Excessively fine-tuning the overall compensation plan, however, risks making executive pay too complicated to serve as a good motivator. For all their flaws, pay packages based on ordinary options are at least easy to understand. "You get some companies that have options, restricted stock, a performance plan with five metrics, all coupled with an annual bonus plan that has multiple metrics," says Watson Wyatt's Van Putten. Tell managers that everything is important, and there is no way for them to focus their efforts. "Complexity really can dilute the effectiveness of a plan," Van Putten says.

The Corporate Library's Paul Hodgson also believes in a simple approach. His solution: do away with all long-term incentives not linked to specific performance goals, preferably the objectives laid out in the company's long-range strategic plan. "If you're going to use equity over the long term, all of it should be performance-vesting — not just 25 percent or 50 percent," he says.

In fact, few companies take that approach. More typical is Fairchild Semiconductor's plan. In 2005, the company granted CEO Mark Thompson $4.4 million worth of stock options and restricted stock worth $715,950 on the date of the grant. The plan called for an additional target amount of performance shares, linked to a cash-flow goal, that roughly equaled the restricted stock grant. Notably, the performance shares weren't granted, because the company didn't meet the performance requirement. Had the shares paid out they would have constituted only about 13 percent of long-term incentive pay totaling, $5.8 million.

The small proportion of at-risk pay is just one flaw Hodgson sees in the way companies design their performance plans. In some cases, he says, companies set hurdles low enough that managers could easily hop over them. In other instances, executives receive a portion of their award merely for reaching the 25th percentile of a peer group, as is the case with Agilent. Further, he points to how slowly companies are changing their programs. Of the 12 companies employing the highest-paid CEOs in America, only 4 outperformed their peers in terms of shareholder return. "It's a stark judgment," says Hodgson.

Hellerman of Sibson Consulting concedes that companies are reluctant to tie all of an executive's long-term pay to performance. "Some compensation committees have a hard time letting go of the idea that executives should be entitled to certain kinds of pay," she says. "But there are also circumstances where a company may not have performed that well against peers, but there were specific extraordinary reasons why that happened. It's hard to be as tough as the outside market says you should be."

To be fair, some companies do put all of their chief executive's long-term pay at risk. Half of GE chief Jeffrey Immelt's equity pay, for example, depends on the company's operating cash flow growing by at least 10 percent annually for five years. The other half will vest only if GE's five-year TSR meets or exceeds the return for the S&P 500 index.

Many boards are also wary of getting too far ahead of their peers when it comes to compensation. If one company makes its compensation plan far more rigorous than others, the CEO might defect to a more lax competitor. But that possibility assumes an extremely limited supply of potential CEO candidates.

Hodgson says companies can easily avoid this risk. "If your board is functioning properly, you should have at least four or five candidates from within your senior officers to take a CEO position," he says. He calls the idea that a Fortune 500 company should consider only the pricey top executives of like-sized firms "absolute nonsense."

In any event, there is some evidence that such high-profile managers aren't worth their price. A 2005 study by Ulrike Malmendier of the University of California at Berkeley and Geoffrey Tate of the University of Pennsylvania's Wharton School found that "superstar CEOs" — highly paid executives who won awards from the business press — consistently underperformed the market after being recognized.

Not that the progress being made in the area of pay for performance is insignificant. While the pace may be too slow for some, it will continue, according to Hellerman. "We're in transition," she says. "Over the next couple of years you're going to see organizations really start to take action on compensation. I suspect that those that have already implemented their new pay plans will have a lot of tweaking to do."

Don Durfee is research editor of CFO.

Back to the Drawing Board
Tying stock awards to performance requires new calculations.

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