If there were a “Top 10” list for best management incentive plans ever, the Nucor plan created in 1966 for the senior officers of this steel company would certainly rank near the top. Over the next 30 years, CEO Ken Iverson and his Nucor team would create one of the legendary stories of American business. Everyone who wrote their story, including Iverson, singled out Nucor's incentive plan as a cornerstone of their success.
By today's standards, Nucor's old compensation program looks oddly primitive. It consisted of just three elements: a cash salary, an annual grant of stock options, and a bonus consisting of a fixed share of profit above a threshold return — what we would today call an economic profit or EVA-style plan. Each year, the threshold return would automatically ratchet up, based on the firm's growth and their prior achievement. Incentive awards were paid 40% in cash and 60% in stock.
That was it. No perks. No bulletproof, supplemental retirement plans. Nothing that wasn't available to the rest of Nucor's rank and file. The incentive plan at the heart of this program remained essentially unchanged for over three decades, which turned out to be an unexpected source of its power; the longer this plan remained intact, the more it reinforced management's value-creating behavior.
All of this background leads to the following question: If you were tempted to implement a similar compensation program today, why should you have to risk the wrath of ISS? (This is not meant to pick solely on ISS. Glass-Lewis, GMI and other compensation governance watchdogs have similar standards to those critiqued here. ISS is highlighted simply because they are the largest and most influential proxy adviser, and they are relatively transparent regarding their standards.)
Caps on performance
There are many reasons to be concerned about ISS's response. For example, Nucor's bonus plan had no caps. According to ISS, “Best practices suggest companies disclose bonus caps for CEOs that are tied to a fixed and/or disclosed value such as base salary.” But anyone who has worked in a regime with pay caps knows that a cap on pay can be tantamount to a cap on performance. They have seen colleagues climb over the cap and, finding themselves on a plateau of unrewarded performance, their exertions — and company performance — magically level off for the remainder of the performance period.
Nucor's strategy included diligently building its manufacturing capabilities during recessions in advance of an eventual recovery. When they once again found the winds at their backs, they would not stop, or even pause, when their bonuses hit “two-times target” or some other artificial barrier that didn't exist for them. The more they produced, the more everyone earned, and their shareholders were immensely grateful.
Proxy advisers like bonus caps because their standards are largely focused on controlling compensation costs, and capping bonuses is a ham-handed way of doing so. However, if one is concerned with motivation as well as cost — and proxy advisors at least purport to care about alignment — then the appropriate way of controlling compensation cost is to moderate the rate at which pay increases with performance, called pay leverage. Unfortunately, none of the proxy advisers distinguish, let alone track, pay leverage. As a result, problems with pay leverage are increasingly being “solved” by bonus caps, as has recently been done by Time Warner and Nabors Industries in reaction to criticism of their pay practices.
For the record, Nucor's pay leverage was modest; in their best years, their executives earned great bonuses, but not eye-popping amounts that would rattle their stockholders. That moderation contributed to the durability of their plan as much as the lack of caps contributed to its power.
And what does ISS mean by “Best practices suggest . . .” anyway? Who suggests these things, and how they are suggested? Well, we know one place this particular suggestion did not come from: empirical evidence that bonus caps actually benefit shareholders. In 2001, Hackett Benchmarking & Research performed a systematic review of human resource practices over the prior decade. Their most significant finding was that companies with uncapped bonuses significantly outperformed their industry peers. No study since has contradicted these findings.
Metric madness
The lack of empirical data relating proxy adviser standards to actual shareholder returns is a recurring theme. For instance, ISS considers “A single or common performance metric used for short- and long-term plans” to be a “problematic pay practice.” Their concern is that a focus on a single measure may induce gaming of the system by manipulating performance results, or by indulging in risky business behavior. Concern about gaming is warranted when money is at stake because an incentive to perform is indistinguishable from an incentive to cheat. But that is true whether you have one measure or a dozen. Just because some golfers find creative ways to subtract strokes from their score doesn't mean we should supplement “strokes” with other metrics, such as average length of drives, or number of shots out-of-bounds, etc., to determine how good a golfer is.
You only need one measure to determine how well a for-profit company is performing, i.e., some plausible measure of profit, such as net income, earnings, or EVA. Of course, the firm's owners want those profits to be real and sustainable, but multiple measures in a reward program do not guarantee that, and often distract managers from a focus on sustainable profits.
Furthermore, there is no empirical evidence that a single-measure incentive plan hurts shareholders, or that multiple measures (or “diversified measures,” as GMI calls them) within or across incentive plans help them. On the contrary, a comprehensive 2005 study of the effectiveness of various incentive plan practices published in the Journal of Applied Corporate Finance concluded that variable compensation based on a single measure of profitability was a statistically significant predictor of outperformance. Furthermore, this research made it into stock selection screens of at least two hedge funds that tracked the “single-measure” impact on their actual returns, i.e., their alpha, and found that they closely matched the predicted results of the research. In other words, the empirical benefits of single-measure (i.e., profit-focused) incentives has been demonstrated by both rigorous backtesting of actual shareholder returns and by abnormal returns in live portfolios.
Of course, Nucor's managers didn't have the benefit of this research; they did not need it. Common sense told them that whatever else they achieved, it mattered only to the extent that it ended up improving profitability over time. That's exactly what they paid for, and that's what their shareholders got. Their remedy for short-termism was built into their incentive plan design via a target-setting mechanism based upon actual, prior-year results. This unusual design feature got rid of the whole debate over “the rigor of targets” and insured that bonuses over time closely matched profit growth over time, yielding an almost perfect relationship of pay with performance that one could not possibly achieve via multiple measures.
‘Non-performance' pay
The only thing that Nucor's bonus plan left out was the possibility that the stock price would not closely track profit every single year. This made it possible in certain years for the company to pay bonuses when the stock price was depressed, or vice versa. To round out their incentive plan, Nucor provided an annual grant of service-based stock options. Service-based options, sometimes called time-based options, vest over time, but become valuable to the recipients only when the stock price goes up.
Unfortunately, service-based option grants would also run afoul of current proxy adviser standards. ISS disdainfully refers to such grants as “non-performance” pay. Stock options are all the more suspect these days since they provide a reward profile that may promote risky management behavior — the kind that became notorious in the financial crisis of 2008. Proxy advisers won't automatically recommend against “non-performance based” grants of stock options, but they clearly do not love them.
If you think about it, though, “non-performance based” is a peculiar distinction. There is no expectation that one hundred percent of anyone's compensation should be performance-based. No one criticizes salary as non-performance based, even if it makes up over half of an executive's target pay. So, for instance, if a company has been paying its CEO a $2 million cash salary, and decides instead to offer $1 million of that salary as stock options instead of cash, is the “non-performance” equity award a bad thing? On the contrary, if the equity has a vesting period — which is generally the case — we would expect that a substitution of options for cash would enhance retention and alignment at no additional cost to the company, all of which accrues to the benefit of the shareholders. In other words, condemning a portion of fixed pay as “non-performance” because it uses equity rather than cash as the instrument of pay is illogical.
Unsurprisingly, illogical standards will fail to produce empirical evidence of their benefits. Such is the case with “non-performance” equity grants. In fact, multiple studies confirm that the significance of management's exposure to their firm's stock price performance, including via service-based stock and options, appears to be strongly related to shareholder returns. These empirical results are so pronounced and persistent that if you were contemplating investing in a company, and could know only one thing regarding management's financial relationship with that company, you should want to know how many shares they own, regardless of the details of how they acquired them.
Obviously, the size of equity grants in any given year or over time greatly matters in terms of keeping compensation costs in check. But criticizing such grants because they are “non-performance based” is a different matter. When Steve Jobs became Apple's CEO, he got 20 million options, a private jet, and a salary of one dollar per year. One can question whether this overall package was too much, but it is not obvious how Apple's shareholders would have been better off with more salary or a bigger jet and less “non-performance” equity in the mix.
Overcoming bad standards
In the age of “say on pay,” proxy advisers have an incredibly difficult job. They must pass judgment on the compensation plans of thousands of companies in the roughly 60 days between the time data is publicly available and the time that investors must vote, including giving companies a reasonable time to respond to negative recommendations. In this context, it is understandable that firms like ISS will fall prey to criticism about incomplete data, or pressing that data into one-size-fits-all standards. This article makes neither criticism. I am suggesting, instead, that they have bad standards, i.e., standards that would reward perfect conformance based on perfect data with lower shareholder value.
Ironically, these bad standards arise from the practice of proxy advisers polling their investor clients regarding their “concerns.” Institutional investors are naturally interested in alignment of overall pay and performance, but most won't suggest specific standards; they don't consider it part of their jobs. Those investors most vocal in suggesting standards, such as union pension funds and religious charities, are far more interested in reducing executive compensation than in the impact these standards might have on retention, motivation, or other objectives of compensation governance. ISS blends this cacophony as best it can into a product they can sell, in accordance with its business model, which includes making their investor clients feel “heard.” This works well enough at their revenue level since they have a virtual monopoly in the proxy advisory business. But at the level of the standards themselves, with their overwhelming focus on compensation costs, the system is broken. Nearly everyone knows it because companies and their investors keep running up against the standards' logical inconsistencies. That's a shame because a great plan like Nucor's would now get snagged by a set of arbitrary standards that actually harm shareholders.
Directors must do the best they can for their shareholders given the constraints that they face. The easy thing to do is to surrender to the existing standards and let ISS, in essence, design your incentive plans. More than a few compensation advisers are egging them on in this direction because their interests are well-served both by the complexity of the plans that these new standards promote, by the level of involvement (i.e., billable hours) they require of advisers in establishing fresh measures and targets each year, and by the rigor these consultants bring to the task of helping directors wend through the thicket of proliferating standards. Even Nucor eventually changed their plan to conform to the prevailing trends. Their original plan is now a ghost from a more vigorous age of compensation as a potent source of competitive advantage.
What to do?
So what does a public company director do in today's age of compromised standards? You can take the easy way out, and check them all off. Your board seat will be safe, and your shareholders none the wiser. But if you care about value maximization, and believe that incentives matter, surrender is a grossly suboptimal solution for your shareholders.
Fortunately, you can still create simple, powerful incentives if you are willing to take a calculated risk in not making the proxy advisers entirely happy, but still OK, with your overall plan. In fact, with a nuanced implementation and more careful disclosure, you can come pretty close to a Nucor-style plan without getting slapped down by ISS.
On a final note, remember the incredible longevity of Nucor's plan? The longer it was in place, the more powerfully it reinforced profit-building behavior. Even though today it would be characterized as an “annual” or “short term” plan, Nucor's managers rightly viewed it as rewarding a long-term focus because they knew they would get a share of the profit growth whenever it materialized. Any plan built on internally inconsistent standards could not possibly last a decade, let alone three, because those standards are constantly being modified as their defects become obvious. ISS is not, after all, conspiring to permanently foist bad standards on the corporate world. Once their investor clients see their defects, their “concerns” shift, and ISS adapts.
Today, the term “incentive” has been corrupted to mean any variable compensation dollars flowing from shareholders to managers. The proper meaning of incentives is the promise of certain rewards to drive behavior. Superior incentives drive superior performance. At the end of your board tenure, all that your investors will remember is the value your company delivered to their portfolios, not the proxy ratings you earned along the way.
Are options dead?
Not yet . . . but sentiment is favoring a more balanced portfolio of compensation.
Ed. Note: On Oct. 25, 2013, the CHRO Board Academy convened several of the country's foremost experts on executive compensation to share their insights on long-term incentive programs and the use of stock options. The CHRO Board Academy — founded by Korn Ferry Vice Chairman Dennis Carey — is a select group of large-cap, U.S.-based chief human resources officers. The twice-yearly forum features intensely collaborative sessions designed to provide a free exchange of insights and intelligence among peers. The organization is co-chaired by three senior CHROs: Sandy Ogg of The Blackstone Group, Carole Watkins of Cardinal Health Inc., and Benito Cachinero-Sanchez of DuPont Co. The October panel included: Charles Tharp, co-CEO, Center on Executive Compensation and executive vice president of the HR Policy Association; John England, managing partner, Pay Governance LLC; Thomas Desmond, chair of the Corporate Practice Area and co-chair of the Executive Compensation Group of Vedder Price; and Daniel Ryterband, president of Frederic W. Cook & Co. Following are observations made at the roundtable on the future of stock options.
Daniel Ryterband
There are several key factors contributing to the declining use of options for long-term incentive programs:
• Cost efficiency: For the 250 largest U.S. publicly traded companies, the introduction of stock option expensing under FAS 123 was a large driver of the transition from a 99% prevalence of options in 2003 (before mandatory expensing) to 70% in 2013. Expensing led to a view that the cost of options is high versus the value employees perceive.
• Investor pressure: Some believe that the asymmetry of options (i.e., unlimited upside but downside capped at zero gain) might lead to excessive risk taking if options are underwater. Also, options aren't considered performance-based by the proxy advisory firms (ISS, Glass Lewis), who apply a penalty to compensation versus peers in a disproportionate manner when options are used.
• Opportunistic management: Given the perceived cost inefficiencies and the fact that share prices were sideways or declining for several years, many companies felt that options were delivering little value so they used it as an excuse to move from options to full-value rewards.
Nevertheless, options are not dead yet, for a variety of reasons:
• Cost inefficiencies have been mitigated due to a steady, multiyear trend of decreasing Black-Scholes ratios, which enables the granting of more option shares for a given level of targeted value.
• Many institutional investors remain strongly in favor of options as performance-based, despite what ISS and Glass Lewis think.
• There is risk convergence between options and other incentives as a result of numerous factors. First, most investors view time-based restricted shares negatively, which creates pressure to reduce the amount of pay delivered in this form. Performance shares are viewed more favorably, but pressure to measure results over a multiple-year performance period requires a precision that companies don't have when setting performance goals, and if they set the bar too low they'll run afoul of say on pay.
• Opportunistic management now goes the other way, with many reasons to favor options again.
John England
Options are not dead, but they've been kneecapped, and probably justly. In the past, executive compensation used to be all about “how much?” so it was heavily skewed to options. But things changed:
• Shareholder advisory firms rose to prominence. They came to the table with a fairly socialist or redistributive bent, backed by pension and university money. And they embraced research that says that if 70-80% of a stock's movement is based on market or industry movement, then options are an imperfect vehicle because outside forces have more influence than performance.
• “Lead steers” in two key industries set a pattern for corporate America. Financial services, impacted by the regulators' disdain for options, dialed way back. And major tech firms like Google, Amazon, LinkedIn and Yahoo don't grant options.
I rarely advise a company to abandon options altogether. But I do encourage a well-balanced portfolio of compensation, typically with a relative TSR performance plan, restricted stock and performance options.
Thomas Desmond
Options are not dead. In fact, if I were a compensation committee member, I would be in favor of options. They are easy to implement, easy to explain, and they work. In particular, they work well when things are going well . . . but:
• The problem is that when things are bad, like in the financial crisis, options become worthless as incentives. However, they still have to be expensed and you cannot get rid of them.
• As discussed, regulators do not like options due to the asymmetry problem: they fear that when options are underwater, they create an incentive for management to double down on risk. Dodd-Frank introduced the concept of risk review and excessive risk into compensation decisions.
• Mixed compensation portfolios are here to stay, and it is unlikely that options will swing back to be a majority. This creates a bigger challenge for committees. Whereas options are easy to administer and perfectly aligned, performance share awards are harder, with many moving parts and more elements on which someone can challenge the board's judgment (metrics, peers, etc.).
You do not need to allow the shareholder advisors to lead the parade. If committees make well-reasoned decisions, you get good outcomes. If you have good reasons and explanations to shareholders in your CD&A, you should pass say on pay, regardless of what the advisory firms do.
More views on optimal compensation design
A quick poll of the CHRO Board Academy member companies attending the October 2013 roundtable discussion revealed a disparity of viewpoints on the issue of options. Several companies have eliminated options for everyone, moving to restricted stock and performance shares. However, members believe there's a place for options going forward, depending on the mix and how deep in the organization they go. One member company actually increased options from 25% to 50% of the mix — and still received a “for” recommendation from the shareholder advisors. Other discussion pointers:
• Remember that options are about alignment, not just incentive. They ask a recipient to co-invest in value creation, investing their human capital alongside the company's financial capital to create value.
• Recruiting packages are sometimes still skewed toward options, since options provide more leverage and can be helpful in “make whole” situations.
• Companies making supplemental compensation disclosures (such as realizable pay) usually have tougher pay for performance stories to tell — they need to explain why their compensation system is appropriate. Option-heavy systems often run afoul of ISS and Glass Lewis analyses, thus they can require supplemental disclosures.
• One member's view on optimal compensation design: 1) reasonable salary; 2) robust bonus plan tied to short-term performance, but paid out over the long-term; and 3) options, to drive a vested interest in value creation.
• Bear in mind the context in which a compensation committee operates. Board members are effectively “renting” their reputations, thus they are under intense personal pressure with increased transparency. Many board directors start by saying, “We're going to do what's right for the company, despite ISS,” but then move to “How do I pass the vote and preserve my reputation?”