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WORKSPAN
FEATURE |

Pay For All Seasons

A Pay-for-Performance Makeover

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It would be nice if compensation committees could write a compensation discussion and analysis (CD&A) like the Magna Carta: a touchstone for all time. But when it comes to pay design, the right philosophy, principles and practices don’t last that long. The economy slides, industry changes, new leadership comes in, corporate cultures transform, a turnaround requires retrenchment … in short, the same philosophy and approach to compensation doesn’t work for all seasons.

That's why compensation committees should assess whether they have designed pay plans with the right pay-for-performance balance on an annual basis. As circumstances change, so do the incentives that best motivate and reward performance.

Every year, the compensation committee is faced with options:

  • Should pay plans be more or less aggressive? Risk-based? Certain?
  • What degree of performance-oriented pay motivates executives to create the most value through the inevitable cycles of business?
  • Every company wants the best cumulative performance possible, but how do commit- tees motivate executives to arrive at that best endpoint?

On one end of the spectrum, compensation committees can spur executive performance with highly leveraged payouts. The aim might be to establish a pay program that galvanizes the leadership team to tackle specific but challenging initiatives. In that situation, executives often are paid in highly leveraged, performance-based vehicles, have a lot of pay at risk and receive higher payouts for delivering big, outsized returns.

At the other end of the spectrum, the committee can spur executives with less leveraged vehicles. The aim still is to motivate top performance, but also deliver payouts that act more to confirm results than to drive specific behaviors. In these situations, executives often are either building new foundations for growth that don’t immediately translate to higher stock prices, or in circumstances where long-term goal-setting isn’t feasible.

Over time, many boards move from one end of the spectrum to the other because connecting pay with performance varies depending on the business context fit, leadership style and company culture. Committees must ask themselves:

  • Is it a time of galloping growth, steady building, harvesting or rebuilding?
  • What is the company’s position in the industry cycle? Economic cycle?
  • What are the industry dynamics?
  • How is “winning” defined?
  • Should we primarily reward individual executives or executive teams?
  • Can appropriate goals be set to link to pay?
  • In a down cycle, can pay be set in a way that deserving executives get payouts at least some of the time?
  • Can incentives be designed that are viewed by the leadership team as challenging yet rewarding?

In the eyes of shareholders, paying for performance by default means aligning executive payouts with share-price results (preferably compared to peer groups) measured as relative total shareholder return (TSR). All incentive plans should have this outcome as an ultimate objective. However, getting maximum relative TSR over time may require some detours and retuning along the way.

So, the question is, “How can the compensation committee tune the pay program to get the maximum cumulative performance, whether in a springtime of growth or an autumn of foundation building?”

FINDING THE RIGHT BALANCE

In some periods, pay structures need to offer executives the jet fuel of highly leveraged incentives to stimulate their efforts to shoot for the stars. In other periods, they need to offer the powerful diesel fuel for the heavier, less glamorous lifting to assemble new platforms for longer-term growth.

Consider the case of a drug maker on a long run of out-performing its peer group in relative TSR, thanks to heady top- and bottom-line results from blockbuster drugs. But in looking ahead, the board felt the payouts — based solely on relative TSR — had lost their incentive power. Instead, they had become simple rewards for past perfor-mance. In the board’s mind, pay design was not spurring executives to earnestly position the company for a future in which profits required ramping up new drug approvals and limiting revenue losses from drugs going off-patent.

The compensation committee decided it had to shift away from a long-term incentive program (LTIP) that overempha-sized relative TSR performance. It modified the program to pay executives in performance stock units (PSUs) based on both relative TSR and three-year operating income growth goals. This retuning resulted in a refocused atten-tion on the right behaviors — enough to highlight the need for raising operating income through new drug approvals and by nursing continuing revenue from drugs losing patent-protected exclusivity.

That is, instead of waiting for the relative TSR results to come in at the end of a three-year period, the compensation committee could orient executives toward achieving a more actionable goal: a goal that challenged and moti-vated executives to chase the performance that mattered most to the sustainability of the company.

In today’s fast-changing industries, the factors that govern long-term performance go through a constant evolution. This means companies can’t sit on their Magna Carta too long before examining each component that contributes to long-term pay for performance — performance extending to two, three, four or more years. Compensation committees must set aside time to re-evaluate the pay plan without deadline pressures to ensure they continue finding the right balance between the two ends of the spectrum.

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Table 1 shows the factors committees might consider. The left side of the table are characteristics of pay-for-performance design that committees and shareholders normally think about by default, including aggressive performance goals with highly leveraged payouts for outsized results. The right side of the table shows characteristics that, at one time or another, may become relevant as the business, industry and economic seasons change. Where should a committee position the pay plan in each season?

In periods of steady business or high growth, the left column works well. During other times, a company may need to adopt elements from the right-side column to reward executives in a way that affirms they are accomplishing strategic results that will produce the next leg up in growth.

For example, in company turnaround situations, the board can’t expect executives to wait for hefty payouts when outsized relative TSR performance isn’t possible. When the company is mired in share-price doldrums, low payouts could too easily signal that the company is ignoring management’s significant platform building. That leaves the company vulnerable to having headhunters poach top talent. Low payouts also could inadvertently lead the executive team to lose faith in a pay program, sapping their motivation. The reality is, the company still needs to pay for performance, but how the board thinks about that relationship is different.

That’s when the compensation committee may need to shift to more metrics for hitting both milestone financial and strategic goals and use different pay vehicles to stabilize payouts. The payouts may not be off the charts, but they will at least feel fair to executives. At such times, the committee also might want to leave more room for board discretion. To ensure executives stay around for a certain length of time, those executives need to feel they are getting more “pay for certain” and probably less “pay at risk.” As one board member told us at a turnaround, “We don’t want to starve people while they’re waiting for Thanksgiving dinner.”

To be sure, companies should be prepared to ask executives to hang tough during short-term hits to payouts — that’s only in keeping with a pay-for-performance philosophy. Discretion to make executives “whole” during ephemeral hiccups would fly in the face of shareholder interests. Nevertheless, as directors look out several years, if the pay plan’s annual physical shows short-term hiccups will turn into long-term intestinal problems, the compensation committee should prepare to rework pay-for-performance elements to send the right motivational signals.

Even for companies not in turnaround, pay plans can still go stale in their effect. That’s when the board should eliminate pieces that distract executives from doing what matters. In one mid-sized aerospace and defense company, even as top management repeatedly delivered solid operational performance, incentive payouts, which were tied to relative TSR and operational metrics like margin, lagged industry benchmarks. At first, the divergence between perfor-mance and pay was mystifying. But the compensation committee, in a correlation analysis, determined that the financial metrics linked to pay didn’t connect strongly to share-price growth over multi-year periods. This analysis was supported in comments received from top shareholders.

The upshot? The compensation committee rebalanced the metrics — and refueled the incentive-pay machine. One big change was to remove a margin-improvement metric that had become ineffective because executives had largely maxed out improvements by delivering premium margins. In its place, directors — who wanted to see free cash flow invested into growth initiatives — put a cash flow metric in the LTIP, which better aligned with the goals expected by industry analysts. The aim was to retain metrics linked to strategy, but revitalize efforts to find the right ones, under the new circumstances, to best drive share growth and properly reward executives for strong performance.

TRACK RESULTS AND ACT

If your company is like most, the compensation committee will produce the best long-term motivation through regular pay-plan retuning, explicitly deciding where the company should fall between the two columns in Table 1. You can then track results to see if the compensation committee’s decisions have the desired effect.

One way to track is to conduct a realizable pay analy-sis. Are executives earning payouts proportionate to their achievement of target relative TSR and other key financial metrics? Do the outcomes make sense in relation to payouts of peers delivering equivalent performance? Do the outcomes make sense relative to budget (i.e., does pay vary when financial outcomes change)? Also consider charting performance versus key financial metrics and TSR over three-year periods. Compare that to peers and analyst expectations.

When executive performance is subpar, payouts should be subpar as well. But if payouts are grinding down for too long, a company should ensure that the pay plan still encourages executives to deliver on strategic achievements that will pay off in the future. If not, it’s time to make changes — and be sure the changes allow the company to hang on to top-notch people in the winter of discontent. Track results by checking to see if attrition is lower since the pay-design change. Is realized pay more stable? Is the current value of each pay component similar to time of grant? Do executives appreciate the stability or are they disappointed with wealth creation?

After a slack performance period, if executives can’t execute on their new strategic plans — even with the incentives the compensation committee considers fair — a reckoning may be in order. Changing the pay plan may not be the right tool for spurring change, and the company may be faced with the need for a shakeup of management itself. In the meantime, be sure the balance of pay-for-performance characteristics is right for the season. If you take the time to give the plan its annual physical, you will not need to do surgery later.


Derek Fleck Bio Image

Derek Fleck is a consultant with Semler Brossy Consulting Group LLC. He can be reached at dfleck@semlerbrossy.com. Connect with him on LinkedIn.


Blair Jones Bio Image

Blair Jones is managing director with Semler Brossy Consulting GroupLLC. She can be reached at bjones@semlerbrossy.com. Connect with her on LinkedIn.