Pay Daze

Linking pay to performance is harder than it looks.

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.

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