Pay Daze

Linking pay to performance is harder than it looks.

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.

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