Whatever the form, the appeal is clear: companies may calibrate their plans to allow their executives to get rich only if investors do, too.
Such plans are growing more popular. An October report from executive-compensation firm Frederic W. Cook & Co. found that over the past two years, the percentage of big companies using such long-term performance pay (both cash and equity) rose from 49 percent to 65 percent.
The Price of Poor Backup
Despite the new choices that boards have, a plan
that pleases shareholders while rewarding managers
for strong performance remains elusive.
Consider the accounting implications. In the old
days, "plain vanilla" options didn't show up on
the income statement, while other forms of pay did, including
any that contained a performance link. FAS 123R changed this
by requiring a charge for all compensation. It added a number
of wrinkles, too — most notably, different treatment for equity
awards that are linked to external market measures such as total
shareholder return (TSR) or price/earnings ratio. If an award is
market-based, a company must record a value on its income
statement, and the expense stays there even if the company misses
its target. Recognizing that these incentives are not guaranteed
payments, FASB permits companies to record a lower,
probability-adjusted figure.
Other rules apply in the case of pay geared to nonmarket, internal measures, such as earnings or customer-satisfaction levels. A company can reverse that charge if the executive misses the target. As with the market-based metrics, the expense can be discounted depending on the likelihood of the goal being met. But unlike the expenses associated with market measures, expenses stemming from use of internal metrics can be revised later on. Two years into the program, if the company expects to fall short of its cash-flow targets, for instance, the expense can be cut to zero.
Stacy Powell, equity compensation practice leader with CCA Strategies, a Chicago-based actuarial unit of JP Morgan, cautions that companies need to be careful in documenting how they arrive at their probabilities, through processes that can range from Monte Carlo simulations to reviews of past company results. "There's more to this than just saying, 'Fifty percent sounds good to us,'" says Powell. "Your auditors will second-guess your calculations if you don't provide enough support and backup." (See "Back to the Drawing Board" at the end of this article.)
Such accounting considerations inevitably influence the company's choice of measures. The attractiveness of internally based awards — in which the compensation expense can be reversed if the performance methods are not achieved — leads some companies to give them a close look, says Mike Savage, senior vice president of Aon Consulting's compensation practice. But boards aren't ignoring market-based measures. Indeed, TSR is a common measure for performance plans, according to Peter Lupo of Pearl Meyer & Partners. "Many companies like TSR because it truly represents value delivered to shareholders," he says.
Agilent came to this conclusion after initially using both a measure of relative earnings growth and a relative TSR measure, with managers having to hit both targets to qualify for a payout. After a couple of years, it dropped the internal measure in favor of shareholder return alone. "After a lot of discussion, the board decided it was best to keep things simple," says Grau. "Our earnings metric was complicated and not very transparent to investors. Relative shareholder returns is something shareholders can really understand."
The board can understand it better, too. "The management team sets financial objectives, and the compensation committee doesn't have a strong sense of whether it's a stretch goal or a layup," says Lupo. "One way to balance that is to index TSR versus a peer group and have that be half the award."
Still, internal measures have their advantages. A manager's influence over something as complex as the stock price is quite limited. And arguably, CEOs and other top executives have more control over EBITDA. Further, just as stock options provided some executives with a motivation to take shortsighted steps for a temporary lift in the stock price — or even fiddle with financial results — measuring performance against the market could also induce such undesirable behavior.
But which internal financial measures should a company choose? A Watson Wyatt analysis recently sought to determine the metrics that correlate most closely to shareholder returns. The answer varies by business concentration. For general industrial companies, for example, return on invested capital is the best predictor of shareholder returns. In financial services, it is cash flow per share.
Since the new disclosure rules call for proxy statements to provide evidence that such a link exists, firms should prepare their own analysis. Increasingly, that job is falling to the finance team.
Fine-tune at Your Peril
Performance shares present their own challenge: how to fit this form of pay into the overall compensation program. Aon's Savage argues that boards should think in terms of a portfolio of compensation tools. Companies use compensation to achieve different goals, and no single form of pay does it all. Reducing high employee turnover rates, for instance, might call for the granting of time-vesting shares. Driving an already successful company to try harder could mean installing relative performance measures among other existing incentives. "I think we will eventually see a common compensation package that uses a number of vehicles, including a long-term retention component, a long-term value-creation component that will include performance shares, and a short-term performance element through the bonus," says Savage.
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