More Taking Extreme Measures to Tie Pay to Performance

Companies, facing pressure from investors and proxy advisory firms to strengthen the connection between pay and performance, are increasingly taking sweeping measures to increase the at-risk portion of executive pay. But some critics caution that companies can go too far and that some measures are too short term-oriented or could provide incentives to game the numbers.

Intel announced this month in a letter to shareholders that it will be making numerous changes to its compensation structure for executives and its broader employee base, with more emphasis on pay-for-performance. For top executives, 90 percent of pay will be based on performance under the new compensation plan. The goal, Intel says, is to better align its executive compensation with stockholders' interests.

Among the biggest changes to compensation at the chipmaker is that performance-based equity awards for senior executive officers no longer have a “floor” value. If relative total shareholder return over a three-year period falls below threshold levels, the payout will be zero.

Intel additionally redesigned its annual cash bonus program for all employees, with greater emphasis on operational objectives. “These changes are designed to help drive positive business results by further increasing accountability and enhancing the link between individual pay and company performance,” Intel stated.

Intel is not alone in its efforts. Companies such as Air Products & Chemicals, Disney, IBM, Johnson & Johnson, OM Group, Quest Diagnostics, Smithfield Foods, and many more have also gone farther to tie their executive pay more tightly to performance and put a higher portion of executive pay at risk.

Executive compensation consultants say the new, more extreme measures to tie pay to performance are partly the result of increased dialogue between board members and large shareholders. “Companies are starting to recognize not only the need, but the value in having that direct dialogue with shareholders,” says Aaron Boyd, director of governance research at Equilar, a firm that tracks executive compensation trends.

Investor groups, such as the Council of Institutional investors, as well as proxy advisory firms like ISS have been beating the pay-for-performance drum for a long time.

Companies, some fearful of failing shareholder advisory votes on compensation plans, are listening. According to analysis conducted by executive compensation advisory firm Farient Advisors, 1,855 companies in the Russell 3000 have taken steps to align executive pay more closely with company performance, with some making more drastic changes than others.

Not all companies, however, have been so willing to hitch a good portion of executive pay to results. Farient identified a total of 293 companies across a wide spectrum of industries with “potentially systemic pay-for-performance alignment issues,” based on comparisons to industry and peer groups, according to its analysis. Some of these companies include Apple, Oracle, RadioShack, Abercrombie & Fitch, AK Steel, and many more. Many of them also failed say-on-pay votes.

Stock-Based Performance

While many compensation consultants support the move to executive pay plans that emphasize pay-for-performance, they say companies can go too far. Basing too much compensation on the stock price, for example, can be short-sighted, says Steven Hall, a founding partner and managing director of executive compensation consulting firm Steven Hall & Partners. “You run the risk of having people figure out how to make the stock price go up, and maybe it's in the short term and not necessarily the long term,” says Hall. “It's not rocket science; a lot of it is common sense, but sometimes companies just don't get it.”

“Unfortunately, what we're really getting now is not necessarily say-on-pay, but say-on-stock-price, or say on something else that investors didn't like that companies did.”

—Steven Hall,

Partner,

Steven Hall & Partners

Recognizing this risk, many large companies have begun to veer away from using stock as its sole performance incentive, or they are pushing out time horizons to make them longer-term focused. “There have been some subtle shifts in how these programs work to help to ensure that the executives feel some of the same risk as the investor and make sure there is not too much risk to cause imprudent actions to be taken,” says Steven Kline, a director with executive compensation firm Towers Watson.

Oracle, for example, rewards employees only if they are successful in achieving two primary business objectives: driving year-over-year growth in non-GAAP pre-tax profits and increasing Oracle's stock price. “In other words, our top performers potentially may earn significantly more compensation than their counterparts at similar companies, but only if we grow our profits substantially (not just remain profitable) and our stock price increases,” the company stated in its annual proxy statement.

Too Much Say-on-Pay?

The main impetus for companies making big changes to their compensation structures is the Dodd-Frank Act, which gave shareholders an advisory vote on executive compensation plans. “Say-on-pay really spurred a number of companies to have these discussions on a more regular basis, or to have them for the first time,” says Boyd.

Some executive pay experts express concern, however, that investors and proxy advisory firms may now have too much influence on compensation plans. What proxy advisory firms expect when it comes to pay-for performance, however, doesn't always align with what companies should be doing. For example, investors prefer to see relative total shareholder return (TSR) in long-term incentive programs. “As a result, relative TSR has soared in prevalence as a long-term incentive metric,” says Steven Van Putten, a managing director with Pearl Meyer & Partners.

Say-on-Pay Support Levels for 2013

The chart below shows shareholder support levels for the executive compensation plan from say-on-pay votes at 2,177 Russell 3,000 companies in 2013.

Source: Farient Advisors.

According to Van Putten, TSR is “not really an incentive metric; it's more of an accountability metric, because TSR really is an outcome of the company's execution of its decision strategy and how investors perceive that,” says Van Putten. “TSR is not something an executive can necessarily influence, or control, through their actions.”

A well-designed executive incentive program shouldn't necessarily be built on the basis of what other companies are doing, or what proxy advisory groups prefer, says Van Putten. Rather, it should “align with, and support, a company's business and leadership strategy,” he says.

“You want to make sure you have a balanced program that's well thought out,” advises Hall. That requires building a compensation plan in which performance metrics are linked to the business plan of the company, not just over a one-year period, but up to a five-year period.

Another problem is that say-on-pay votes don't always reflect shareholder views on compensation. According to compensation consultants, investors sometimes use the votes to express displeasure with other aspects of the company or with the performance of the stock price.

When say-on-pay was first put in place under Dodd-Frank, the idea was that shareholders would analyze companies' executive pay programs. “Unfortunately, what we're really getting now is not necessarily say-on-pay, but say-on-stock-price, or say on something else that investors didn't like that companies did,” says Hall.

In some cases, companies that passed say-on-pay votes last year with 90 percent or greater in their favor failed this year, even though those companies made no major changes in their compensation programs, says Hall. The only difference is that their stock price came down dramatically, he says.