Pay for performance: Rethink your metrics

 

Recent Towers Watson research confirms what many observers feared would be an outcome of say on pay and growing advisor influence: greater conformity in pay program design among U.S. public companies. In particular, U.S. companies continue to shift more of the long-term incentive mix toward grants with explicit performance conditions and increasingly use total shareholder return (TSR) as a performance measure.

These trends reflect an appropriate emphasis on “pay for performance” in designing executive compensation programs. But, with the growing focus on TSR, companies may run the risk of overpaying for past performance and market-based fluctuations in share price, rather than rewarding executives for sustainable company performance and differentiated value creation.

While market trends and proxy advisor views are important, it is critical for compensation committees to resist the urge to default to a single, simplistic measure of performance. Instead, they need to take a more holistic view to ensure that their pay programs do, in fact, drive future performance by focusing executives on the right strategic priorities. In addition to paying for performance, boards also need to remember to pay for strategy.

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Race to the middle

Companies' growing use of TSR as a performance metric represents a race to the middle in incentive plan design. Towers Watson's recent analysis of proxies filed by 270 S&P 1500 companies as of the end of March shows just how widespread the use of TSR has become in the say-on-pay era. While a small number of companies use TSR as either a circuit breaker (14%) or a modifier (17%) in their long-term performance plans, the vast majority (82%) use it to measure executive performance. What's more, over 60% of these companies use it as the only performance measure.

The advantages of TSR are its transparency, simplicity, and strong alignment with shareholders over time. And since proxy advisor Institutional Shareholder Services uses it as a key factor in assessing pay-for-performance alignment, it's probably a safe choice for companies seeking positive say-on-pay voting recommendations. However, TSR offers at best a weak “line of sight” in terms of motivating executives, and the outcome of TSR-focused incentives is often driven more by when TSR is measured than by TSR itself.

Given the imperfect correlation between TSR and corporate operating and financial performance, it's reasonable to question whether placing all of your eggs in the TSR basket is the best approach. This is not to say TSR isn't important. Clearly, it's very important to shareholders. But using TSR as the only incentive metric is likely to lead to unintended consequences in terms of executive motivation and may not ultimately reflect sustained, long-term value creation.

Paying for strategy

To drive business performance and lay the groundwork for long-term shareholder value creation, compensation committees should consider using a combination of measures from across the income statement (e.g., revenue growth, earnings per share growth), balance sheet (e.g., return on assets), and cash-flow statement (e.g., operating cash flow growth). Indeed, in other recent Towers Watson research, we found that top-performing companies are far more likely than other companies to use a range of performance measures, including strategic or qualitative measures, in their annual and long-term incentive plans. While TSR is often one of their metrics, they cast the net more broadly and often have three or four measures in each incentive plan.
The urge to resist conformity shouldn't stop with the selection of performance metrics. Top-performing companies also put more emphasis on long-term incentives in the total pay mix and make individual performance a more highly weighted component in bonus awards as compared to the overall market.

Ultimately, we found that companies that outperform their peers approach pay design differently. While not determinative, our research and consulting experience suggest that treating pay design as a competitive differentiator for business and talent can have an impact. Companies that design pay programs that not only reflect current trends but also their unique strategic priorities will truly pay for performance.  â– 

The authors can be contacted at doug.friske@towerswatson.com and todd.lippincott@towerswatson.com. 

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