Monthly Archives May 2013

Are Relative Total Shareholder Return (TSR) Plans “The Answer”?

Posted by Paul McConnell on May 06, 2013  /   Posted in Compensation Committees

[Originally published in Board Member Magazine 2013 Q1.]

stockThere has been a great deal of recent interest in performance share plans that use Total Shareholder Return (TSR) relative to a peer group as a measure of performance.  Clearly, these plans usually look good in a pay for performance comparison and can help secure favorable say-on-pay votes, but the additional questions Compensation Committees should be asking are:

  • Do they motivate executive performance?
  • Are they right for this particular company?
  • Does TSR reflect true executive performance?
  • Is this the only performance-linked program we should use?

Any discussion of total shareholder return must start with the understanding that TSR is a result of good management performance, not the performance itself.  The desired management performance is the production of great products/services, properly priced for consumer value, that deliver consistent financial returns commensurate with the riskiness of the required investment.  If the market sees this performance, share prices are bid up relative to peer companies and positive relative TSR results, assuming of course, other, exogenous events do not occur.

From a motivational perspective, the strongest incentives are those where a clear line of sight exists between the desired behaviors (performance) and the reward.  TSR plans may not provide as clear a linkage as plans tied to measures of operating performance.  Even though it may be very hard to do, executives know what it takes to raise net income by 10%; it is less clear what it takes to raise the stock price by 10%.  And the market is not necessarily rational, certainly not in the short term but also seemingly for the long term as well.  Thus plans tied to operating metrics more clearly convey performance expectations and behaviors.  However, executive pay is not just about incentives and motivation.  It’s also about sharing the risk and reward of ownership.  What then are the situations where risk sharing is more important than communicating performance expectations?  Although the following list is not exhaustive, it shows the areas where we think these plans have value.

Shareholder Relations Issues:  In cases where there have been historical issues with the pay for performance relationships, relative TSR plans alleviate that problem – in fact, better than outright share ownership.  By definition, the change in the value of executive shares owned has a 1 for 1 alignment with TSR.  TSR performance plans have a more exaggerated relationship, due to the fact that the value of the shares awarded as well as the number of shares themselves vary with TSR.  The value of these shares typically climbs faster and drops more quickly than total shareholder return itself does.

Change in Strategy/Turnarounds:  In these situations, it is difficult to set reasonable performance goals.  Success will likely be much different than current expectations.  But a successful turnaround will likely have a dramatic impact on TSR, as the market builds new expectations into the market price.  These kinds of awards are also useful in justifying the kind of above market grants that are typically required to attract new management required to effect the change in strategy/performance.

Technology/Life Sciences:  These industries are known for high risk/high reward – particularly in the pre-IPO stage, where large equity grants are the rule.  These grants are either very valuable or worthless.  (Executives that have worked in these industries often have enough worthless stock option certificates to wallpaper their office.)  Relative TSR plans can replicate this highly leveraged reward practice in the public company stage.  Very successful strategies produce high relative TSR, which these plans magnify into even larger reward.

In Conjunction with Other Plans:  When other long-term plans are in place that use other metrics, a TSR plan can be good for balancing the total plan so that a company doesn’t create negative perceptions that management gets very generously rewarded when shareholders don’t.

Are relative TSR plans “the answer”?  No, they are “an answer” that can be very appropriate in the right situations.

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CEO and Executive Pay Plans: Help for a Broken System

Posted by Paul McConnell on May 06, 2013  /   Posted in Compensation Committees

[Originally published in Board Member Magazine 2013 Q2.]

Broken Somewhere along the way, executive compensation veered off the road.  It became too complex, isolated from true performance and downside risk, and in many cases, too high.  The original idea of executive compensation was to pay an adequate and fair wage and good benefits.  Any additional pay was intended to place executives in the same position as owners.  However, with high base salaries, equally powerful short-term incentives, long-term incentives that are treated as income rather than investment and often protect against downside risk, and the potential for golden parachute payments that reward executives when they fail, something went wrong.  The good news is that it can be fixed.  The bad news is that it will require some bold new thinking on the part of boards and management.

Performance.  Before discussing pay, let’s examine performance.

  • More often than not we reward CEOs for luck and good timing rather than for leadership, stewardship and good strategy.  Research has shown that as much as 80% of total return may be based on macro-economic factors and industry trends unrelated to company behavior.
  • Performance against internally-developed goals is important, but may be unrelated to actions that build long-term value for investors.  If a CEO is truly operating at a strategic level, the real impact of their leadership may not be evident for 5-10 years, and in some industries with long development or capital cycles, perhaps 15 years.  Yet for the most part we define CEO performance in terms of annual financial results rather than on more broad indicators of long-term value creation.
  • Current year plan-based targets, ROIC (return on invested capital) and share price are all great dashboard measures, indicating directional progress, but these measures should not be confused with actual success of a strategy or long-term value creation within an organization.  Boards need to think long and broad when it comes to assessing performance.

If we are to improve the pay model, we must first be willing to commit to a longer-term view of performance and articulate exactly what success looks like.

Pay.  Much of the current executive compensation thinking is a product of the 1980’s and 1990’s.  Many of today’s practices are influenced by the SEC efforts to standardize disclosure in an effort to bring more transparency and comparability to executive pay.  Unfortunately, as with many things, there were unintended consequences.

  • We think about and communicate pay in annual terms rather than in long-term outcomes.  If in doubt, read the “compensation philosophy” section of the typical CD&A.
  • We emphasize annual bonuses that pit CEO’s self-interest against investors when negotiating performance targets.
  • We claim that equity is an incentive to create alignment and balance risk, but we allocate it on the basis of “competitive pay” like cash; we too rarely acknowledge an intended career allocation or a targeted ownership objective.
  • We rationalize equity programs as putting executives in the same position as owners, but, in our experience executives rarely lose money. Annual equity awards are typically based on dollar-denominated “target values”, protecting executives from stock price changes, and executive stock holdings are often sold to the extent they exceed minimal ownership requirements.
  • We use “competitive practice” as a synonym for minimum requirement, whether dealing with salary and incentives, terms of employment, or severance.  As a board we seldom exercise leadership in crafting employment arrangements directly supportive of the company’s mission.

To say that executive pay is “broken” may seem overly harsh, but we should at least acknowledge that executive pay often falls far short of delivering on its objective of rewarding executives for long-term value creation.  The first step in the cure is admitting you have a problem.

In later articles, we will examine several solutions to these problems.

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© 2013 Board Advisory.
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