Pay Daze

Linking pay to performance is harder than it looks.

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.

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