How to Fix Executive Pay: A Harvard Business Review Debate

In response to the all the attention on executive pay these days, and with corporate leaders attempting to outrun federal regulators in addressing concerns and issues about how executives are rewarded, Harvard Business Review has createda debate forum on how to fix executive pay.

Is it fair – or useful – to limit executive compensation?

Do limits hurt companies’ competitiveness?

Is CEO pay a moral issue?

What’s the best way to structure executive pay?

HBR has invited a group of experts to lead an online discussion of these and other questions. 

Recent posts include:

How to Help Directors Increase Oversight of Pay by Don Delves, the Delves Group (July 1)

To Fix CEO Pay, Focus on the Big Shareholders by John Mackey, Chairman & CEO of Whole Foods Market (June 30)

On Executive Pay, Simpler is Better by John T. Landry, Business Development Editor at Harvard Business Review (June 25)

How to Tie Equity Pay to Long-Term Performance by Lucian Bebchuk & Jesse Fried, Professors of Law at Harvard and U.C. Berkeley Law Schools, respectively (June 24)

Executive Pay, It's About "How", Not "How Much" by V. G. Narayanan, Professor of Business Administration at Harvard Business School (June 22)

And there's more...

Tune in for an interesting and informative debate on this critical topic from a diverse group of business leaders, academics, researchers and consultants.

 

 

 

The Perils of Allowing Popular Opinion & Conventional Wisdom to Drive Executive Pay

Last week's appointment of a Federal Compensation Czar represents one of a number of steps the federal government is taking to insert itself into executive compensation - initially at companies receiving federal bailout funds, but potentially much beyond.

One aspect of executive pay that is drawing particularly acute attention is its relationship to institutional risk.  As a result, we are seeing a lot of pressure and attention from government officials not only on the levels of executive pay but also on the steps taken - in pay design and structure - to mitigate risk.

Problem is, this is neither as simple or straightforward as it looks.  New research from Watson Wyatt brings us an appropriate cautionary note here, as it demonstrates how some compensation elements conventionally believed to aggravate risk may actually do the opposite ... and vice versa.

Watson Wyatt conducted an empirical analysis of the executive compensation architecture at more than 1,000 firms from the S&P 1500 from 2005 to 2007, examining each individual program element in view of the relationship between the executive's realizable pay and the Z-score (a measure available through S&P or Blooomberg which has been historically used to measure credit risk, and which has been shown to be predictive of bankruptcy).  The purpose of this exercise was to identify which executive compensation elements acted as "risk mitigators" (i.e., strengthened the relationship between pay and risk reduction, encouraging executives to manage risk more effectively) and which as "risk aggravators" (i.e., weakened the relationship between pay and risk reduction, potentially encouraging executives to take excessive risks).  For the most part, the study results contradict widely held beliefs, as the chart below illustrates:

 

Image Source:  Watson Wyatt

Note, by way of example, that one of the design changes which has been pushed by government representatives recently - increasing the proportion of fixed (salary) versus variable (incentive) pay in the overall mix - turns out to be the one least related to high credit risk. 

The upshot?  I don't know all the details and particulars of the Watson Wyatt research, and there may even be elements of its methodology that are open to challenge.  I do believe, however, that it brings home some very important points, not the least of which are:

• That executive compensation design is a complex process full of subtleties and unknowns, which demand rigorous study and deep understanding in order to grasp the consequences of different structural actions and restraints, and

• That, therefore, there is peril in letting popular opinion - much less political whim - drive mandates on the level and architecture of executive pay. There may also be peril in appointing otherwise intelligent and capable people without deep expertise in executive compensation (and who will, as a result, be forced to rely on their "common sense") to positions of broad oversight in this matter.

The Watson Wyatt study, and the article in yesterday's Wall Street Journal on this topic, also sound a note of caution with respect to the efforts at stamping out risk.  Economic recovery requires that companies, whether they have accepted bailout funds or not, produce returns on shareholder investments.  Too much emphasis on avoiding risk may eliminate the prudent risk taking that goes hand-in-hand with the kind of growth and innovation that will be necessary to turn these organizations - and the economy at large - around. 

More on this to come tomorrow, when the Obama administration releases its proposal for overhaul of financial system regulation.

And Now ... A Federal Compensation Czar

By now, many of you have heard that the Obama administration has appointed a Compensation Czar whose responsibility it will be to set salaries and bonuses for 175 top executives at seven of the nation's largest companies - companies who have received federal bailout funds.

The new official, Washington lawyer Kenneth Feinberg (recommended for the post by Connecticut Senator Chris Dodd) is best known for having served as Special Master of the Federal September 11th Victim Compensation Fund, a role in which he spent several years overseeing payouts totaling $7 billion to victims of the September 11 attacks.  In this capacity, he was responsible for investigating claims and ultimately putting a value on the lives of the victims in order to determine government benefits to be paid out.  An overwhelming challenge, at which - it appears by most accounts- Mr. Feinberg did an extraordinary job.  He captured his experiences in a 2005 book "What is Life Worth?".

While Mr. Feinberg appears to be an individual of exceptional capability, I see his selection for this new role as both interesting and revealing. 

The fact that administration officials and Senator Dodd chose a Washington attorney and gifted arbitrator/negotiator rather than a private sector business leader, corporate governance expert or even (gasp) someone seasoned in executive compensation design/administration says a lot about their perspectives on the structuring and administration of executive rewards.

At least that's what I think.  Your take?

More in the articles noted below...

New York Times:  Obama Names Overseer to Set Pay at Rescued Companies

Time.com: Kenneth Feinberg, Compensation Czar

Wall Street Journal:  White House Set to Appoint a Pay Czar

The Latest, Global Look at Rewards in the Downturn

The effects of the recession continue to impact pay, benefits and job prospects for employees around the globe, according to the findings of Hay Group's just released Reward in a downturn study.

Select overall findings include the following:

• Executive pay seems to be hit hardest but job restructuring with an aim to reduce staffing levels is highest for white collar employees.

• A range of HR programs are hitting the chopping block.

• Most short-term incentive plans are paying out at levels below target.

• Long-term variable pay value has dropped significantly.

And yet, most participating employers report that talent management remains a high priority for their organizations.

Compensation Cafe contributor Becky Regan provides her own detailed look at the findings of the Hay study: click over to read her post.

Image: Creative Commons Photo: "Blue Marble (Planet Earth)" by woodley wonderworks

Economy Impacting Executive Compensation Programs

Earlier this month, Watson Wyatt surveyed 145 large U.S. based organizations to determine the effect that the economy is having on their executive pay programs, a repeat of a similar study done last December in order to examine trends over recent months.  Survey results suggest that companies - at least the large ones represented here - are making some pretty dramatic changes to their programs.

Some key findings from the study:

Base Salaries

• 55% of respondents have frozen executive salaries (up from 21% in December).

• 20% have reduced, or are considering reducing, executive salaries (up from 8% in December).

Annual Incentives

• 38% are making changes to their annual incentive plan performance measures (up from 29% in December).

Long Term Incentives

• 30% are making changes to their long-term incentive plan performance measures (up from 21% in December).

• 36% have changed or plan to change the type of LTI vehicle used.  Of these, 43% are putting more emphasis on time-vested restricted stock and 32% are putting more emphasis on performance-based shares.

• 33% expect to reduce their LTI dollar grant values compared to the prior year (up from 23% in December).

• 42% expect to grant more shares compared to the prior year.

• Most companies are managing with the shares they already have; 59% do not plan to request additional shares earlier than expected.

• Only 1% have taken action on their underwater stock options, but 17% are considering action in the next 12 months.

The Issue of Excessive Risk

• Only 9% have made changes to their executive compensation program to address the issue of "excessive risk", with another 3% planning to do this in the next 12 months.

On the Possibility of Driving High Performing Talent From the Places We Need It Most

I'm not going to stand here (er, sit here) and tell you that there are no issues with the level and design of executive compensation or the way bonuses were paid at some Wall Street firms.  To use a well-turned phrase from a recent Hay Group missiveon the topic, "incentive plans that focus on the short term, that take no account of risk and that drown rational thought with life-changing sums of money" have certainly proven themselves to be no recipe for success.  But before we leap to paint all incentive pay with the same broad brush of condemnation and send the pendulum swinging too far in the opposite direction, I'd like to suggest that some calm, rational thought about the steps we are taking might be in order.

Geoff Colvin, senior editor-at-large of Fortune, shares some thoughts in a recent article on whether the pay restrictions added to the stimulus bill may create bigger problems than the ones they were intended to solve:

The main reason they'll backfire is that they make pay for performance, otherwise known as bonuses, illegal beyond a modest allowance, yet they permit unlimited pay for nonperformance. An executive may be paid a guaranteed base salary of any size but may not receive a bonus exceeding one-third of total pay. And even that minor bonus cannot be based on profits; the rules prohibit any pay plan "that would encourage manipulation of the reported earnings" of the firm, which is of course what any plan based on profits would encourage. So paying top executives in any sensible way is forbidden.

Colvin's concern: that the net effect of these provisions will be to drive the most talented financial minds away from the institutions who need them the most.  Those choosing to remain will be those content with a comfortable (or comfortable plus) salary and not much upside for producing results.

While it might be somewhat cathartic to put the screws to the financial sector, let's not forget that a strong financial industry is an essential piece of finding our way out of this mess. 

What do you think?

Bailouts, Boondoggles & Bonuses: Getting Our Signals Straight for a Productive Discussion

There's a whole lot of discussion - mostly heated - going on these days about executive bonuses, incentive awards, business meetings and travel, etc., particularly in light of the economic crisis and government bailouts.

To many of us involved or even just observing, these discussions can be very frustrating because of the wide range of topics that are being lumped together and collectively derided as "excessive compensation".  Jumbling together a number of distinct business tactics and different economic scenarios isn't helping us have a constructive conversation on any of them.

So what will?

Here to help us sort the signals from the noise is Paul Hebert of Incentive Intelligence, who has a guest post on this subject up over at The Employee Factor.

From Paul's post:

It is easy to lump executives traveling on corporate jets to far-off resorts for “planning meetings” to the incentive travel earned by employees or independent distribution channels. It’s easy but wrong. We need to make sure that we understand what we’re discussing before we jump in guns-a-blazin’ and start taking pot shots at all travel. So for “discussion’s” sake, let’s at least frame the argument this way…

There are four buckets of discussion:
1. Executive bonuses, salary, stock options, etc.
2. Executive travel – corporate jets, retreats, brainstorming and planning meetings
3. Business Meetings – for employees and channel partners to exchange information, train, etc.
4. Incentive Awards – predominately travel, but could include other non-cash awards.

We need to argue the relative merits of each one – and how they affect both bailed out companies and non-bailed out companies. We cannot lump them together as they are distinct and different things.

From here, Paul proceeds to build a framework for more fruitful discussion.  He also generously shares a set of slides he developed in order to help all of us put a stake in the ground as we work to determine how best to use incentives in our current economic situation.

 

Clarifying The Discussion

View more presentations from Paul Hebert. (tags: bailout compensation)

Addressing, Avoiding Moral Hazard in Executive Compensation

Wikipedia defines moral hazard as "the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk".  In an article focusing on moral hazard in executive compensation, Frederic Cook discusses how this can play out when executive teams are "rewarded for the positive outcomes of good investments, but insulated from the negative consequences of investments that turn sour". 

A timely topic given the focus on executive incentives, by our representatives in Washington and the public at large, and their potential role in the credit crisis.

In the article, Cook provides a thoughtful examination of the concept of moral hazard in executive compensation.  He walks us through the ways that some of the more common executive incentive devices may fall short in mitigating potential moral hazard, and offers some "thought starters" to business leaders interested in avoiding this pitfall in their own compensation design and governance efforts.  I encourage you to read Cook's brief article in its entirety to check out all his ideas; here, however, are a few that make a whole lot of sense to me:

• Pay modest or no severance for failed performance. Senior executives could be subject to two tiers of severance benefit – one, a higher tier, for "no-fault" terminations; the other, a lower tier, for "good reason" terminations relating to failed performance that fall short of "for cause" definitions. The public simply cannot understand why boards allow executives to receive multi-million dollar settlements when they are fired for leading the company to failure. It undercuts public support for good executive compensation practices and contributes to public perceptions that the game is rigged in executives' favor.

• Prohibit "flipping" of option gains. Require executives who exercise valuable options to hold a portion of the after-tax profit shares. For example, requiring executives to hold 25-50% of the net after-tax profit shares remaining after covering the option exercise price and taxes for one year after exercise is not onerous. It would function as a form of "claw back" if the executives exercised at a high point and the stock subsequently declined because of poor performance.

Sound ideas from one of the premier experts in the field, and a reminder to any of us involved in executive compensation design:  While we must keep in mind the need to attract and retain the executive talent required to lead our organizations in these difficult times, we must also ensure that the pay programs we implement reflect a responsible and sustained balance between the interests of all affected parties.

Image: Creative Commons Photo "Hazards! Ahead!" by Podknox

2009 - A Game Changer for Long Term Incentives

With the economy and markets in turmoil, many organizations are struggling to find the best response across all elements of their compensation strategy, but particularly for their equity-based pay plans.

In an article covering initial results of its recent study "Weathering the Storm in 2009", Mercer discusses the game-changing nature of what we are now facing, notes some of the early approaches being taken, and suggests a list of factors to consider in finding the solution for your organization.

From the Mercer article...

We believe that many companies will be hard-pressed to maintain the same value of LTI grants for upcoming awards due to plan share deficiencies or the appearance of overreaching, or both. The economic turmoil in today’s markets is unprecedented, so unprecedented actions are likely to be taken.

While companies are still planning their actions for 2009 grants, early indications are that many companies will be reducing grant levels this year, potentially by significant levels (10 percent – 30 percent). While strategies are still evolving and we are seeing a wide range of responses to these market conditions, early approaches include the following:  

-Reducing value by a fixed percentage – Some companies are considering an across-the-board haircut to target LTI grant values. For example, a 10 percent to 30 percent reduction in grant guidelines from 2008 is being considered to recognize the market decline and mitigate share usage. 

-Using an average share price and volatility to calibrate grants – Instead of using a current “spot” price of stock for calibrating the number of shares granted, companies may use historical 3-, 6- or 12-month average prices to smooth the impact of recent price declines. Similarly, companies could adjust share price volatility calculations to mitigate the impact of recent sharp price declines on option values. (Note that these suggestions apply to the calibration of award levels and should not be used to set the fair-market exercise price or determine accounting costs.)  

-Using a “collar” approach to at least partially adjust grant levels to meet a target value – Companies are allowing an adjustment to the number of shares to adjust to value, but are providing a cap on the maximum adjustment to share grants versus the prior year (for example, 25 percent to 50 percent increase). 

-Calibrating grants in light of company performance – Performance for 2008 can be used as a barometer for grant sizes. For example, LTI grants may be adjusted proportionately to be directionally in line with annual incentive payouts relative to targets. This approach takes a performance-granting perspective of awards.

Current surveys generally reflect practices from early 2008 while proxies reflect LTI grants from 2007. This means that market data will play a modest role, if any, in decision making for 2009. We recommend that companies evaluate a range of factors to determine the best course of action for 2009 to suit their unique situations. 

-Impact of the economic environment on your company and industry – Consider the shareholder perspective. Share prices in some industries, such as consumer packaged goods, have held up well in this environment, while others, such as financial services organizations, have been hit hard. Grant value reductions are likely to be greater in those sectors with greater share price declines.

-Total share usage and plan capacity – Model the total share usage as a percentage of common shares outstanding under a range of grant scenarios to assess the share-based run rate and implications for share plan capacity. Run rates over the past few years have declined substantially. While 2008 levels may be unrealistically low to replicate for 2009, a dramatic increase (for example, two to three times in the prior year) may be too much. Further, the amount of shares available may not support grant levels without adjustments, and it may take a while for performance to recover enough to obtain a significant new authorization. 

-Economic run rate – Consider the proportion of a company’s total market capitalization delivered in equity awards relative to the prior year, and relative to peer organizations. This value is the market value of share grants and the Black-Scholes value of options, divided by market capitalization. This provides perspective on the value transfer and executive “stake in the enterprise,” and is scrutinized by shareholders. 

-Retention value of outstanding awards – Analyze the value of unvested LTI awards under a variety of stock price scenarios over the next two to four years to understand the role 2009 grants need to play in retaining critical talent. Unvested gain of two to four times base salary for executives is a guideline to consider to counter potentially attractive hire-on offers from competitors. 

-Differentiation for critical talent and high performers – Assess the impact of maintaining values for critical talent and high performers, but reduce grants significantly for others to drive the allocation of awards based on impact and the need to retain. This may require making changes to LTI eligibility or participation rates at certain levels, or for specific job families within the organization. 

-Financial expense – Many companies that are aggressively cutting costs and equity expenses may come under review as well. Modeling the impact on accounting expenses will help frame the tolerance for LTI grant levels and how to balance dilution versus value.

-Shareholder and advisory guidelines – Institutional shareholders and proxy advisers such as RiskMetrics Group (formerly ISS) have guidelines on share and economic run rate levels. The impact of grants on those levels should also be examined. 

-Compare relative impact on peers – If peer share prices have declined more than your company’s, you may need to use proportionately more shares than your peers for this year, and vice versa. This may point the way to what your peers’ share usage may look like in 2009 to assess the competitive imperative for adjusting grant levels.

These are challenging times, particularly for those of us charged with managing LTI and equity-based compensation programs.  I suspect we'll continue to learn our way - collectively - through this unique period, but it helps to get the kind of perspective and guidance that Mercer offers here.

Peer Group Selection for Benchmarking: Overcoming the Obstacles

Like all other aspects of executive compensation management, the competitive benchmarking process is coming under harsh scrutiny.  This poses particular challenges for the selection of an organization's competitive peer group, the group of similar businesses that are selected and used for the purpose of compensation and performance comparisons.

Jim Heim, managing director of Pearl Meyer & Partners, in an article "Peer Group Pitfalls" published in the October issue of WorldatWork's workspan magazine, hones in on the five most common obstacles we encounter in this process and provides some advice for overcoming them.

From the article, in summary:

Obstacle No. 1:  Our Competitors Are Generally Larger (or Smaller).  Ideally a peer group should include somewhat larger and smaller companies, such that your firm's size approximates the group median.  When this doesn't hold true, consider a couple of alternatives.  First, use regression analysis techniques to determine "predicted" pay levels for a company your size.  Second, select a reference point (e.g., the 25th percentile) that is either above or below the group median, but reflective of your company's size and place in the group.

Obstacle No. 2:  We have Outperformed (or Underperformed) Our Competitors.  Year-to-year performance can vary significantly, and using annual performance as a key to peer group selection can result in substantial churn in the group roster from one year to the next.  For a more consistent set of comparisons, use longer-term (e.g., a three-year aggregate) financial performance measure(s), preferably those that are most meaningful to your investors and analysts.

Obstacle No. 3:  We Generally Recruit Executive Talent From Larger Firms.  "Aspirational" peer groups (groups that include larger, more complex, higher-performing firms which the company wishes to target for recruitment) have been rightly criticized when used as the sole reference point for benchmarking executive pay.  A more acceptable approach might be to develop and utilize two separate peer groups; one of aspirational peers and the other of size-relevant companies.  If strong financial performance is sustained over time, the aspirational peer group will become increasingly size relevant.

Obstacle No. 4:  We Have Few Clear, Direct Competitors for Our Product or Service Offerings. It may be that direct competitors are foreign-based, privately held or subsidiaries of larger companies, or it may just be that your company operates in a pretty specialized niche.  In such situations, the best approach may be using firms from "like" industries - in the way that brewers, distillers and winemakers may be considered like industries.  Be mindful of any particular differences in financial performance, choice of pay vehicles, etc. from one like industry to another.

Obstacle No. 5:  Our Industry is Consolidating and Several of Our Competitors Were Acquired. Industry consolidation makes it difficult to maintain a consistent year-to-year frame of reference.  Companies should establish a thorough, rules-based process of revisiting their selection every year to determine whether new firms should be added and any current firms removed.  This will ensure that the peer group used each year is valid for external benchmarking, even if there has been turnover in the group roster.

With all that is happening in our world and markets these days, this challenge will only get tougher.