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As the challenges facing executives grow, their compensation shrinks.
Jason Karaian, CFO Europe Magazine
April 2, 2009
Last month, Jan Hommen made a "moral appeal" to senior staff at his firm to pay back the bonuses they received a few weeks earlier, such was the public anger about payouts at ING, the Dutch bank that's been propped up by a government bailout. The tipping point, it turns out, was a 100,000-share award—worth up to €1.3m—to incoming CFO, Patrick Flynn. It was difficult for Hommen, ING's supervisory board chairman, to justify this and previous payouts amid widespread scorn.
There is no doubt that executive pay at banks will change dramatically, given the state aid they have received and the blame for the financial crisis heaped upon them. That said, "there is bound to be a certain amount of seepage into the broader executive scene," says Calvin Jackson, a senior consultant at Watson Wyatt. Though the changes may not be as radical, non-financial companies will still find it difficult to justify previous pay practices.
Take Volvo. In February, the Swedish truckmaker said that according to recent benchmarks, its executives were underpaid in relation to competitors. In response, the company wanted to raise the ceiling for performance-based pay as a share of salary and boost the amount of shares in its long-term incentive plan. In the wake of a large fourth-quarter loss and more than 16,000 layoffs, the backlash was swift, with Sweden's prime minister, Fredrik Reinfeldt, calling the actions "offensive." Within a week, the company was forced to rescind the proposal.
Not the only company experiencing losses and layoffs, Volvo serves as a useful example for firms struggling to retain, motivate and reward executives in a hostile environment. "When I read the newspapers, it seems that executive pay is responsible for the entire financial crisis," says Xavier Baeten, manager of the Executive Remuneration Research Centre at the Vlerick Leuven Gent Management School in Belgium. Opinions vary widely on what the ideal executive pay package should include, with greater consensus about what should not be allowed. (See "Seven deadly sins" at the end of this article.)
For its part, the European Commission urged member states in late March to address "excessive" executive remuneration. All members should mandate disclosure of pay policies and individual directors' pay, the commission asserted, adding that only two-thirds do today. Executives should have "no involvement whatsoever" in setting pay, severance should be restricted to two years' worth of salary and benchmarks should take account of pay variations both inside and outside a company. As always, however, the follow-through on these proposals will lie with each member state.
To date, Germany has gone further than most. A draft bill expected to be passed by this summer requires listed companies to have, among other things, executive packages with long-term incentives of at least four years and charges the entire supervisory board—not just a sub-committee—with responsibility for setting pay policies. Executive compensation must also be "adequate" and "customary" in relation to individual, corporate and industry performance. Given the bill's vague language and uncertain enforceability, it is "more or less a threat," notes Kerstin Schmidt, a partner at Lovells in Dusseldorf. The "vivid" expression of anger by the general public is more likely to drive change to pay policies, she adds.
Whatever the starting point, experts predict a range of reactions as companies rewrite the traditional rules. "We are in completely uncharted territory," says Mary Robertson, an interim HR executive and director of Reward Matters, a consultancy. "A year ago, I was doing a lot of work on flexible benefits and elaborate incentive schemes," she says. Today, with cash scarce and bonuses taboo, she is "helping companies spend the money they have better." This often includes making incentive plans simpler.
For most firms, the simplest form of pay—base salary—is likely to be frozen for at least this year. However, the share of fixed pay in remuneration packages—around 30% at most large European firms—is likely to grow as variable pay shrinks. (See chart at the end of this article.) With previous performance targets now almost impossible to achieve, lower hurdles will be needed to ensure executives are realistically motivated. "Shareholders will be willing to accept lower targets for future rewards but the quid pro quo might be a smaller reward," says Rob Burdett, a principal at Hewitt New Bridge Street. Of course, in the current job market, many executives may be happy simply to remain employed. "A lot of executives would do their same jobs for 30% less," reckons Baeten of Vlerick.
The metrics for measuring performance-based pay are also likely to change, says Baeten. "You need, at maximum, five performance measures," he says, asserting that this won't affect the effectiveness of previous plans. "Going for simplicity can, in a way, make decisions more complex because CFOs will need to decide what performance measures really count for their companies," he adds.
What might these metrics include? Governance and compliance measures may find their way into incentives as companies aim to bolster risk management processes. And rather than ubiquitous EPS and TSR-based metrics, Peter Boreham, a director at Hay Group, expects "cash, cost control and customer" measures to rise in importance. This means that the trend towards uniformity in pay packages could reverse as company-specific measures gain prominence. "This is a time when the market has never been less relevant to remuneration committee decisions," adds Eric Duffelen, a principal at Towers Perrin.
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.