Pay Daze

Linking pay to performance is harder than it looks.

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.

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