Table of Contents
Part One - FAIR PAY
Chapter 1 - SAME PROBLEMS, DIFFERENT CONTEXT
A Case in Point
The Role of Compensation
Old and Persistent Problems
What Exactly Are the Problems?
Fair Pay and Alignment
Searching for Alignment
Analytic Tools Needed
Fair Play and Alignment
About This Book
Chapter 2 - SHAREHOLDER VALUE
Shareholders Are Owners
The Merits of TSR
Financial Performance Drives Value
Shareholder or Stakeholder Value?
TSR Over Time
TSR by Industry Sector
Chapter 3 - THE ANATOMY OF PERFORMANCE-ADJUSTED COMPENSATION (PAC)
Calculating Performance-Adjusted Compensation
PAC Pay Mix
Coming Full Circle
Chapter 4 - THE PERFORMANCE AND PAY ALIGNMENT ZONE
Alignment: The Stated Objective
The Devil Is in the Details
Alignment Questions and Answers
Chapter 5 - THE ALIGNMENT REPORT
We Don’t Need Perfection
Using the Alignment Model
Reading the Alignment Report
Chapter 6 - FROM MALIGNED TO ALIGNED
Good Comp, Bad Comp
Hitting the Reset Button
Restructuring the Company
A Story Told
Chapter 7 - PATTERNS OF MISALIGNMENT
More Than One NOzone
An Alignment Picture Can Lead to More Questions
Good Processes Set You Up for Fair Play
Part Two - FAIR PLAY
Chapter 8 - THE ROOT CAUSES OF MISALIGNMENT
Moving from Hindsight to Foresight
Five Design Forces and Two Decision-Making Amplifiers
A Culture of Misalignment
Something Else to Consider
Macro to Micro
Chapter 9 - AGGRESSIVE TARGET PAY
On Being Average
The Case for 50th-Percentile Pay Positioning
Above Target Pay for Average Performance
Aggressive Target Pay: What to Do About It
Chapter 10 - TURBO-CHARGED UPSIDE
Turbo -Charged Upside
Alignment Issues with Turbo-Charged Leverage
Turbo-Charged Upside: What to Do About It?
Chapter 11 - CONVENTIONAL GOAL-SETTING
Goal-Setting Is Frustrating
Not Much Guidance
Deconstructing the Compensation System
The Goal-Setting Inherent in Equity
The Effect of Conventional Versus Unconventional Goal-Setting on Alignment
Absolute Up-Front Versus Relative After-the-Fact Goal-Setting Benchmarks
No Perfect System
A Range of Possibilities
The Alignment Report and Goal-Setting
Finally, Better Guidance
Conventional Goal-Setting: What to Do About It
Chapter 12 - SHORT TERM GAIN; LONG TERM PAIN
Adversity Is a Teacher
Short Termism in Executive Pay
Deconstructing the Compensation System, Again
Grant Frequency and Performance Cycles
Time Horizon and the Alignment Report
Short Term Gain; Long Term Pain: What to Do About It
Chapter 13 - FLATTENING THE CURVE
Don’t Assume Alignment
Flattening the Curve: What to Do About It
Chapter 14 - AD HOC DECISIONS
Planned, Bounded Discretion Is Not an Ad Hoc Decision
Discretionary Decisions Outside of the Pay Plans
Changing the Pay Plans with Economic Conditions
Ad Hoc Decisions: What to Do About It
Chapter 15 - DECISION-MAKING INFLUENCES
Asymmetric Performance Attribution Bias
Peer Comparison Bias
Asymmetric Information Bias
Individual Personality Biases and Group Dynamics
Decision-Making Influences: What to Do About It
Chapter 16 - CREATING AND MAINTAINING ALIGNMENT
What I Know Now
For the Greater Good
APPENDIX B - GICS SECTORS
APPENDIX C - LIST OF INTERVIEWEES
“I like the way that Ferracone tells real-world stories on executive compensation, as recounted by board members and executives on the front lines, and she backs up these narratives with well-researched statistics. Her way of looking at performance-adjusted pay is highly innovative and offers insights that we had previously not seen.”
—Roy J. Bostock, non-executive chairman of the board, Yahoo! Inc.
“This book is the best authoritative source on executive compensation today. It takes an extremely complex topic and boils it down to its simplest terms: alignment between pay and performance. Ferracone’s Alignment Model gives us a way to test and analyze alignment in our companies. In a word—it is superb! The Alignment Model is a tool that boards, executives, and investors alike can use. This book is required reading for every compensation committee member, CEO, head of HR, and institutional investor in America.”
—Alexander L. Cappello, chairman and CEO, Cappello Capital Corp.
“Ferracone provides a set of principles combined with actual accounts of how companies can achieve pay-for-performance alignment on a sustainable basis. Making this happen is critical to building trust and a high-performance culture.”
—Richard Floersch, chief HR officer, McDonald’s
“Ferracone does an excellent job of describing how executive performance and pay should be aligned. She combines quantitative research with qualitative commentary from those who are on the front lines in determining executive compensation. This combination makes the book eminently readable and a very useful guide.”
—Ed Lawler, author,Rewarding Excellence
“By constructing a highly fact-based and thoughtful road map, Ferracone has taken the emotion and fear out of executive compensation decision making. Following the recommendations and analyses contained in this book will enable struggling boards and compensation committees to execute better, and well-performing boards to flourish.”
—Anne C. Ruddy, CCP, president, WorldatWork
Copyright © 2010 by Robin A. Ferracone. All rights reserved.
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The subject of CEO and senior-level compensation is all too often a hot -button issue. It meets with outrage, jealously, condemnation, and, occasionally, admiration. More recently, it is meeting with government scrutiny in the aftermath of the worst financial crisis since the Great Depression. For companies in the United States that received federal bailout money, the government is overseeing, at the time of my writing this book, the pay practices of these firms through an appointed “pay czar.” The role of the pay czar is to ensure that the institutions that are supported by taxpayer money are not unduly passing these dollars along to executives through excessive pay and also to ensure that the pay system is not causing these executives to take undue business risks. After all, taking on risks that, in retrospect, were not well-understood, or worse, that people were not paid to care about, is to some extent what got us into this financial mess in the first place.
But while executive pay is receiving intense scrutiny, our fixation on the subject is still not offering us a way to think differently and gain new insight about it. Nor does it give us the ability to separate truth from myth. To be sure, we’ve gotten a bit smarter about how to design and govern executive pay. The external pressures have forced some reform. But at its basic level, we still are not only nipping around the edges of real and lasting solutions but also still defining the problems.
As I see it, executives should be paid on the basis of how well they perform for their shareholders, relative to the external market, within contemporary standards of fairness and propriety. This is what I call “fair pay.” This compensation objective meets with general agreement and seems relatively simple, at least in concept. But when we drill down just one level, the controversy begins. This is where we get into debates about the definition of performance and pay, and what we mean by the standards of propriety, which have their roots in both a free market economy and societal norms. The devil is truly in the details.
So this is why I decided to write this book. In my view, investors; boards and their compensation committees; executives with line, human resources, financial, and legal responsibilities; government officials; and the public in general do not need another “how-to” book on best practices or on the technical aspects of compensation. Rather, they need new perspectives, not conventional wisdom; they need facts, not fiction; and they need to gain an understanding of the real issues, not the imagined ones. They also need practical, not theoretical, ways to analyze and solve problems. They need processes to avoid the common pitfalls. And finally, they need ways to bring people together on ideas and direction, rather than to further fractionalize an already divided corpus. In other words, we all need to see some convergence on this topic.
I set out to write a book that would meet these needs. To develop new thinking, including my own, I reflected on the various roles I’ve personally played over the years as a line executive of a large-scale, publicly traded, global organization; as a board member and compensation committee chair; as a strategy and executive compensation consultant; and as an investor. These roles have helped me to look at the issues from all vantage points. In addition, I reflected on the thousands of consulting engagements I have conducted and the hundreds of clients I have served.
I worked with my colleagues at Farient Advisors LLC, a premier executive compensation and performance advisory firm, to analyze extensive performance and pay data over a fifteen-year time frame. The Farient team and I also collaborated with Steve O’ Byrne, managing director of Shareholder Value Advisors LLC, a firm that works in the performance and incentive arenas. We worked with Steve to create a top-flight database and analytic capability around the alignment of executive performance and pay. Finally, Joel Kurtzman, my collaborator on this effort, my partners from Farient Advisors, and I conducted nearly two dozen interviews with board and compensation committee members, executives, shareholder advisory leaders, lawyers, and well-respected academicians to ascertain their views on all aspects of executive pay, as broad ranging as the societal norms around executive pay, the motivational value of pay, and pay as a way to align outcomes for shareholders with those for executives—a concept that we call “alignment.” From this work, we developed a proprietary fact-base on what constitutes reasonable compensation—“fair pay,” and grounded perspectives on how to achieve it—“fair play.”
The core of this book centers on the objective for executive compensation about which I spoke earlier—executives should be paid on the basis of how well they perform for their shareholders, relative to the external market, within contemporary standards of fairness and propriety. Rather than putting forth theoretical “h ow-to’s,” I have developed methodologies and guidance on how boards, compensation committees, and executives can think through and achieve reasonable executive compensation that is appropriately aligned with performance. These same methodologies can be used by investors to evaluate executive compensation from their vantage point as well.
The issues that I have attempted to resolve include
• What is fair pay?
• How much is enough?
• How much is too much? How much is too little?
• What is good performance?
• How much is good performance worth?
• How can we maintain a fair relationship between performance and pay, particularly when the market for executive talent is tight?
It is my hope that this new, collective wisdom on performance and pay alignment will help all of us
• Converge on common standards of fairness and propriety
• Act out of conviction, rather than out of fear
• Mitigate the need for government intervention
• Rely more on inspiration and talent development, rather than on compensation, to attract, motivate, and retain executives
• Develop a more efficient and disciplined market for executive talent
To sum it all up, I am hoping that “fair pay” and “fair play” will help us truly create and maintain alignment between executive and shareholder interests that embodies the highest levels of rationality and integrity.
SAME PROBLEMS, DIFFERENT CONTEXT
A Case in Point
When I walked into the boardroom, I saw four compensation committee members staring at me, eager to hear my presentation on how to retain the CEO of this publicly traded, high-flying company. The CEO had enjoyed meteoric performance, but he was threatening to quit if he didn’t receive a generous helping of restricted stock1 as part of his new employment agreement.
Weeks earlier, I had been called by the chairman of the compensation committee to provide advice to the committee regarding this matter. And while the members of the committee said they wanted my opinion concerning what they should do, my hunch was that they really wanted me to bless the CEO’s requested grant.
Like most board and compensation committees, this one wanted to be supportive. It would be easier to say “yes” than “no.” Further, the compensation committee thought that the CEO was doing a splendid job. The stock price had risen more than 50% since the CEO had taken charge three years prior. They figured that the company would be at considerable risk if they lost their “rock star” leader. After all, there was no successor in sight. On the other hand, the committee realized that what the CEO wanted was “over the top, ” and that they could be subject to undue criticism if they approved the requested package, particularly without an outside, objective opinion.
My report was not a surprise. I had telegraphed my preliminary findings well in advance of the meeting. My analysis showed that the requested grant would put the CEO ’s compensation well above the market, even considering the company’s high performance. As a result, I recommended a more modest grant, contingent on performance. I delivered my report to the compensation committee in the executive session, with the CEO absent from the meeting. The compensation committee heard my report and asked a few questions, and then the committee chairman excused me from the room.
A few days later, I called the chairman to see what had happened. He said, “The compensation committee was extremely pleased with your work, but decided to give the CEO what he wanted.” In fact, the board had penned a lucrative new employment agreement, complete with generous severance, change-in-control, tax gross-ups, and other bells and whistles. Of course, the news media had a heyday when the agreement was disclosed, and shortly thereafter, one member of the compensation committee even resigned from the board, although I suspect that it wasn’t only about CEO pay.
Fast forward to a year later, when the demand bubble for the company’s services burst and the financial performance collapsed. The CEO was asked to resign in return for the large severance deal that had been provided by his employment agreement. As the consultant who had given the compensation committee advice to pare back the sought-after restricted stock grant and apply performance hurdles, I felt vindicated that my advice had been sound, but not satisfied that it had been dismissed.
Is this a story out of today’s news? It sounds like it is, but it’s not. It actually took place a decade ago. But in a fundamental way it doesn’t really matter. Getting the pay-for-performance equation right is a long -running issue that remains an issue today. But why should we care? Does pay for performance really matter? Do incentives really motivate good performance?
The Role of Compensation
Among academics there is a great deal of debate regarding the motivational power of incentives. Some, such as Dan Ariely, James B. Duke Professor of Behavioral Economics, Duke University, think incentives are not good motivators. “In experiments, we’ve seen that in some cases, people’s performance actually was lower the larger the bonus they got,” Ariely said. As a result, stock bonuses, stock grants, and other incentives are “probably better for creating loyalty than performance,” he said. Among other academics, some agree with Ariely; some disagree.
My own view from working on matters of compensation over the years is that good people, and top executives in general, are intrinsically motivated, but incentives provide a powerful messaging and focusing device. In addition, the market for executive labor is generally willing to pay more for an executive who produces great performance versus one who does not. For these reasons, incentives matter.
As for the question “Why should we care?” investors have said that they care. In a study conducted by the Center on Executive Compensation in 2008, twenty of the top twenty-five institutional U.S. equity investors were interviewed regarding their views on executive compensation. Investors resoundingly reported that the most important issue of concern was the alignment between executive performance and pay. Correspondingly, their second most important concern was having a compensation committee that they could trust and rely on to represent their interests. For this reason, we should care.
Nearly every board in America states that its philosophy for executive compensation is to align pay with performance (or words to this effect). This is not without reason. Not only is paying more for better performance intuitively appealing, it also has motivational value to executives and seems fair to investors. And although I have not proven causality, companies whose pay is more sensitive to performance also have better performance (as I’ ll discuss later in this book). Further, corporate leaders are not living up to their pact with investors and employees if they don’t put real meaning behind the mantra “our objective is to align our executive pay with performance.”
Finally, pay for performance has become a biting social issue. The populist view is that executive compensation is the root of all evil. In fact, some blame the largest financial collapse since the Great Depression on egregious executive pay. While I have not met anyone sophisticated in business and finance who agrees with this view, the fact of the matter is that it has built up a head of steam and is implicitly shaping public policy. According to a study conducted by Farient Advisors, the executive compensation and performance advisory firm I founded, the vast majority of board directors and executives feel as though greater government intervention will not only not solve the pay-for-performance issue, but could make matters worse.
Except for requiring clearer disclosure, there are almost always unintended and negative consequences to government intervention in matters of executive pay, the most famous of which was the decision made to cap the deductibility of non-performance-based pay at $1 million for certain executives in public companies. As a result of this governmental decision made in 1993, early in the first Clinton Administration, CEOs began receiving less in the way of cash, but more in the way of stock options2 and restricted stock. Ultimately, rather than pushing down CEO compensation, the result of this action was to raise CEO pay levels.
But if we come back to our question, “Should we care about linking pay to performance?” the answer is a resounding “yes.” Short of inviting the government to do our work for us, it is incumbent upon boards, their advisors, and management to crack this code. Charles M. Elson, director at the John L. Weinberg Center for Corporate Governance at the University of Delaware, sums it up nicely: “Government will only make it worse. If you didn’t like what they did in 1993, then you ’re really not going to like what they’ re doing now.” It is something that we all need to get right.
Old and Persistent Problems
For nearly thirty years I have worked on solving vexing issues around performance and pay. I certainly am not the first or only one to tackle these issues. Many have gone before me and acknowledged the difficulty. As far back as the 1980s, Robert A. G. Monks, founder of Institutional Shareholder Services, Inc. and cofounder of The Corporate Library, was practically inventing the shareholder rights movement when he took on Sears, Roebuck for the way it generously compensated its top team, made poor investments, and developed an ill -fated strategy. From Monks’s point of view, the compensation system is far too arcane. In fact, he calls it “complex, difficult, remote, and virtually inaccessible to anyone without a lot of experience.”
At about the same time, Graef “Bud” S. Crystal left the world of compensation consulting to become the b ête noire of American CEOs by widely publishing articles with extended tables showing how CEOs compared to each other with regard to pay and performance. Crystal’s analysis led to a great deal of finger pointing. What he did was to tally CEO salaries, bonuses, stock options, restricted stock, and other types of compensation. He then compared what CEOs received relative to the performance of their companies and created tables comparing who got what, when, and what for. Crystal’s 1992 book In Search of Excess: The Overcompensation of American Executives became a best-seller and for many people a reason for outrage, since so much of the information Crystal uncovered was hidden in proxy statements that were difficult to decipher. Crystal is still at it and publishes a weekly newsletter not surprisingly called The Crystal Report, but let’s pick up where Crystal’s book left off.
What Exactly Are the Problems?
What exactly are the problems? Is it that executive compensation is simply too high? Or are there executive pay outliers that attract undue attention and create a media feeding frenzy? Is the problem that there are too many instances when executive pay is high but performance is low (including cases in which executives take lucrative stock option gains off the table right before the bottom falls out of company performance)? The short answer is “all of the above,” although my view is that the most significant issues are outliers, which I am defining as companies paying at the 95th percentile or higher, and high pay coupled with low performance.
Median executive compensation is not really the issue. On the surface, performance-adjusted CEO pay (to be defined later in this book) increased threefold since 1995. This seems like a lot. But if we take into account (1) inflation (as measured by the Consumer Price Index) and (2) the increase in median company size (larger size begets higher CEO pay) over this same time period, then real size- and performance-adjusted CEO pay has increased approximately 1.6 times the 1995 level. This implies a compound annual increase in real performance -adjusted CEO pay of 3.6%. Because Gross Domestic Product rose by 2.6%, productivity gains account for all but $400,000 of the total compensation increase. As a result, I conclude that the absolute level of executive compensation is not the issue on which to focus. The real issues are about outliers and performance and pay alignment. Investors agree with me. About 75% of the investors surveyed by the Center On Executive Compensation in 2008 said that they had no real concerns about the levels of executive compensation in the United States.
How Investors View Pay
According to Patrick S. McGurn, vice president and special counsel to RiskMetrics Group, Inc.
“There are some investors and obviously other interested parties for whom the numbers are very important, and I think there are some people who simply would like to see pay go down. However, I can’t remember having too many conversations with our clients with that as the ultimate goal. The conversation is generally not about how much you pay them but how you pay them. How much you pay them does come into play, particularly when boards do an absolutely terrible job of calibrating those pay programs and get these huge outsized payouts that I think, even from a board perspective, were never intended when they designed the programs. They simply didn’t take adequate care in either setting maximums or multiples or whatever it is they’re going to use to stop those payouts from going into uncharted waters.”
Let’s consider outliers. They shock the senses. They’re the stuff that headlines are made of, and for good reason. As shown in Exhibit 1.1 (page 20), there are always a few outliers—companies that generate performance-adjusted compensation that looks “off the charts,” regardless of how high performance might be. For CEOs, these outliers can range anywhere from 15 to over 250 times median performance-adjusted pay in any given three-year rolling period.
Moreover, outliers are powerful contributors to public perception. As you can see from the chart, the outlier issue is not new. It’s been going on at least as far back as the database will take us. Outliers often are the result of runaway pay programs that weren’t intended to pay out that way in the first place.
For example, take Cisco Systems, Inc. in the mid-1990s. The company was on a roll, generating an annualized average total annual shareholder return of 96% in the last half of the decade. I’m sure that the compensation committee thought it was doing the right thing when it bestowed upon John Chambers, chairman and CEO, five to six million stock options per year during this period, along with a modest annual salary of $300,000 and an average bonus of $400,000 per year. However, this equity-laden package resulted in three-year average Performance-Adjusted Compensation of approximately $300,000,000—that’s right, $300 million.3 Other employees’ compensation rose too because of stock options. As one Silicon Valley observer said, “What I saw was entitlement. It was worse with options than with an annual bonus because people started living on their options. They could do this because options vested monthly. These people would say to the CEO, ‘You have to give options now. The price is only going to go up. ’ They were living it up. ”
Today, Cisco has moderated its CEO pay package to be more in line with the market. Total cash compensation (both salary and bonus) is targeted to be below the 50th percentile of peer companies, including a continued modest salary level of $375,000, combined with a target bonus of $2.5 million, such that a greater percentage of Chambers’s total cash compensation is directly tied to Cisco’s operating performance. Long-term incentives are targeted at the 75th percentile of Cisco’s peers, and equity grant sizes are considerably more modest than those of ten years ago. In addition, the company has shifted away from relying solely on stock options as a long-term incentive vehicle, to a combination of stock options, performance -based restricted stock units, and time-based restricted stock.
Why Pay Level Is in the Spotlight
According to Jay W. Lorsch, Louis E. Kirstein Professor of Human Relations, Harvard School of Business, and chairman, Harvard Business School Global Corporate Governance Initiative
“The people who are complaining in many respects are the people who have a political or some kind of moral reason for being upset, and I’m even talking about the shareholders. Why did the people at the AFL-CIO get so upset? They’re not getting upset because the investment is in some way damaging their return. They’re getting upset because the union guys don’t like it. Or the media get upset because it sells newspapers.”
According to Stephen W. Sanger, retired chairman and CEO, General Mills, Inc., and director of Wells Fargo & Company, Target Corporation, and Pfizer, Inc.
“I would say with the general public and the politicians that you could make a case that executive pay level is the main issue—’Nobody needs to be paid that much’ kind of mentality. I don’t think the big shareholders look at it that way. The big shareholders want to talk about other things.”
Fair Pay and Alignment
Now, let’s consider the issue of high pay despite low performance. This question is one of misalignment, that is, the extent to which pay is high when performance is low, or vice versa. In mining our database, we found plenty of examples in which executive pay was too high for the level of performance delivered. In fact, approximately one-third of the “cases” (to be defined later in the book) in our database fell outside of what we consider to be an acceptable range for the relationship between performance and pay.
In my work with boards, I have developed a simple definition of fair pay, which I am also calling alignment. Fair pay, or aligned pay, is when total compensation, after performance has been factored in, is
• Sensitive to company performance over time
• Reasonable relative to the relevant market for executive talent and for the performance delivered
In my explanation of fair pay, or alignment, I’ve deliberately kept it simple. I’ve excluded caveats, footnotes, measurement information, and definitions. But while my definition may be succinct, I believe it is powerful because it makes an important philosophical point: executives ought to earn compensation on the basis of the performance they generate over time relative to others in the marketplace.
I believe my definition of fair, aligned pay is simple enough that an outside observer would be able to discern when a CEO’s pay is fair and when it is not. As such, it is the kind of definition that can be written on the back of an envelope or committed to memory, and by being kept in mind, can keep boards and executives from getting unwanted calls from the press.
For most of us, the concept of alignment is intuitively appealing. As shown schematically in Exhibit 1.2 (page 21), executive compensation is aligned with performance when company performance and executive pay both are high or low over a sustained period of time. Conversely, executive compensation is not aligned with company performance when executive pay is high and performance is low or executive pay is low when performance is high over time.
Searching for Alignment
Why do companies pay high when performance is low? There are a number of reasons, but the one that tends to crop up the most is when compensation committees want to retain and sustain executives through difficult economic times, in other words, when poor performance is a result of a tough environment and not because of poor leadership. It is in times like these when beefed-up pay packages are particularly painful to investors, as well as to employees who are not doing as well. It is in times like these when the social agenda of wealth redistribution builds a new head of steam. It is also in times like these when boards are jittery and in the mood for buying some “insurance” to retain their top talent.
Jill S. Kanin-Lovers, former senior vice president of human resources at Avon Products, Inc. and director of Bearing Point, Heidrick & Struggles, First Advantage Corporation, and Dot Foods, shared her perspectives with me about what tends to happen in the marketplace in general. “When performance is poor, everybody involved with certain companies—their boards, executives, employees, and shareholders—are in an uproar. Some of the executives in these companies get paid numbers that are lightning rods. I don’t believe they were based on any kind of analysis.”
In most of these instances, compensation committees and management think that they are doing right by shareholders. After all, retaining good executives when the going gets tough is ultimately good for shareholders, isn’t it? But this not only is shaky logic, it also undermines the pay-for-performance objective that is clearly stated in most proxy reports. Further, one wonders why in the first place certain elements of the pay package weren’t designed to tide executives over for a rainy day. And one also wonders whether executives are coming to work for more than just the money. Finally, what is the psychology driving this fear of losing a good leader? Are the executives instigating this fear? Or are the compensation committees just an overly cautious bunch?
The evidence is that the retention issue is generally overblown, particularly for the CEO. “I think the retention issue is grossly overstated in most companies, ” says Robert A. Eckert, chairman and CEO of Mattel, Inc. and chairman of the compensation committee of McDonald’s Corporation, “because people aren’t really leaving. If somebody says, ‘Well, we have to do this for retention, ’ I say, let’s look at the retention track record. How many of your top fifty people have left in the last three years? If nobody has left in the last three years, why do you think they’ re all going to leave now? So I think the retention argument is a weak one and is frequently abused.”
Now, don’t get me wrong, most compensation committees aren’t deliberately paying high when performance is low. When this happens, the transgressions are usually much more subtle, and may not show up right away. They come in the form of such things as a handsome dollop of low -priced stock options in lieu of no bonus payout. These low-priced options will hardly even show up in the target pay numbers when assessing competitive pay. But most assuredly, these options will show up in performance-adjusted pay once the company’s fortunes turn around, and likely will show up as excessive pay at that time.
It’s important to point out that upward discretion isn’t the only game in town during tough times. Compensation committees use downward discretion as well. Kanin-Lovers witnessed acts of restraint following the 2008 financial debacle. “Several of the companies that I was on the board of in 2008 didn ’t feel the impact of the economic downturn until later in the year. They were sort of humming along, and then the economic downturn hit. So when we looked at their annual numbers, they didn’t look as terrible as we thought they would. But then, we had to consider how to pay these people, because coming into 2009, we knew these companies could potentially crash further. So we had this situation where we were supposed to pay bonuses in early 2009 for 2008 performance, but we had to use downward discretion because the downward momentum in 2009 was so awful that it would look like we were drunk and disorderly if we paid large bonuses at that point in time. ”
As you can see from these examples, the list of the types of “system overrides” that are used is long.
Analytic Tools Needed
In making these types of decisions, most compensation committees and management lack the proper analytic tools needed to understand the subtle shifts in alignment that are taking place. For that reason, when I started Farient Advisors, I built it around three important elements: people who have a deep understanding of executive talent strategies, corporate performance, and executive pay; a set of proprietary analytical tools designed to assess pay and performance, as well as other things such as risk; and our ability to provide objective, fact-based advice. The analytics that we developed and will be described in this book are quantitative in nature. They are based on an evaluation of executive pay and performance in the S&P 1500 companies over rolling three-year periods since 1995. From nearly 50,000 data points, or “cases,” we have been able to determine the relationships between executive pay and company size, industry sector, and performance. Most of the data in this book are shown for the CEO, although we also analyzed data for the top five named executive officers (NEOs). I feel comfortable using the CEO data to make my case because it is an easy way to illustrate the issues:
• CEO pay is generally the highest among the executives, so it carries the most exposure for companies while also giving us the most demanding test for alignment.
• The data show that companies generally pay other executives in a way that is consistent with the CEO. In other words, if the CEO is paid relatively high, then there’s a good chance that other NEOs will be paid relatively high as well. So showing the CEO data is indicative of how other members of the executive team are paid.
Farient’s Alignment Model was constructed for the entire S&P 1500, covering all industry sectors. We also can model industry groups (which make up a sector), subgroups, select peers, and even individual companies. It represents the first time that compensation committees, executives, shareholders, and the media have access to a tool that can objectively assess whether their company is paying fairly over time. In addition, the alignment model represents the first time executives and compensation committees are able to determine whether certain programs, or actions that they intend to take, will create more or less alignment, making it both forward and backward looking. As a result, all constituencies evaluating executive pay will be able to determine, on an objective, analytically grounded basis, whether pay actions and design are within an appropriate range for the performance delivered (or to be delivered).
Fair Play and Alignment
If I’ m making all of this sound formulaic and shrink -wrapped, this isn’t the intent. The intent is to provide more meaningful benchmarks and guidance than what has been offered to date. To be sure, resolving thorny issues will still consume time and require judgment. But my hope is that stronger guidance from our Alignment Model, coupled with insights from years of experience, my own as well as that of the people we interviewed, will help strengthen and streamline the decision-making process surrounding pay. This process is where fair play comes in.
To make use of the Alignment Model, companies don’t just need fair pay, they also need fair play. What do I mean by fair play? In its most basic terms, I mean having an overall pay philosophy, analytic methodologies, and decision-making processes in place to test and ensure alignment. In other words, boards and management need to ask and be able to answer the following questions:
• How much compensation is enough for our executives for the performance delivered? How much is too much?
• How have our pay system and actions affected the relationship between executive performance and pay in the past? How will our pay systems and actions affect this relationship in the future?
• What program designs or actions might cause poor alignment between performance and pay?
• How can we design an Alignment Model that is right for our company (fair pay)?
• What decision-making processes best support this model (fair play)?
• How should performance outcomes be measured and translated into pay decisions?
Suffice it to say, without fair play, you are unlikely to have fair pay. Companies need comprehensive fair play methods that consistently result in fair pay outcomes, for the good of investors and executives alike.
About This Book