With Comp Under Fire, Performance Pay Tightens

With Investors and the media blasting excessive executive compensation, boards are enforcing minimum performance thresholds far more rigorously in order to send a strong pay-for-performance message.

 

Performance thresholds are minimum levels of acceptable performance, below which an executive would not get paid a performance-based incentive.  The more an executive exceeds her target performance, the larger the award.  Conversely, the size of the award drops off dramatically if performance is below target, usually at an exponential rate.

 

“The significant change that we are seeing is that with all of the added focus on board actions, companies are acting to set more realistic performance measures, with bottom levels of acceptability – performance thresholds – and to stick by them,” says Paul Dorf, managing director of Compensation Resources.  “It’s not that the plans haven’t been in place, but that they are being more conscientiously adhered to.”

 

That’s due to a more vigilant governance culture spawned by intense media and investor scrutiny of executive pay.  The pressure should rise as salaries continue to skyrocket, with CEO compensation up 30% over the last year and nearly 50% over the last two years, according to The Corporate Library.

 

“I don’t think there’s any doubt that boards are inclined to live to the letter of the compensation plan,” says Jim Henderson, a director on the management development and compensation committee at International Paper.  “Certainly it isn’t automatic anymore that they would look beyond the minimum standards of performance and just follow what the CEOs recommend.”  Henderson also serves on the boards of SBC Communications, Ryerson Tull, and Nanophase Technologies.

 

Minimum performance thresholds are almost universal in both annual incentive plans and multi-year cash- or equity-based long-term incentive plans.  The thresholds in most cases are 70% or 80% of the performance target, which is usually a mixture of metrics such as cash flow or return on assets, depending on the industry.

 

In the past, boards often didn’t punish executives for not hitting their goals, rejiggering the pay after the fact so that executives didn’t feel shareholders’ pain.  Directors were driven by retention considerations and a desire to compensate executives for their efforts, as opposed to a true pay-for-performance ethic.

 

Take Coca-Cola:  In 2000 the board set high goals for CEO Douglas Daft to receive 1 million performance-based shares.  But in May 2002, the board not only lowered the pay-for-performance bar to reflect lower earnings growth targets, but increased his salary 18% to %1.5 million, his bonus by 16% to $3.5 million, and his options grant to 1 million from 650,000 shares.  The result, according to BusinessWeek, was that in a year when net operating revenues were essentially flat and shares fell 23%, he was the ninth-highest-paid CEO, with a total compensation package of $55 million.

 

“If the results were not achieved, a lot of pressure was put on the comp committee to provide something for the efforts of the executives, and to ensure they stayed,” says Dorf.  “The committee would capitulate and take one of three actions:  lower the target and make the award anyway, lower the target and provide a reduced award, or provide an alternative such as additional grant of options or restricted stock.”

 

The inherent conflict is that shareholders expect to pay for results while executives often expect to get paid for effort, notes Dan Ryterband, managing director of Frederic W. Cook & Co., a compensation consultancy.  “The most substantial effort is often exerted when times are toughest and performance has slipped,” he says.

 

Now boards are trying to anticipate unexpected circumstances and to specifically state what factors will be excluded from the performance measurement process such as changes in accounting principles and extraordinary and nonrecurring events.

 

“Boards are also attempting to build more flexibility into the performance measurement process to ensure that they can use more discretion in assessing the quality of the final result,” says Ryterband.

 

This is a departure from the way thresholds were once set.  “In many instances, the setting of the performance targets was somewhat loosey-goosey and not totally realistic, nor necessarily tied to a strategic plan,” says Dorf.  “In other words, in many instances they were driven from management, not top-down from the board.”

 

That is not to say that thresholds should be implemented in each and every situation.  “I think that any compensation committee would feel that if really there were extenuating circumstances, they would consider compensating executives for their efforts,” says Henderson.