Setting executive pay in the 'hard spot'
By Ira T. Kay

EXECUTIVE COMPENSATION Setting executive pay in the 'hard spof The big challenge: when financial performance is strong but the stock price has not yet responded to reward shareholders. What should the compensation committee do in this scenario? BY IRA T. KAY AND STEVEN VAN PUTTEN B EYOND THE SWEEPING MYTHOLOGY that now surrounds executive compensa- tion, the reality is that boards at the vast majority of U.S. companies appropri- ately reward CEOs who perform well and punish those who do not with comparatively lower compensation or termination. Our extensive research, conducted over two decades, shows that this performance-driven approach to executive pay has played a major role in the success of the U.S. corporate model, which has generated enormous wealth for shareholders, millions of jobs, and ex- ceptional economic growth. Despite empirical support for the effectiveness of the pay-for-performance model, some sharehold- ers and executive pay critics remain skeptical. They pose several arguments, but one of the most stri- dent, popular, and seemingly persuasive is that com- panies still pay too much for executive "failure." Two examples of "pay for failure" are commonly cited and used to undercut the efficacy of the model itself. The first involves the substantial severance and accelerated stock incentive value that some executives receive at termination, even when the company performed poorly. We agree that these incidents of "pay for failure" must be addressed very carefully by boards and management. Ira T. Kay, Ph.D. {at left), is global director of executive compensation consulting at Watson Wyatt Worldwide ( He has helped U.S. public, private, and international companies develop annual and long-term incentive plans to increase shareholder value Steven Van Putten is the east division leader of Watson Wyatt's execu- tive compensation consulting practice. He focuses primarily on advis- ing compensation committees and senior management on executive and director compensation matters. They are co-authors of Myths and Realities of Executive PayfCambridge University Press, 20Q7). 38 DIRECTORS & BOARDS In fact, many companies are now revisiting their severance plans, spurred on in part by the new SEC disclosure rules, and changes are already occurring. For example, some companies are reducing cash severance payments and eliminating change-in- control-related excise tax gross-ups. The second example of "pay for failure" cited by the critics focuses on large cash and stock payments made to active executives when the stock price per- formance is mediocre. This example, which might be called "pay for disappointment," usually unfolds in one of two scenarios. In the first, a company ex- periences both poor operating/financial perfor- mance and poor stock price performance. In the second, the company experiences strong operating/ financial performance, but that performance has not yet generated strong stock price performance. This second scenario is the "hard spot" in setting executive pay. Understanding the challenge To evaluate the efficacy ofthe pay-for-performance model and understand the challenges that compen- EXECUTIVE COMPENSATION sation committees face, we must make a clear distinction between pay opportu- nity and realizable pay. Pay opportunity is what the compensation committee actually controls and sets, namely tar- get annual bonus opportunities and the fair (economic) value of new long-term incentive awards, including stock op- tions, time-vested restricted stock, and performance shares. The compensation committee also approves the financial performance goals, typically after a re- view and discussion of management recommendations. In contrast to pay opportunity, realiz- able pay is the actual cash bonus paid, the in-the-money value of stock options, the real value of restricted stock, plus the payout of performance plans. Realizable pay is therefore ultimately determined by the actual financial performance of the company plus stock price apprecia- tion. The theory is that if both financial performance and stock price apprecia- tion are weak, realizable pay will be very low. If realizable pay is not very low, the compensation committee is probably setting pay opportunity too high. Contrarily — and critical to the model's success — if fmancial performance and stock appreciation are strong, realizable pay should be high. In our research, we fmd no correlation between pay op- portunity and company performance. Pay oppor- tunity is competitively set independent of recent performance. However, we find a strong, positive correlation between realizable pay and company performance (see sidebar, "Pay Opportunity vs. Realizable Pay"). Clarifying the situation The real challenge for the compensation commit- tee occurs when financial performance — typically captured in EPS growth, for example — is strong, but the stock price has not yet increased. What should the compensation committee do in this hard spot scenario? Understanding that the compensation commit- tee does not directly set realizable pay helps clarify this situation and disaggregates it into manageable pieces. It must be remembered that the compen- sation committee also does not know what EPS growth and stock price appreciation will be when it sets pay opportunity. With the distinction between pay opportunity and realizable pay clearly drawn, we can now an- swer the critical questions that arise in setting ex- Strong EPS, Weak TRS When a company experiences strong finan- cial performance that has not yet translated into a higher stock price, the compensation committee must design an executive com- pensation plan that will motivate and retain the executive and simultaneously address shareholder concerns. The committee can balance these multiple objectives by taking the following steps: 1. Target pay opportunity at the median to ensure that future realizable pay is aligned with both future operating and stock price performance. 2. Use a portfolio of stock incentives, with greater emphasis on performance-based shares. 3. Offer time-based restricted stock judi- ciously for retention of key employees with longer than normal cliff vesting of, for exam- ple, four or five years. 4. Set reasonably difficult performance goals based on an analysis of the goals adopted by the peer group and the expecta- tions of analysts and shareholders. 5. Encourage stock ownership to demon- strate thatthe executive and the board have alignment with the shareholders on both the upside and the downside. 6. Explicitly discuss in the proxy CDA the committee's strategy to balance the inter- ests of the executive and the shareholders over the short and long term. 7. Clearly define the difference between pay opportunity and realizable pay in the proxy CDA, discuss the realizable pay for perfor- mance alignment, and explain the difficulty of the performance goats. — tra T. Kay and Steven Van Putten ecutive compensation at any company, but particu- larly at companies where there may be a delay in translating earnings improvements into stock price appreciation. The critical questions are as follows: • How should pay opportunity be determined and at what pay level? • How difficult should it be to meet performance goals? • How should the realizable pay or performance leverage be set relative to financial metrics versus stock price performance? There are a number of reasons why companies may experience strong earnings growth but low shareholder returns. This scenario may play out when a company has performed well historically and the market builds high expectations into the stock price. As the company or the industry matures, however, these expectations be- come increasingly unrealistic and the stock price may decline even though earnings growth remains strong. In other cases, earnings growth and shareholder returns may diverge when an industry hits a period of volatility and share prices turn down. A com- The first Step is to reconsider targeting pay opportunity at the 75th percentile. FIRST QUARTER 2008 39 EXECUTIVE COMPENSATION The real risk in the hard spot is that there will be low or no payout. pany within the industry may see its share price decline even though it is performing well relative to its peers. The hard spot scenario may also occur when a company is moving out of a period of low performance. The company improves operations and drives up earnings, but this improvement is not immediately recognized in the stock price. S&P 1500 Pay Scrutinized Our research reveals that executives at companies with strong operating and financial results but weak stock price performance generally receive lower re- alizable pay than their counterparts at companies with higher financial results and better stock price perfor- mance. We looked at pay and performance relationships for 2004-2006 at the 1,067 S&P 1500 companies with the same incumbent CEOs. For each of these com- panies, we compared their - •«-•- three-year EPS growth per- formance with their three- year realizable long-term incentive value for their CEOs. Again, realizable long-term incentive (LTI) value includes in-the-money stock option value, period-end restricted stock value, and any period- end payouts attributable to long-term performance plans in place during 2004-2006. Our findings, shown in Exhibit 1, reveal that the median realizable value for CEOs at companies with high EPS performance but poor stock price performance was $1.7 million. In comparison, the realizable value for CEOs at companies with high EXHIBIT1 Realizable pay for CEOs aligns with shareholder returns, not earnings per share High EPS/High TRS High EPS/Low TRS 3-Year Cumulative TRS 81% 30% 3-Year Realizable Pay $5.1 $1.7 Survey of 1,067 companies EPS performance and high TSR performance was $5.1 million. Executives at companies with high operating results but poor shareholder returns are penalized relative to executives at companies with strong earnings and strong shareholder return per- formance. Balancing objectives When a company is caught in the hard spot scenar- io, the compensation committee's task is to balance multiple objectives. Because shareholder return metrics typically dominate the executive pay pack- age and most incentives are based on share price, the real risk in the hard spot is that there will be low or no payout. The compensation committee must balance its motivational and retention objectives for the executive with alignment and accountability objectives for shareholders. The best strategy is to adopt a prudent diversified portfolio approach with the goal of providing the CEO with median pay opportunity and some stock options. The first step is to reconsider targeting Pay Opportunity vs. Realizable Pay Although the new SEC proxy disclosure rules have cast a brighter light on execu- tive compensation arrangements, confusion remains about the difference between pay opportunity, which reflects compensation that potentially can be earned, and realizable pay, which reflects compensation actually earned. This confusion stems in part from the fact that there are three separate disclo- sures for stock-based awards: the summary compensation table, the plan-based awards table, and the realized equity table. The key is to look at realizable pay over a specific period compared with corporate per- formance overthe same period. Our research demonstrates that realizable pay closely EXHIBIT2 Realizable pay for CEOs aligns with financial performance^ High TRS Low TRS All Companies Number of companies 536 536 1,072 Cumulative TRS (2004-2006) 99% 17% 49% Cumulative realizable LTI value (MMS) $5.2 $1.7 $3.3 Cumulative realizable TDC (MM$1 $10.5 $6.0 $7.9 'All numbers and percentages are median except far number of companies. tracks three-year corporate performance. Watson Wyatt data on 1,073 companies in the S&P Super 1500 show that CEOs at com- panies with high total returns to shareholders earn 75 percentmore realizable total pay than CEOs at companies with low TRS (see Exhibit 2). Additional data from our research demon- strate that the pay opportunity boards offer to their CEOs is fully realized only at companies with superior TRS performance. — Ira T. Kay and Steven Van Putten 4.O DIRECTORS a BOARDS EXECUTIVE COMPENSATION pay opportunity at the 75th percentile. Instead, the compensation committee should target pay oppor- tunity at the median and use a halanced selection of long-term incentive plans set in the medium range to deliver medium-range realizable pay for median fmancial and stock price performance. This approach allows the compensation commit- tee to avoid a situation in which the company is underperforming in shareholder returns but pro- viding realizable pay that is above the median. The committee can reward earnings growth through a variety of vehicles, including, for example, perfor- mance shares that tie a portion of compensation to longer-term measures such as three-year growth in EPS. The compensation committee should keep some stock options in the package to reinforce alignment with shareholders, but in the hard spot it is prefer- able to use relatively fewer stock options and more performance shares based on earnings goals. Shares are still the underlying vehicle, but performance shares create more line-of-sight for management. The second step is to rigorously assess perfor- mance metrics. The committee should consider relative measures for performance and adopt met- rics that have the greatest likelihood for tracking stock price performance. The performance metrics selected should measure both short-term improve- ments and long-term value creation. For commit- tees working in the hard spot, the best course is to choose metrics that will have a high correlation with shareholder value creation over the long run. We have helped numerous companies set fmancial metrics that balance all of these interests. This ap- proach is also very useful when used in the new proxy disclosure format. The real challenge for compensation committees is to select appropriate long-term incentive oppor- tunities. Boards that target LTI opportunities above the median run the risk of misalignment in the pay- for-performance model. Our data demonstrate that companies that provide high LTI opportunities but then perform in the medium range for TRS end up with high realizable executive pay. The work of the hoard This result is not in keeping with pay for perfor- mance and is not shareholder-friendly. In contrast, companies that provide medium-range LTI op- portunities deliver medium-range realizable pay for medium-range performance and above-market realizable pay for above-market performance. Our new survey of board mem- bers and institutional inves- tors shows that both groups believe a high pay opportu- nity level is "shareholder un- friendly." The work of the board does not end with the cre- ation and implementation of an effective compensation plan. Particularly if the board is operating in the hard spot where earnings growth and shareholder returns are not running in tandem, the board should communicate the context for this diver- gence. In addition, it must clarify for all stakehold- ers the critical difference between pay opportunity and realizable pay. Understanding this difference is a prerec]uisite for any meaningful dialogue about executive compensation and its role in corporate performance, particularly when companies are sit- ting in the hard spot. • The authors can be contacted at ira.kav@watsonwvatt. com and The board must clarify for all stake- holders the critical difference between pay opportunity and realizable pay. FIRST QUARTER 2008 41

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