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EXECUTIVE COMPENSATION: Taking a Holistic Approach

In the coming months and years, HR executives will need to take the lead in compensation and benefits design to help their companies and boards embrace a bigger vision of executive rewards and pay-for-performance.

Monday, November 19, 2007
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The old paradigm of executive pay, in which compensation, benefits, retirement plans, equity incentives and severance provisions were delineated and managed separately, is disappearing. In its place, the "total rewards package" is emerging.

While a good start, and certainly an improvement from the old days when some companies clearly did not have a handle on the magnitude or cost of the equity-incentive packages executives were accruing, it cannot stop there.

The total rewards approach lends itself to a new paradigm of looking beyond the regular payment of salary, benefits and incentives as an annual process, to viewing the long-term "big picture" of executive-wealth creation.

Because of their nature, equity incentives -- including options, stock and performance-based plans -- carry the potential for a dramatic upside, amounting to portfolios worth millions of dollars if not tens of millions. In fact, long-term equity incentives make up 60 percent to 80 percent of the compensation for the average CEO, and 40 percent to 60 percent of the compensation for other senior executives.

The opportunity is here for HR executives to be leaders in corporate governance, particularly to help board members understand the composition and magnitude of executive-compensation packages. In the coming months and years, HR executives need to lead the way in breaking down the traditional barriers between reward components and creating a long-term, holistic vision for management and the board of directors.

Further, they need to contribute in important ways to help companies ensure that long-term equity-incentive packages for executives carry the right kinds of performance measures so they can be aligned with the goals and values of the company.

A Fundamental Shift

Today's crossroads in executive compensation is the result of a fundamental shift that has occurred over the past 12 to 15 years. Back in the early 1990s, about 5 percent of outstanding stock was dedicated to equity incentives.

With the proliferation of stock-option packages through the late 1990s and until accounting reforms took effect in 2006, that percentage grew to between 12 percent and 15 percent. Further, in most companies, the vast number of those shares and options are in the hands of executives who have been amassing enormous wealth and potential wealth.

With such a dramatic shift in the allocation of shareholder resources -- given the bulk of executive wealth that comes from long-term equity incentives -- companies are beginning to question whether it is appropriate to fund retirement plans separately and provide separate benefits.

In this new environment for executive compensation and incentives, HR executives have the choice to lead or to be led. Taking the lead means having direct input in the development of far more flexible long-term incentive programs that emphasize the wealth-accumulation nature of long-term incentives, while shifting the weight of retirement funding from traditional defined-benefit and defined-contribution plans into the equity-compensation arena.

If HR executives do not take the lead, however, they may very well find themselves being led -- particularly by board members who take very seriously their roles as stewards of shareholder resources and are moving in the direction of pay for performance, looking at compensation in the aggregate and over the long-term.

Shareholder Resource Allocation

It is helpful for HR executives to view equity incentives from the perspective of board members. Knowing that the options, stock and other equity incentives literally grant future ownership of the company to executives, board members want to ensure the company is getting a commensurate amount of performance and contribution from management.

With this understanding, HR can take the lead by helping to ensure that resources dedicated to executive rewards are provided in a more cohesive and holistic way. The objective is to align the total rewards package with the interest of shareholders, with greater personal responsibility at the executive level for earning, and allocating life savings and retirement benefits.

(There is a powerful lesson to learn from private equity firms, which typically do not give retirement benefits, but instead provide large equity and option positions -- along with the charge to executives to make these instruments increase in value through their actions.)

To achieve greater alignment in the total executive-rewards package, there are three specific initiatives that HR can undertake:

1. Take a portfolio approach to long-term executive compensation.

Forward-looking companies acknowledge that long-term equity incentives are not annual events, but have a significant cumulative buildup. Further, they realize that over time, these long-term equity incentives amass to the point that they dwarf an individual executive's retirement plan. In addition, some companies are taking creative steps in making long-term equity more flexible and effective as a vehicle for balancing risk and amassing personal savings and wealth.

For example, Best Buy has developed a flexible "multiple-choice" long-term incentive plan, whereby executives and other participants have their choice of several combinations of four long-term incentive vehicles, which include options, performance-vesting restricted stock and two different performance-based cash plans.

Each combination has a different risk/reward profile, and each executive has the opportunity to match his or her long-term incentive portfolio with his or her personal risk profile, lifestyle and life stage.

Other companies, such as Kimberly-Clark, are providing a mix of three long-term incentives, including options, time-vested restricted stock and performance-vested restricted shares or stock units.

They have made adjustments to come up with the appropriate mix of these elements; however, they are not just looking at the mix on an annual grant basis.

Rather, they are also looking at the mix of executives' cumulative holdings and the effect that stock performance has on their future wealth.

There are six "incentive imperatives" that should be part of any long-term equity incentive plan. They are:

* Motivate the upside to give management a significant stake in the growth of the company's stock price or value.

* Protect the downside. Incentives should cause management to feel the shareholders' pain if stock prices fall.

* Create an ownership stake. Most boards and CEOs agree that management should have a significant personal ownership stake in the company -- large enough to affect the individual's personal wealth.

* Reward real performance. Long-term incentives should establish long-term financial goals and reward long-term financial performance.

* Retain top talent. Incentives should have "deep hooks" that cause significant financial pain if executives leave prematurely.

* Compete effectively. The total package should provide competitive payouts that are in line with competitive performance -- in other words, median pay for median performance; 75th percentile pay for 75th percentile performance, etc.

Companies will be increasingly considering these and other objectives in creating a balanced incentive portfolio that combines various types and designs of annual and long-term incentives to create the optimal mix.

2. Unify compensation, retirement, severance, equity incentives, and change-in-control provisions.

In the past, these elements were separate because an executive's retirement plan was his or her main long-term asset. Now, in a successful company, long-term equity incentives dwarf the retirement plan to the point that it has become insignificant and even redundant. In addition, the retirement plan represents a financial expense burden to the company that is unrelated to performance.

Accumulated equity incentives also make up the vast majority of severance and change-in-control benefits for most executives. The need for special plans and contracts that pay out multiples of salary and bonus should be questioned once an executive accumulates a substantial equity-incentive portfolio.

From this perspective, companies are beginning to ask why they should continue the ruse of providing separately funded retirement and severance benefits for executives, when the main source of wealth building for executives is long-term equity incentives.

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Perhaps traditional retirement, severance and change-in-control programs can provide a minimum floor level of benefits until executives build up a targeted amount in their equity-incentive portfolios. The equity incentives, however, should be expected to do most of the heavy lifting in providing the bulk, if not all, of an executive's retirement, savings and job-protection funding.

By unifying compensation, retirement, severance and change-in-control agreements, companies have the opportunity to gain greater control and philosophical alignment. By erasing the lines between these traditional categories, HR can lead the way to a more holistic view of executive total rewards, utilize shareholder resources more wisely, and promote greater individual responsibility for personal wealth accumulation, risk management and retirement planning.

While the total rewards terminology is meaningful in the HR world, it is not a term that most boards will be familiar with or, quite frankly, find particularly helpful. Where boards will benefit from HR expertise is understanding total rewards from a multi-year perspective of three, five, 10 years or longer, and how elements of compensation -- particularly long-term equity incentives -- affect executive behavior and corporate results.

3. Create a system of performance measures built on a "science of value creation."

With the total rewards package as a starting point, companies have an opportunity to create a powerful, integrated system of incentives and performance measures that truly drive long-term value creation.

This balanced value-creation approach is more likely to be adopted now that companies have shifted dramatically from granting only options to granting long-term incentives that include both options and performance plans. Because of this change, most companies are in the position of having to measure long-term performance and set long-term financial performance goals.

Therefore, they need an integrated combination -- or system -- of annual and long-term-incentive performance measures and goals. These goals should be developed and integrated in a holistic, balanced way, with three to five key measures of performance that work together harmoniously to drive and maximize long-term sustainable value in the organization.

Through the well-established tools of value creation, companies are beginning to fine-tune their combination of annual and long-term measures so that all of a company's key value drivers are included. For example, many companies have found that a combination of a growth measure, a margin or profitability measure and a return-on-capital measure, capture the key value-creating activities of the company. This may result in "profit before tax" being used as the key annual incentive measure, and "net margin" and "return on capital" being used in the long-term performance-based incentive, for example.

Other companies have found that measures of innovation or new product development are key drivers of value and are adding them to their incentive system. The point is that we will find ourselves with more complex and flexible incentive tools, and more places to choose appropriate performance measures, set goals and reward performance.

The Time for HR Leadership

As HR leaders embrace the total rewards package concept and apply it to executives, they take an important step toward leading the drive for more meaningful, fair and effective executive compensation. By looking at compensation, retirement, long-term incentives and other components in the aggregate and over a multi-year time frame, the perspective shifts from what is granted on an annual basis to a longer-term, strategic view.

HR can use its expertise and leadership in compensation and benefits design and implementation to help their companies and boards define and embrace a bigger vision in executive rewards and pay-for-performance.

By identifying key performance measures and value drivers, HR provides to the company and its board the context for achieving greater alignment between compensation and incentives on the one hand and the company's overarching goals on the other. The result is greater balance and alignment, driving value into the future.

Donald P. Delves is principal and founder of The Delves Group, a Chicago-based firm that fosters the growth, profitability and value of healthy businesses through building highly effective compensation and governance systems. He is also the author of Stock Options and the New Rules of Corporate Accountability: Measuring, Managing and Rewarding Executive Performance (Second Edition), and CCH Accounting for Compensation Arrangements (2006).

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