Moving the goalposts
As well as a new set of metrics, the process of setting targets for these metrics will change. Given the difficulty of forecasting and planning, performance goals may feature more target ranges and moving averages. Part-year targets may also become common, with the huge difference between the first and second half of 2008 fresh in the minds of board members.
The pressure to defer rewards—even after they are earned—should see incentive-based payouts pushed further into the future. This gives companies time to rescind awards if a given year's performance is later challenged, something already happening at many troubled banks. At the extreme, one idea currently making the rounds is the "career deferral," in which earned incentives are vested only when an executive leaves a company.
While satisfying the general appetite for a longer-term perspective on performance, in practice, "once you go beyond three years, the mental discount that executives put on rewards gets very large," notes Boreham of Hay. Given ever-shrinking executive tenures, "any longer and it becomes a lottery ticket," he quips.
The grief caused by balancing the risk and rewards, fixed and variable, short and long-term aspects of executive compensation plans is also spawning more radical ideas that don't conform to the traditional three-pronged package of salary, annual bonus and long-term incentive. For example, a profit-sharing arrangement allows executives to share a proportion of earnings made above a certain threshold, requiring boards to set only one target. "It says to shareholders that if—and only if—executives make money for them, will they take a share of the excess," says Duffelen of Towers Perrin.
A system on the other end of the complexity scale is championed by Lars Oxelheim, a professor at Lund University in Sweden. The Macroeconomic Uncertainty Strategy, or MUST, claims to explain changes in the intrinsic competitiveness of a company, stripping out economic factors beyond executives' control—it is explained in Corporate Decision-Making with Macroeconomic Uncertainty (Oxford University Press, 2008). Using these tools, one of Oxelheim's samples found that 60% of CEOs' pay was affected by macroeconomic factors. "What should be rewarded is true performance," the professor says. "Otherwise there is no bite in these incentives."
Few companies provide enough information for shareholders to determine whether incentives reward "true" performance, much less allow them to employ something like the MUST model, Oxelheim says. "The optimal compensation from an executive's perspective to take as much as he or she can until the audience is outraged," he says. "I advocate greater transparency on pay because you do not dare do as much if people truly understand what you're doing."
Jason Karaian is deputy editor of CFO Europe
Seven deadly sins
Though opinions vary about how companies should build the ideal executive compensation package, there is greater agreement about what they shouldn't do, according to consultants at Mercer.
1. Earnings per share is the primary driver of shareholder value. In many cases, EPS is not closely correlated with long-term value creation. It can be influenced by changes in accounting policy and rendered meaningless when earnings are negative. Focusing on the cost of capital may provide a more meaningful, sustainable incentive.
2. Total shareholder return is the only performance measure you need. TSR's relationship to executive behaviour is far from direct and can capture many factors beyond management control. Mixing TSR with metrics linked to business strategy-like return on invested capital-captures both financial and market-based results.
3. A balanced scorecard is the best framework for measuring performance. Placing equal weight on financial, operational and strategic metrics may not always reflect a company's priorities. A framework that changes the weightings of metrics can reflect the evolution of a strategy.
4. If a competitor uses a measure, you should use it too. Even within a sector, the stages of development and organisational structures of firms may vary. Each company should emphasise metrics of internal relevance.
5. To be effective, performance measures must be understood by everyone. There is a trade-off between accuracy and complexity, with metrics such as cash flow return on investment often more accurately reflecting performance than revenue growth. Focusing on the behaviours that drive complex metrics can make explaining them easier.
6. The budget is the performance target. Using only internal measures can lead to misaligned incentives, with executives tempted to set easily achievable targets.
7. All executives should use the same performance measures. Common goals encourage collaboration and teamwork, but more differentiation is needed at large, diversified companies.
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