Strengthening the Pay-for-Performance Link
A recent survey finds more companies using total shareholder return as a key metric to assess the link between pay and performance. While this approach has its benefits, HR leaders have a number of factors to consider before making TSR a significant component of long-term performance plans, experts say.
By Mark McGraw
With say-on-pay voting now very much a reality, more companies are taking additional steps to better link pay programs and company performance.
According to a recent survey from Lake Forest, Ill.-based Meridian Compensation Partners, using total shareholder return – the internal rate of return of all cash flows to an investor during the holding period of an investment -- as a means to assess the strength of that link is an increasingly popular step for a growing number of organizations.
The 2013 Trends and Developments in Executive Compensation Survey, which polled approximately 140 companies with median revenues of $3.9 billion and median market values of $5.6 billion, found 58 percent of companies using total-shareholder return as a key metric in their long-term performance plans, up from 44 percent in 2011 and 50 percent in 2012.
For many companies, total shareholder return is one of the most straightforward ways to show the connection between pay and performance, says Patrick Powers, a consultant with Meridian.
"Total shareholder return is currently viewed as one of the most direct measures for linking realized compensation -- i.e., compensation actually received by, not awarded to, executives – with the shareholder's experience," he says. "Additionally, companies want to maintain the external view that they are focused on the return they are generating for their shareholders, both from an absolute standpoint and from an alternative investment decision."
Using TSR is also an attractive option for organizations having trouble setting long-term financial goals, adds Powers.
"Many companies are finding it difficult to set financial performance goals three or four years out, for a multitude of reasons, particularly during volatile economic times," he says. "In comparison -- because TSR is measured on a relative basis -- no goals need to be set, per se."
Rather, performance is most often measured as a percentile ranking versus a comparator group, Powers continues, adding that "TSR has the added benefit of incorporating and reflecting the anticipated value of various forms of major corporate events and transactions such as mergers and acquisitions, divestitures, discontinued operations and other major initiatives."
Institutional shareholders' growing influence -- due to say-on-pay -- has "unquestionably" impacted the number of companies considering the use of TSR in long-term performance plans as well, says Powers.
"Shareholder advisory firms such as ISS and Glass Lewis have clearly made it known that they believe some portion of pay should be based on TSR performance, preferably on a relative basis."
Powers sees the move toward using total shareholder return as a key metric in long-term performance plans continuing.
"One contributing factor … is the simple fact that more companies are granting performance awards, either instead of or in addition to time-based vesting awards such as restricted stock or stock options."
Don Lindner, executive compensation practice leader with Scottsdale, Ariz.-based WorldatWork, shares a similar view.
"I think the use of TSR will continue, because shareholder advisors like ISS use TSR as their key measure in their pay and performance testing, which in turn influences how they recommend on say-on-pay votes," he says. "Boards want to maintain good relationships with their shareholders and want to achieve positive say-on-pay votes, so using TSR as at least one measure helps in that endeavor."
It's worth noting that publicly traded companies "are still waiting for the SEC rules regarding the pay-for-performance disclosure that will be required under Dodd-Frank," says Olivia Wakefield, a Boston-based director in Towers Watson's executive compensation consulting group.
While uncertainty remains around what metrics will be mandated to measure performance under Dodd-Frank, "it's reasonable to expect that performance as measured by TSR will be a consideration [for many companies], given shareholder scrutiny and ISS' prominent use of TSR to measure pay and performance alignment," she says.
Still, this trend "easily" could reverse itself if the stock market flattens out or tails off, says Martin Somelofske, a Jersey City, N.J.-based senior principal and Northeast practice leader for executive compensation with Hay Group.
"This is a case where executives like this metric when things are going well, but not so much when things are trailing off," says Somelofske.
A better performance metric that utilizes the some of the same data may be relative shareholder return, he says.
"That is, how did your return compare to your peers, the market overall or a selected index? It's very nice if you have a shareholder return of, say, 10 percent, but if the majority of your peers are up 15 percent to 20 percent, then it's not so impressive," says Somelofske. "Conversely, if you have a modest return of a few percent but everyone else is down, then you really are a top performer."
Even so, the approach isn't without its own problems, he says.
"Do you want to pay executives – and make them winners – while at the same time shareholders lose?"
Indeed, HR and compensation leaders have a host of pros and cons to weigh before making TSR a significant component of long-term performance plans.
"The benefit is that it does directly align an executive's pay with shareholder value," says Lindner.
"However, there are many factors that influence total shareholder return which are outside the control of a company's management. Therefore, exclusively pursuing TSR in the short-term can be harmful to long-term growth and viability. That is why using more than one measure or metric, including those tied to an organization's business strategy, is a better approach in the long-term."
"One of the appealing qualities for relative TSR is that it tends to screen out the many macroeconomic factors of impacting absolute stock price," says Powers. "For example, inflationary expectations, interest rate fluctuations, industry-specific phenomena and general economic prospects all have considerable impact on stock prices. These are obviously not company-specific factors that management can control."
HR and compensation committees have additional questions to consider as well, he adds.
"For relative TSR plans, is it appropriate for executives to receive payouts above target when TSR is negative over the performance period? Some may argue that executives should be rewarded for superior performance relative to peers, even when TSR is negative. Others may argue executives should receive zero payouts when TSR is negative, regardless of the company's ranking relative to peers, so as to align their pay with the shareholder's experience."
Ultimately, "the use of TSR as a metric doesn't have to be in isolation," says Powers.
"There are ways to balance the benefits of a relative metric with the merits of an internal financial metric -- return on invested capital, economic profit or operating profit. The weighting assigned to TSR can of course vary. HR leaders should consider other aspects of the company's compensation program, including the other types of long-term incentive awards being granted, when considering the appropriate weight to assign to TSR."