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May 12, 2016

Are board refreshment policies improving?

Activism may be doing more than board self-evaluations to speed changes in board composition, PwC report finds

Are board self-evaluations helping to improve board composition? As many of you know, there’s a growing disconnect between director sentiment about how effective board evaluations are and the increasing number of directors who say at least one member of their board needs to be replaced.

In PwC’s 2015 corporate directors survey, 91 percent of directors say their evaluation process is effective and 86 percent say their board leadership productively leads the process, which includes following up on results. Yet 63 percent also criticize evaluations for being overly focused on checking the boxes and for limiting how frank directors can be in assessing their peers. Last year, 39 percent of board members surveyed said somebody on their board should be replaced, an increase from 31 percent of respondents who said so three years earlier, according to PwC’s research.

It doesn’t seem [boards are] doing the refreshing we would expect to see,’ says Paula Loop, who heads PwC’s Governance Insights Center. ‘And 34 percent say their biggest impediment to replacing an underperforming director is that board leadership is uncomfortable addressing the issue.’

One major drawback of board evaluations is they tend to focus on how well the board as a whole is functioning. ‘When you’re focused on refreshment, you need to also get down to individual director assessments, and then you need to take action based on the results,’ says Loop.

Shareholder activism is helping to drive board refreshment by providing an excuse for board leaders to be very direct with certain directors about the quality of their performance, thanking them for their service while making it clear they need to move on. And activism isn’t directed only at board performance but ‘has also spurred a lot more discussion about whether we have the right diversity from a gender perspective and ethnicity perspective, again giving the board an excuse to take action,’ Loop adds. In the May edition of its Director-Shareholder Insights series, PwC quotes its own 2015 corporate directors survey in which 20 percent of respondents say their boards changed their composition because of actual or potential shareholder activism in the past year.

PwC’s report also shows boards’ mandatory retirement age policies moving in the wrong direction. Of the 73 percent of S&P 500 boards that currently have a mandatory retirement age in place, 97 percent set that age at 72 or older, compared with 57 percent of boards that did so 10 years ago. And 34 percent set the age at 75 or older. While other boards think director term limits may be a better way to encourage board refreshment, just 3 percent of S&P 500 boards have such policies. PwC quotes Calpers’ global governance principles, which warn that director independence can be compromised after 12 years of service and advise that in such situations companies should ‘carry out rigorous evaluations to either classify the director as non-independent or provide a detailed annual explanation of why the director can continue to be classified as independent.’

In a blog post on the Harvard Law School Forum on Corporate Governance and Financial Regulation in February, London-based asset manager Legal & General Investment Management (LGIM) recommends that boards should comprise roughly one third relatively new directors, one third mid-tenured directors and one third longer-tenured directors, which ‘would allow a company to [use] the experience of the longer-tenured directors while limiting the risk of high director turnover over a short period.’

LGIM also says the board refreshment process should consider the board’s and its committees’ future needs in light of the company’s current and future business strategies and how well matched directors’ qualifications and skills are to those strategies. ‘This process will help recruitment as the potential director knows in advance that [he or she] is signing up for a finite period and will also empower the [lead independent director] or independent chair to ask a board member to not submit for re-election, taking strength of character that we would expect in such a role.’

That may be asking a lot more than board leaders can be expected to deliver given the collegial relationships that have been known to override other interests in board recruitment and service.

For Loop it means boards need to think long and hard about board succession and have a plan about what the board’s composition will be. She regards individual board succession as equal in importance to CEO succession. To get it right, however, requires giving more thought to various elements that need to work more effectively, such as board assessments and the transparency of disclosures around board composition, including director skill sets. ‘We see some terrific boards that have a great diversity of experience and thought and even gender and ethnicity, but they don’t do a terrific job of telling their story in their proxy,’ Loop says.

Not only are the vast majority of S&P 1500 companies probably not including director skills matrices in their proxies but most also fail to disclose whether or not they have women on their boards, which can’t always be discerned from directors’ names if photos aren’t included. Companies should take the lead by studying the higher-quality proxies and trying to emulate their example, Loop says.

David Bogoslaw

Associate Editor and Online features producer for Corporate Secretary