pay incentives

Executive Pay Practices: The Road Not Taken

Posted by Paul McConnell on August 17, 2014  /   Posted in Compensation Committees

Two RoadsThe evolution of current executive pay practices may require more and more companies to take the “road less travelled by” in order to provide superior returns to shareholders. Pay practices continue to create heated debates among executives, boards, institutional investors and their proxy advisories (e.g., ISS and Glass Lewis). Underlying the debate are two contrasting views about executive pay and the economy in general – zero sum economics and expanding wealth.

Zero sum economics simply holds that one person’s gain, is another person’s loss. To wit, if the board pays their managers more, there is less for shareholders. The current metrics employed by ISS to assess pay-for-performance are really cost control measures that seem to reflect ISS’s view that executive pay is a zero sum game. While zero sum may capture the economics of trading pork bellies or oil futures, it does not describe how an economy creates wealth and how managers should share in the wealth they create.

The view of expanding wealth is embodied in the likes of Steven Jobs, Meg Whitman, Jack Welch and many others — business leaders who created substantial benefits for consumers and in the process created substantial wealth for themselves. In short, the pie got bigger and owners shared in the increasing size of the pie. It would be rare to find an investor who would begrudge the wealth these superstars have earned. Interestingly, among this illustrious group, some would likely fail today’s proxy advisor screens.

Rewarding managers for wealth creation is a “value sharing” approach to executive pay. The model dates back to the industrial giants who emerged prior to WW II. GM, JC Penny and others paid a share of the profits (after a fair return to investors) to the senior managers. After the War, public companies migrated to a “competitive pay” model that pays managers what other managers earned in the same sector and adjusted for size.

Unfortunately, with the exception of significant collapses in performance, competitive pay is often “memory less” — regardless of performance, the CEO gets what the CEO’s peers get. It should be noted that private equity has pretty much retained the “value sharing” approach to incentive pay, a potential source of competitive advantage in attracting talent.

While competitive pay addresses retention risk (if everyone’s paid the same, no one will leave for more money), it may not address performance. High leveraged plans pay out more as performance increases, but could run into the immoveable code of the proxy advisors. While no board member wants to be voted off the island, boards may unknowingly be taking the road to mediocrity by de-levering the compensation plan in order to assure favorable votes from investors.

Yet if ever there was a time to avoid mediocrity, this is it. Mediocrity, is what puts a company on the short list of potential takeover targets. In a world where the economy creates new wealth, “value sharing” compensation programs do matter. They matter not only to attract and retain talent, but also to encourage managers to pursue all value-adding investment opportunities. The biggest impact on shareholder wealth from the competitive pay approach may well be the opportunities foregone.

It’s time for boards to take a stand against mediocrity. Start with strategy – management must make a compelling case for their strategy and how it will create value for investors. The board must support the strategy (or change it). In supporting the strategy, the board must adopt a compensation program that is aligned with the strategy and allows managers to participate meaningfully in the value they create for shareholders. Finally, boards and managers will need to explain to institutional investors and their proxy advisors how they intend to create value (strategic intent) and how they will allow managers to “share” in the value created. In short, the road less travelled by may not be an easy road; but then it may make all the difference. BoardMember 2014 Q3 The Road Not Taken

Are You Paying for Performance or Just Paying for Results?

Posted by Jeff McCutcheon on February 08, 2014  /   Posted in Compensation Committees

Performance reportPaying for performance is assumed to be the objective of most executive and employee pay plans. A quick read of a handful of proxy statements will likely find the phrase “pay for performance” prominently used. The Dodd-Frank Act expressly instructs the SEC to require companies to describe their pay-for-performance program. However, we find many of these programs simply pay for results.

Let us explain. Paying for performance infers that the reward is somehow  linked to actual contribution, whether as individuals or as a team. It requires some level of cause and effect. In the context of a management long-term incentive arrangement (LTI), this might be achieved by linking the number of shares vesting to achievement of a key strategic objective, like successful diversification into a new business or developing a pipeline of new products to sustain a higher gross margin.

Paying for results is simply managing incentive payments to an outcome, whether the direct result of performance or not. For example, a company’s stock may rise for many reasons, including factors well outside the impact of management. This approach is typical of many total shareholder return (TSR)–based long-term incentive plans. The plans are defensible on the basis of their alignment with shareholder returns over the same period of time. However, let’s not lose the distinction here—paying for results is not the same as paying for performance.

Investors support long-term incentives primarily because they believe the incentive will both reduce the risk inherent in strategy execution and decrease the eventual investor cost to realize the strategy. The LTI should reward successful strategy execution and serve to complement and, at times, counterbalancethe short-term nature of the annual incentive. It’s about providing a financial incentive to create future value through execution of a strategy, which may require an extended period of time to achieve.

For these reasons we argue that performance—causality to results—is critical to maximize the valueof the incentive investment. If you simply pay for market-based returns using absolute or relative  TSR, the LTI may serve more as a lottery ticket than an incentive. By this we mean actual payout is viewed  more as chance than contribution. This hardly serves to motivate any change in behavior on the part of the executive or help guide the executive team in navigating tactics and priorities. While such programs are often lauded, they may in fact diminish or delay accountability for a poor strategy by rewarding (or punishing) for events reflected in stock price that are unrelated to changes in long-term franchise value.

The LTI should address two equally important objectives—deliver the strategy (paying for performance) and create value for investors (paying for results). The former is an often difficult, uncertain, and time-consuming effort. Yet, achieved thoughtfully, it produces a resilient and successful organization. The LTI should also reflect performance risk. A business-as-usual strategy (or lack of strategy) should provide no more than “caretaker” rewards, even if shareholder returns are exceptional. Similarly, an exceptional strategy that does not produce above-market returns for investors cannot be granted superior rewards. However, the exceptional strategy that is duly rewarded over time by the market should deliver superior rewards to the management team

As we saw in 2013, institutional investors are beginning to migrate from simple, standardized, and often poorly conceived metrics dictated by the proxy advisers (e.g., ISS and Glass Lewis) to a more nuanced dialogue with managers and board members regarding pay. As institutional investors trade the “pass/fail” approach for dialogue, it is critically important for managers and boards to speak clearly to their shareholders about how the LTI is integrated with both successful strategy execution and rewards to shareholders. By clearly articulating the detailed link between enterprise strategy and executive rewards, companies will benefit from not only more effective executive efforts, but also greater investor support.

Are You Paying for Performance or Just Paying for Results? from BoardMember Magazine, Q1, 2014

© 2014 Board Advisory.
^ Back to Top