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L&A ORIGINAL ARTICLE: Pay-for-Performance – Not Just a Public Company Phrase

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Everyone talks about it, but no one seems to know how to perfectly achieve it…pay-for-performance. We see it everywhere, on the sports fields and in the boardroom, everyone wants to correlate pay with performance. This desire has led to the continual search for the newest and best methods to achieve perfect correlation, yet still, none have found it. Likely because perfect doesn’t exist. Regardless, and although possibly futile, it remains important the effort is made and strides taken to develop pay programs that, at the very least, incentivize toward improved performance.

No place is the usage of the pay-for-performance language more prevalent than public company boardrooms, as directors seek to ensure a strong executive performance/shareholder return correlation. However, as with most public company initiatives, private companies, and even many not-for-profits, are taking the same tact and developing programs that utilize corporate and individual performance in determination of incentive compensation.

Many individuals are key to the process of effectively developing these programs. All of these key-players have defined roles and responsibilities:

  • Corporate Executives: Set company and individual performance targets, provide the compensation committee with recommendations on compensation levels for executives, and incorporate the HR team into the compensation planning process. In conjunction with HR leadership, management should work together to marry company performance projections, long-term objectives, budgets and remuneration recommendations for the compensation committee’s consideration.
  • Board of Directors: Supply corporate governance oversight and business experience, while being the shareholder representatives to the company, inside providing inside independence from management.
  • Third-Party Advisors: Independent third-party compensation experts, along with tax, accounting and legal representation, provide opinions on reasonableness through independent analyses and processes.

Creating plans within a silo or excluding any pertinent information provided by these parties may produce an unbalanced process and an ineffective plan design.

It is important that annual incentives do not motivate top executives to forego long-term company goals and objectives for short-term payouts (i.e. Enron). While cash incentives are not by themselves to blame, the plans need to be reviewed on an annual basis to ensure the proper threshold, target and maximum values are being established. For example, a reliable annual incentive plan for a CEO drives annual performance without sacrificing long-term goals and objectives, and provides proper stretch performance (company and individual) with requisite thresholds, targets and payouts.

Generally, market assessments are conducted on an annual basis to ensure proper target setting and potential payout ranges.

 

Annual incentives are important aspects of compensation programs, intended to incentivize participants to achieve short-term goals and objectives. For executives, the prevalence of these types of plans is well in excess of 90%. Although certainly a key component, only a portion of the CEO’s total mix of pay (the blend of base salary, annual incentives, and long-term incentives) is made up of short-term bonus opportunity.

Not surprisingly, for publicly traded companies, the most important vehicle necessary to tie CEO compensation to the interests of shareholders is long-term incentives. While this has been a long-standing tradition, the use of long-term incentives in private organizations has consistently grown in prevalence in reaction to the need to compete on a level playing for talent. Prior to the implementation of a long-term plan, many private companies struggled to find balance since all compensation came through base and bonus.

For CEOs, the long-term incentive opportunity should always outweigh the short-term compensation opportunity. Companies now balance the vehicles used with the associated retention, motivation, and expense of each vehicle. While time-based vehicles remain the most useful retention vehicle, performance shares are gaining prevalence in this pay-for-performance environment. Diversifying a CEO’s equity/long-term portfolio between two or three types of long-term incentive vehicles will allow boards and HR departments to maximize retention in a market downturn and motivate in an economic recovery.

Over 60% of companies use two long-term incentive vehicles, with the long-term incentive mix being predominantly performance-based. This is by the go-to structure at the majority of companies, while stock options continue their decline.

 

One of the most fundamental considerations for any incentive plan, whether short or long-term, is the selection of metrics. L&A has observed that nearly 50% of annual incentive plans consist of at least two financial/operational performance metrics, and an individual/discretionary component. For long-term metrics, one to two metrics is most prevalent. Long-term incentives with performance contingencies also have a metric(s) assigned to them, most prevalently one to two.

Line of sight, or the direct effect an employee can have on company performance based on his/her own actions and decisions, is a key determinant of whether or not a metric is appropriate. CEOs have the single greatest line of sight within an organization to overall corporate results, resulting in a greater percentage of the total bonus/long-term award being tied to corporate results.

The most common metrics in annual incentive programs are earnings-based metrics (EBITDA or EPS), return-based measures (ROIC or ROE), and operational metrics (vary by industry).

When granting performance based awards the use of TSR or other share/unit price related metrics remain the most prevalent, while return-based metrics are making their way into programs at a fast pace. The rise in use of TSR-based metrics has leveled out within the past year, with a renewed investor focus on other metrics which have a correlation to share price growth (i.e. ROIC).

No matter whether public or private, pay-for-performance should and will remain a key focal point in the development of executive compensation programs. Although the amount executives are compensated will always be a lightning rod issue, the utilization of a pay-for-performance program will work to dissuade much of the debate. As such, developing a program with pay correlated to performance is important, and while there will always be skeptics to any approach to CEO compensation, there is no debating that good process, sound business judgment and independent third-party counsel provide the best foundation for CEO compensation plan design.