Human Capital & Careers

Pay Daze

Linking pay to performance is harder than it looks.
Don DurfeeDecember 1, 2006

Throughout the 1990s, stock options were widely seen as a panacea
for all compensation woes — they linked executive behavior with shareholder
value and offered a “cost-free” way to compensate employees for
taking risks on start-ups. In retrospect, of course, options bear a more
striking resemblance to fool’s gold — a jackpot for the executives who collect
them, but a bust for investors, who learned too late that share price
more often reflected market forces than managerial genius.

Not to mention the temptation to greed posed by such massive amounts of easy money. The signature frauds of the early 21st century owed much to option payouts, as do the more recently uncovered backdating scandals.

In recent years, companies have let the
stock option play a much smaller role in their overall pay plans. Nearly every public
company issued options five years ago, according to The Corporate
Library, an independent research firm that analyzes corporate-governance trends. Today, it says, only two-thirds do.
And while the commitment to stock options is greatest among
America’s largest firms, even the corporate giants have scaled
back sharply.

One such company is Agilent Technologies. Three years ago,
the Santa Clara, California-based measurement-products company
announced an executive incentive plan split evenly in value
between “performance shares” and stock options. The performance
shares provide full-value stock based on how the company
stacks up relative to its peers. Previously the plan had consisted
of options alone.

“We did a study and found that half of Agilent’s share-price
movement is driven by economic and industry factors and half
by company performance,” says Dominique Grau, vice president
of compensation and benefits. In a rising market, the performance
shares strip out much of the increase caused by overall
market results. When share prices fall, the company still can
reward executives if Agilent outperforms its peers. “This is a
much better way of compensating our executives,” says Grau. After completing the first three-year performance cycle next year, the company plans to rethink the balance between options and performance shares, possibly increasing the performance-based portion.

Agilent’s experience illustrates where compensation trends are heading. Companies are relying more on performance-linked equity, in combination with other forms of pay. But the question of which performance measures are best stirs heated debate, and confusion abounds about designing the right overall system. The accounting issues can be nettlesome, and executives often disagree on just how much pay should be performance-related in the first place.

“In the past, companies just defaulted to options,” says Steve Van Putten, who runs Watson Wyatt Worldwide’s executive-compensation practice on the East Coast. “It’s become more complex.”

A Split over Restricted Stock

The flight from stock options has been hastened by two practical considerations. The popping of the tech bubble rendered many options worthless, forcing companies to seek other ways to entice executives to stick around. Then came the Financial Accounting Standards Board’s FAS 123R, which required the expensing of options, removing the cost advantage that options once held for companies.

As they shopped for alternatives, directors first settled on
time-vesting restricted stock. That pay form had lost much of its
popularity in the era of stock-option mania. But the full-value
shares remained attractive as executive compensation because,
while the price may fall, the stock retains some value. To some
companies, restricted stock also seemed a more shareholder-friendly
choice, partly because it creates less dilution than
options. Since one restricted share has more value than one
stock option, companies need to issue fewer shares under a
restricted-stock regimen.

But investor advocates don’t like restricted stock either. Some
call it “pay for stay,” since employees need only avoid getting fired
to earn their stock. “Somehow companies got the impression
that the corporate-governance lobby had encouraged restricted
stock,” notes Paul Hodgson, senior research associate with The
Corporate Library. “It said nothing of the kind.”

The use of restricted stock has continued to rise, nonetheless, often in combination with performance-based compensation. As the first article in this series explained (see “Pay Dirt“), the Securities and Exchange Commission’s new rules on disclosure offer fewer places for boards to hide the terms of compensation awards from shareholder scrutiny. “Now that the disclosure rules have been confirmed, we’re seeing compensation committees finally asking themselves, ‘How are we measuring performance? And how well are we linking that with all of the rewards we’re paying out?’” says Myrna Hellerman, senior vice president with Sibson Consulting, a human-capital advisory firm.

Performance-linked pay comes in all sizes, shapes, and flavors. The Boeing Co. links cash payouts to beating a three-year target for economic profit. Sara Lee Corp. passes out stock options to managers if a predetermined stock price is hit. General Electric Co. grants stock when the company meets a combination of goals, such as cash-flow or relative shareholder return targets.

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.

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.

Setting Up Hurdles
Examples of performance plans.
Company Compensation Type* Performance Period Performance Conditions
General Electric Performance shares 5 years Half of award vests if average cash-flow growth from operations is 10%, half if TSR matches TSR for the S&P 500.
Agilent Technologies Performance shares 3 years Shares vest based on TSR relative to a peer group. At the 25th percentile, the “threshold” award is paid. At the 50th percentile, the target amount is paid; and at the 75th, 200% of target.
Boeing Performance units 3 years Units pay out if the company hits an absolute (but undisclosed) level of economic profit.
Sara Lee Performance shares 3 years Shares vest if diluted EPS growth relative to a peer group meets an undisclosed target.
Fairchild Semiconductor Performance shares Undisclosed Shares vest based on an absolute (but undisclosed) earnings before interest and taxes target.
*Performance shares are paid as full-value shares, performance units are paid in cash, and performance options are stock options with performance-contingent features.
Source: Company proxy statements

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

Companies that consider linking equity awards to performance should prepare to dig in for deeper computations of the compensation’s fair value.

For ordinary options, fair-value calculations are straightforward, with values plugged in from either the Black-Scholes options-pricing model or a lattice model to produce the result. But when vesting is contingent on a relative market condition — how much the growth of company total shareholder return exceeds TSR for a group of peers, for example — the computation of fair value must include the probability that options won’t vest. And for that, the standard models usually won’t do.

The reason is that both the Black-Scholes and lattice models reflect a small number of variables, including current stock price, option strike price, and share volatility. But when vesting contains a time element, and such factors as a peer group’s average stock-price volatility compared with the company’s volatility, a more flexible approach is needed.

Typically, that calls for a Monte Carlo simulation, allowing analysts to build models with many variables. A computer creates a forecast by generating random values for the variables and then running the model thousands of times to create a probability distribution. The most difficult part is the modeling. “It’s time-consuming to build the model from scratch,” says Stacy Powell of actuarial consulting firm CCA Strategies, “but once you have it, it’s not much more difficult than using the lattice method.”

Companies have more leeway basing compensation awards on internal company goals. Instead of prescribing a certain method, FAS 123R says that companies must show they are using their best estimate of the likelihood of a payout. For an earnings-per-share-linked goal, that might mean using the firm’s own forecasting methodology. For nonfinancial goals, it might be little more than an educated guess. “What’s important is that you disclose any assumptions that went into the probabilities you’re using,” says Powell. — D.D.