Risk & Compliance

Pay for Performance Comes of Age

2014 is proving to be a banner year in the long evolution of the pay-for-performance movement.
David McCannAugust 8, 2014
Pay for Performance Comes of Age

It’s not exactly news that the trend in executive compensation for the past several years has been toward pay-for-performance models. At the same time, the depth of that trend may have been overblown.

In fact, it’s 2014 that is proving to be the year when pay for performance is settling in once and for all as an overriding theme in executive pay, according to Dave Hofrichter, executive compensation partner with Aon Hewitt.

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“People have been talking about pay for performance for ages. It’s always a top-of-mind question,” says Hofrichter. “But there has not been as much done with it as there has been discussion of it. What we’re seeing this year is a reaction to increasing, heavy pressure from activist shareholders and shareholder advisory firms. They’re saying, ‘If you’re paying at the 75th percentile within a peer group or industry, you ought to be around that neighborhood of performance.’ ”

More compensation committees are asking for that kind of analysis for year-end reviews of compensation vs. performance on goals. More audit committees are focusing on executive pay as part of their risk-assessment function. And from a more outwardly visible standpoint, companies are going to greater lengths than ever to make the case for their pay plans in their annual proxy statements.

The required Compensation Discussion and Analysis (CD&A) section of proxies “is moving from a compliance document, checking off all the boxes for the information you have to provide, to a real sales document that tries to provide a full context for the executive-compensation program,” says Hofrichter. (The Securities & Exchange Commission has been pushing companies harder and harder to provide greater explanation and analysis of their executive compensation in the CD&A for several years, but the follow-through from companies has remained spotty.)

In a recent Aon Hewitt survey of 294 directors and 294 executives (one of each from each participating company), both groups singled out pay competitiveness as their top compensation-related issue (see chart at the end of this article). For directors, next came pay for performance. For executives, incentive payout opportunities and performance goal setting were the second- and third-greatest concerns.

“Executives feel their boards are asking them to do more for the same compensation or less,” Hofrichter says.

That may sound like it contradicts the overall premise that pay for performance is hot, but it really doesn’t. Performance-based criteria can compose a greater portion of an executive’s pay even if the actual amount of pay declines.

Among what Aon Hewitt called “Level 2” executives (those like the CFO, chief operating officer and divisional presidents who report to the CEO), 14% said either that they expect long-term incentive (LTI) values to decline in 2014 or don’t expect any grants this year. The majority, 63%, anticipate LTI value to stay about the same as last year.

Instead of only awarding stock options and restricted stock units that, in many cases, vest upon the passage of time, companies are more often including performance shares in the executive-pay mix.

Performance shares vest upon the attainment of specific goals, like the company’s stock price reaching a certain level and holding there for a certain period of time, or hitting a certain target on cash flow or some other financial metric.

Many stock options and restricted stock also have performance-based elements, but in many other cases “you just have to keep breathing to get it,” Hofrichter notes. Simply calling an award a “performance share” further clarifies the message.

The bar is rising for short-term incentive (STI) plans as well. Among the 38% of respondents who said that their STI programs should be reviewed, almost half (49%) were not sure that minimum and maximum payout opportunities and performance levels were set at optimal levels.

Historically, short-term incentive payouts began to kick in upon the achievement of 85% of a performance target. Recently it’s been common for companies to push that threshold up to 90 or 95%, according to Hofrichter. “Think about the target going up every year,” he says. “It’s, ‘We expect you to grow the business 8%, and we’re also tightening the band under which you get an incentive payout.’ That’s a clear emphasis on pay for performance.”

It also de-emphasizes STIs. On average, CFOs and other executives are now getting 60 to 65% of their pay in the form of long-term incentives, notes Hofrichter. The point of view is that “you’re not going to get wealthy on the annual incentive plan,” he says. “You’re going to get wealthy on the long-term plan, because you’ve positioned this company for success again and again and again.”

Exec comp chart