The following post comes to us from James F. Reda, Managing Director, Executive Compensation & HR Consulting, Arthur J. Gallagher & Co., and is based on his recent paper, “Internal vs. External Candidates for CEO Succession,” which is co-authored by Joseph A. Wert, Regional Practice Leader, Executive Compensation & HR Consulting, Arthur J. Gallagher & Co. The full article, which was published in the November/December 2013 edition of The Corporate Board, is available here.

Despite being a keystone duty of a corporate board, CEO hiring and succession is often a governance afterthought. Pressures from the SEC and investors are driving boards to shape a coherent, responsible succession plan. Are they ready?

For most companies, there are no distinct indicators of CEO succession. Often abrupt or without warning, CEO departures can leave companies stuck in open water, fighting against the elements that are before them. Labeled as a high risk factor by the Securities Exchange Commission, as well as institutional investors, CEO succession planning is important to protect any business from capsizing.

Ultimately, a strong succession planning process helps prepare the entire company to handle senior executive departures when they inevitably occur. Thoughtful executive pay policies and programs are important to CEO succession. A balance in CEO/senior executive pay is important. Vigilance in en­suring that senior executive talent is appropriately paid for their contributions to the company’s success with long-term incentives provides an incentive for the executive to stay while the succession process unfolds. The board of directors should make leadership and succession planning a high priority, with meaningful compensation opportunities, especially for the CEO.

In October 2009, the U.S. Securities and Exchange Commission (SEC) issued Bulletin 14E, which provides that CEO succession planning is not “routine business.” The SEC now strongly recommends that boards provide comprehensive succession plans to shareholders.

In stating its position, the SEC acknowledged that poor CEO succession planning constitutes a significant business risk and raises a policy issue on the governance of the corporation that transcends day-to-day business. Shareholder proposals generally requested that the companies adopt and disclose written and detailed CEO succession planning policies with specified features. These include that the board develop criteria for the CEO position, identify and develop internal candidates, and use a formal assessment process to evaluate candidates. Prior to October 2009, succession was deemed routine and thus excluded from being presented to shareholders.

Surprisingly, 57 percent of CEO transitions were planned, with the other 43 percent resulting from the CEO being fired or resigning, dying or becoming disabled. This underscores the importance of being prepared by naming an emergency CEO, which may be a board member (typically acting or temporary) or a senior manager.

While the CEO selection decision should be based primarily on the company’s strategic direction and circumstances, new data has surfaced showing the unseen burdens that external hires bear. According to Paul Hodgson, principal at BHJ Partners:

“Hiring an outside CEO costs between three and five times the amount it does to promote an existing manager, so boards are failing in their fiduciary duty and wasting shareholders’ money by not having a properly functioning succession plan in place.”

Due to the large pay packages for outside recruits, they are often more publicized and scrutinized than inside candidates. The outside candidates must be paid more for forfeiting prior stock awards and to compensate for the increased risk of jumping to another company.

The best scenario is when an internal candidate is selected for CEO following a planned departure of the outgoing CEO.