Pay Daze

Linking pay to performance is harder than it looks.

The small proportion of at-risk pay is just one flaw Hodgson
sees in the way companies design their performance plans. In
some cases, he says, companies set hurdles low enough that
managers could easily hop over them. In other instances, executives
receive a portion of their award merely for reaching the
25th percentile of a peer group, as is the case with Agilent. Further,
he points to how slowly companies are changing their programs.
Of the 12 companies employing the highest-paid CEOs
in America, only 4 outperformed their peers in terms of shareholder
return. “It’s a stark judgment,” says Hodgson.

Hellerman of Sibson Consulting concedes that companies are
reluctant to tie all of an executive’s long-term pay to performance.
“Some compensation committees have a hard time letting go of
the idea that executives should be entitled to certain kinds of pay,”
she says. “But there are also circumstances where a company may
not have performed that well against peers, but there were specific
extraordinary reasons why that happened. It’s hard to be as
tough as the outside market says you should be.”

To be fair, some companies do put all of their chief executive’s long-term pay at risk. Half of GE chief Jeffrey Immelt’s equity pay, for example, depends on the company’s operating cash flow growing by at least 10 percent annually for five years. The other half will vest only if GE’s five-year TSR meets or exceeds the return for the S&P 500 index.

Many boards are also wary of getting too far ahead of their peers when it comes to compensation. If one company makes its compensation plan far more rigorous than others, the CEO might defect to a more lax competitor. But that possibility assumes an extremely limited supply of potential CEO candidates.

Hodgson says companies can easily avoid this risk. “If your board is functioning properly, you should have at least four or five candidates from within your senior officers to take a CEO position,” he says. He calls the idea that a Fortune 500 company should consider only the pricey top executives of like-sized firms “absolute nonsense.”

In any event, there is some evidence that such high-profile managers aren’t worth their price. A 2005 study by Ulrike Malmendier of the University of California at Berkeley and Geoffrey Tate of the University of Pennsylvania’s Wharton School found that “superstar CEOs” — highly paid executives who won awards from the business press — consistently underperformed the market after being recognized.

Not that the progress being made in the area of pay for performance is insignificant. While the pace may be too slow for some, it will continue, according to Hellerman. “We’re in transition,” she says. “Over the next couple of years you’re going to see organizations really start to take action on compensation. I suspect that those that have already implemented their new pay plans will have a lot of tweaking to do.”

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