Executive compensation is meant to tie the interests of a company’s exec-utives to those of its share-holders. And with shares of financial services companies taking a thumping recently, shareholders would surely like to see executives share the pain. They can take some small comfort in the knowledge that executive compensation is tracking industry earnings fairly closely.

Investment Executive scrutinizes the proxy circulars of the publicly traded financial services companies every year to get a handle on how, and how much, industry executives are paid. (See table on page 36.) Over the years, IE has documented a relentless increase in executive pay. When industry profits were following the same trajectory, it was difficult to begrudge executives their rewards. But, recently, both profits and stock prices have gone south.

This severe downturn in the sector poses an interesting challenge for boards of directors. Do firms pay only for performance on the upside? Does executive pay crater alongside earnings? Will executives be punished for taking massive writedowns on assets that, in past years, generated big profits and, by implication, large bonuses for executives? And, conversely, are executives adequately rewarded for limiting the downside?

It is too early to answer these questions definitively. The latest proxy circulars cover periods that only partly reflect the impact of the financial market turmoil that began in August 2007. For the big banks, with their Oct. 31 yearends, this means that just one quarter of fiscal 2007 was affected by the credit crunch. Most other companies have had, at most, two quarters of weathering these volatile and uncertain markets.

But, nonetheless, these are ques-tions that financial services companies and their boards will have to address. Indeed, compensation structures have been identified as a primary culprit of the credit crunch. It is argued that these structures helped inflate the credit bubble by encouraging bankers and traders to focus on short-term gains and ignore the underlying risks of the products they were building and the securities they were buying.

Washington, D.C.-based Institute of International Finance Inc. ’s recent report, which details its response to the credit crunch, makes seven recommendations to improve industry compensation structures. These include measures to ensure compensation takes into account the level of risk and the cost of capital required to generate returns; that payouts be spread over time to reflect the risk that current profits could be clawed back if market bets go bad; and that incentives should be geared toward overall firm profitability and shareholder value.

Industry executives face the same challenge of encouraging employees to worry about the downside and keep their eyes on the long term — not just rabidly pursue short-term profits.

It will take time to discern whether the lessons from the credit crunch will alter executive compensation schemes. In the meantime, IE’s research shows that even though executive pay in the Canadian financial services industry is not yet tanking, it has, at least, been growing at a more modest rate than previously.

For the latest fiscal years, estimated total industry executive compensation — CEOs and named executive officers — is up to $600 million from $576 million the previous fiscal year. Similarly, aggregate estimated CEO compensation rose to $217.8 million from $196 million a year earlier.

These totals are estimates rather than hard numbers because they include options grants, which IE values in the year they are awarded using a conservative formula that assumes simple share price appreciation at the Toronto Stock Exchange’s long-run historical rate over the life of the grant, which is then discounted to its present value. As for restricted shares and other forms of equities-linked compensation that have a definitive value at the time they are granted, IE includes those in the year they are awarded.

Uncertainty in options valuation aside, the modest growth in executive pay year-over-year is more or less in line with the growth in aggregate earnings over the same period. Total industry earnings rose to about $38.3 billion last year from slightly less than $35 billion the previous year. So, while earnings are up about 9.4% year-over-year, estimated total executive compensation rose by around 4% — although CEO compensation grew faster, rising by about 11% year-over-year.

Excluding both the new names and the handful of deletions in the survey — so that we are comparing identical universes year-over-year — it appears executive compensation actually has slipped a bit. On this basis, total executive compensation is down about 5% year-over-year, while CEO pay has slipped a bit less, 3.5%, from the prior year.

@page_break@However, the vast majority of this decline is accounted for by Toronto-based Gluskin Sheff & Associates Inc., which saw its CEO’s bonus drop to less than $6 million in 2007 from almost $29 million in 2006. That large drop reflects a change in compensation methodology, however, not weaker corporate performance. The numbers reported by Gluskin Sheff in 2006 reflect the firm’s pay practices as a private entity, when it essentially paid out all of its earnings to its employees. That methodology changed after the company went public, yet the compensation disclosure for its first year as a public company used the old methodology.

However, that one large drop in the Gluskin Sheff bonus doesn’t affect the overall CEO salary numbers, which enjoyed a small increase year-over-year if looking at identical universes. For the latest fiscal years, CEOs collected $31.4 million in straight salary, up slightly from $30.9 million a year ago.

Of course, salary is a fairly minor consideration these days, as it represents only about 20% of executives’ take-home pay. Factoring in bonuses and other forms of liquid compensation awarded to industry CEOs last year, compensation for an identical universe came in at $153.6 million in fiscal 2007, down from $164 million in fiscal 2006. (But, again, this is distorted by Gluskin Sheff’s numbers.)

When looking at median rather than aggregate liquid compensation for CEOs, it’s evident that the big Gluskin Sheff bonus drop conceals a modest year-over-year rise in overall CEO pay; the median liquid compensation for industry CEOs crept up slightly to $1.55 million in 2007 from $1.53 million in 2006.

This same trend is evident when looking at total CEO compensation using an identical universe. Here, again, CEO pay is down on a year-over-year basis, to $188.8 million in fiscal 2007 from $195.8 million in 2006. However, median CEO pay is up over that same period to slightly less than $2 million last year from $1.8 million the prior year.

Similarly, aggregate NEO compensation is down slightly year-over-year, but the median NEO group saw its collective pay rise to $5.9 million last year from slightly more than $5 million in the prior year. If Gluskin Sheff is excluded, aggregate NEO pay rose by about 6% and the average executive team saw its collective compensation grow to about $9.9 million from $9.1 million the previous year.

The component of executive pay that saw the biggest year-over-year growth is share-based variable compensation. For industry CEOs, the estimated value of variable compensation rose by 25% year-over-year. But this can be misleading, as this component isn’t nearly as important to overall compensation as it used to be. In years past — before options had to be expensed — variable compensation was a much bigger part of executive pay packets. That trend has eased in recent years, and the latest year was no different, with estimated variable compensation representing about the same share of total CEO pay as base salary. The total estimated value of variable compensation rose to $38.4 million in 2007 from $27.8 million in 2006.

The big banks and life insurers are the most prominent users of this type of remuneration. Many other financial services companies are hardly using it, which is perhaps not surprising after a handful of CEOs found themselves with share-based grants that were underwater in the prior year. Last year, the CEOs of the big banks and insurers accounted for about 80% of total estimated variable compensation; by contrast, they represent less than 50% of total compensation this year.

For the rest of the industry, bonuses and other forms of liquid compensation are making up the bulk of executive pay. That means they will probably not feel the same pinch as shareholders have in the recent market turmoil. It will be up to boards and their compensation committees to determine if bonus payouts suffer in years ahead.

Financial services firms say they pay for performance. But with the restructuring of the global financial system, ideas of what constitutes performance may change, too. IE