The world of business contains a few simple axioms and one of them is this: if you want to attract and retain top-quality talent, you have to pay for it. And if your peers pay a significant premium to their employees, then their greener pastures naturally beckon and you will inevitably lose your most important asset.

Setting appropriate compensation is particularly difficult for the executive ranks of the corporate world where demand for talent is high and the pool of talent is small. At least that is the explanation offered to justify why pay packages handed to executives have ballooned immensely. Indeed, compensation has now reached levels that are forcing the investing public to ask whether executives are being paid too much. But to answer that question, investors have to know how much executives are actually being paid. Compensation packages that combine a base salary with bonuses, stock options, perks, retirement allowances and various insurance and other benefits make it almost impossible to understand what an executive is really being paid or to compare different compensation packages.

The United States Securities and Exchange Commission (SEC)has introduced new disclosure rules that will force corporations to disclose and justify executive compensation in a way that will be meaningful to investors. Now every benefit given to an executive must be given a monetary value, and all future benefits must be discounted to a present value. And, in describing the compensation benefits, corporations are being required to use plain English.

Among concerned shareholders are institutional investors, many of them pension-based, who own the lion’s share of public companies. These investors are uniquely positioned to positively change corporate behaviour—not only do they have the most to lose when a corporation is damaged by the actions of its officers and management, but they also wield the most clout when they decide to act.

Large funds should be sensitive to compensation issues because they themselves are walking the same fine line as public corporations when it comes to adequately rewarding their own ranks and attracting the calibre of people necessary to make the funds profitable and efficient. Accordingly, executive compensation issues affect the pension-fund community in two ways. One, they must be ever vigilant in ensuring that the businesses they invest in are not detracting from shareholder value by overcompensating executives. And two, they must be careful to avoid the same pitfalls when running their own operations or they will potentially face the justified wrath of their own beneficiaries.

Corporate managers and directors have devised many ways to reward their top people, often through a combination of high base salaries, exponential bonuses and restricted stock grants and options packages. Most of these methods are admirably intended to reward executives in tandem with a commensurate increase in their company’s performance and financial health—but many pay packages completely defy logic and strain credulity. A quick look at the Walt Disney Company—a compensation scenario gone awry, which caused both shareholders and regulators to sit up and take notice, and action—is instructive.

Michael Eisner, the chairman and chief executive officer of Disney, hired his friend Michael Ovitz to be that company’s president in 1995. Fourteen months later, Ovitz walked away from an acrimonious break-up with a severance package worth approximately $140 million.

When news of the size of the severance package became public, the business media uniformly and roundly criticized it. However, familiarity breeds acceptance and having seen this type of thing—though perhaps not on this scale—many times before, the collective response was resignation. Such pay packages are typically unassailable due to the discretion traditionally afforded corporate managers by the legal doctrine known as the “business judgment” rule.

Nonetheless, Disney and its board ended up getting hit with a shareholder lawsuit. A ruling in that suit, handed down in 2003, sent shockwaves through boardrooms when it stated that the business judgment rule would not necessarily shield directors in this case and the shareholder suit against Disney and its board could proceed to trial. The ruling shows that angry shareholders who want to combat these sweetheart deals will at least get a chance to make their case against those who control the purse strings of their company.

In the end, however, the shareholders failed in the Disney case because the court accepted that as long as an independent board negotiated and approved the compensation, with the benefit of legal and other professional advice from compensation experts, then the courts should not review the compensation terms even if they seem absurdly excessive.

The most recently revealed compensation game involves the creative backdating of stock options. This is a method by which companies hand over options grants that are timed so that they are “in the money” at the time of exercise. There are a variety of ways to do this, but essentially this involves “travelling back in time” to decide what the grant date will be.

This practice is illegal and has damaging consequences on a company’s finances and financial reporting. The restatements necessary to account for the practice can also result in declines in a company’s share price. Investors have started to file shareholder derivative lawsuits attempting to claw back these unjustified payouts and have them returned to the company coffers.

Investigations and acknowledgements of such practices are not limited to U.S. companies. On Sept. 28, 2006, Research In Motion, the Waterloo, Ont., maker of BlackBerry devices, said that it had started a voluntary internal review of stockoption practices. The review identified errors that could reduce past earnings by as much as $45 million. It is likely a mere matter of time before Canadian shareholders bring similar legal actions.

The common lament among the companies implicated, a large number of which are among the Silicon Valley’s leadership, is “we had to do it to get the best and brightest” on board. Indeed, this argument may have some purchase in what was then a hypercompetitive environment in a nascent industry plagued by a dearth of suitably experienced candidates to run trailblazing companies.

However, regardless of the particular sector or the particular time period, you can find this rationale trotted out to justify outrageous pay packages—even when a company’s recent performance may be poor. The problem isn’t that options were granted; the problem is the way the option grants were implemented.

Shareholder activism, and on occasion shareholder litigation, by public pension funds has become a de facto last line of defence against bad corporate behaviour. However, the vigilance that pension funds have shown in combating excessive and unwarranted executive compensation should not be limited solely to the public companies in which they are so heavily invested. Even though they are not subject to the same requirements that public companies are, pension funds should not forget they have work to be done at home as well. The larger and more sophisticated pension funds become, the more they will face the same challenges as the corporate world in attracting and retaining the top-shelf talent necessary to ensure their funds grow successfully.

The challenge is particularly great on the investments side of plans that manage a significant percentage of their assets on an in-house basis. These funds find themselves competing with investment banks, hedge funds, brokerages and other financial services companies for the leaders in the investment field. The problem is that this is one of the corporate world’s most handsomely rewarded sectors and in order to convince people to leave it, pension funds must make them competitive offers.

The balance that they must achieve in order to justify compensation to their beneficiaries is similar to that used when deciding to hire an accountant to do one’s personal income taxes. As long as your accountant increases the amount of your refund by more than the fee, then there is reason to use him. The same can be said for the top dogs in a pension fund—as long as they cause net investment returns to increase by more than their compensation levels, the plan’s beneficiaries should be happy. Of course, this is a very difficult measure to accurately assess. So what should a savvy plan do to ensure it is striking the right balance and serving its beneficiaries’ interests? There are several simple guidelines to consider.

First, ensure that compensation packages for your executives are set by independent directors, not by the executives themselves or other board members who are subject to conflicts of interest. Second, following the lead of the SEC rule proposals, monetize all aspects of the compensation package in present value terms. Link bonus compensation with the growth of the fund. This could be done by stating that x % of the fund’s growth will be set aside for bonus compensation for all employees entitled to bonuses. Disclose the compensation for key people and use plain English to explain what the amount is and why it is reasonable.

Following the golden rule and “doing unto others” is a good start when it comes to good governance and understanding the nature of executive compensation packages. Providing fund beneficiaries with the same information that you require from the companies in which your fund invests is most likely going to get you the result you are looking for in terms of best practices.

Dominic Auld is special counsel with Bernstein Litowitz Berger & Grossmann LLP in New York.

For a PDF version of this article, click here.