the Board faced a dilemma in the latest fiscal year because the consolidated profit fell far short of the continuing operations profit. The consolidated profit included substantial one-time losses stemming largely from the sale of the Bank’s US regional retail operations. There should have been no dilemma. Consolidated profits are the only profit numbers that matter. One-time write-offs indicate that profits in previous years were over-stated, and it is conceivable as a result that larger bonuses were paid in the past – bonuses that in retrospect were not deserved.

Finally, the Board awarded the CEO and other senior executives performance deferred share units and stock options every year. Three serious mistakes here: Stock options are intended to encourage long-term performance, and thus a one-time grant is all that is needed. Second, the exercise prices are not indexed; Thus, even when the Bank under-performs its comparator group, the options might have considerable value.

Third, the so-called performance deferred share units are a total farce. They are not needed at all. These units, which in the case of RBC also are awarded dividend equivalents, have value for executives receiving them even when the Bank’s share price declines. Options would have no value whatsoever is such circumstances, even with no indexing of the exercise price.

How much money would Gord Nixon have made during his tenure to date as CEO with my compensation proposal? Not much more than his base salary each year, and he would have been rewarded for relative under-performance by not having his first contract renewed. He must truly be thankful to his Board and their compensation consultants.

The opinions expressed in this blog are personal and do not reflect the views of either Global Brief or the Glendon School of Public and International Affairs.