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Quieting the Pay-for-Performance Critics

New research on executive-compensation packages does not paint an especially pretty picture for many organizations, and experts say now is the time for HR leaders to be "talking their talk" with company leaders about aligning compensation to long-term value creation.

Monday, January 19, 2015
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Last October, dissident investors helped to send Darden Restaurants' entire board of directors packing. In 2012, activist investor Carl Icahn targeted Netflix and demanded the company do nothing short of sell itself. Currently, David Winters has his sights set on major changes at Coca-Cola. And according to FactSet Shark Watch, activist investors launched as many as 238 campaigns to make changes at companies in the first nine months of 2014, a pace not seen since 2008.

And, while perhaps not evident at first glance, there is a way HR executives can help tamp down such roiling campaigns.

Experts say HR leaders can help put a stop to such efforts by ensuring their companies maximize their resources and focus on rewarding long-term performance more accurately and effectively, thereby reducing the risk of investors claiming companies are underperforming or in need of major repair.

At least that's the message Mark Van Clieaf hopes HR executives take from his recent research about performance-based pay. Clieaf, a Tampa, Fla.-based partner for the Americas and chief knowledge officer at Organizational Capital Partners, recently teamed with New York-based Investor Responsibility Research Center Institute to take a deep dive into data on executive compensation. Their findings do not paint an especially pretty picture-and perhaps help explain the hyperactivity of activist investors.

He says that as many as 80 percent of S&P 1500 companies are not measuring the right metrics, over the right period of time, for performance-based compensation. The metrics of choice for most companies are total shareholder return and earnings per share-the problems with both being that the former merely measures movement of capital markets (over which executives have little control) and the latter fails to capture future-oriented value creation. And only 10 percent of "long-term" incentives in current public-company compensation packages measure beyond three years.

Van Clieaf's message is that companies are failing at more than just compensation-plan design, they also fail at building for long-term growth. Nearly half (47 percent) of all S&P 1500 companies do not produce returns on their capital greater than their cost of capital.

"Which means they did not create real value," Van Clieaf says, adding that HR executives should see this as a "significant opportunity" to prove their mettle to the chief financial officer and the CEO by "talking their talk" about strategic performance and how to align business strategy with long-term value creation.

It's about giving executives a clear line of sight to controllable metrics that can signal long-term organizational success, he says.

But while Gregg Passin, U.S. leader of Mercer's executive compensation practice in New York, concedes that the facts might be straight in the IRRCi, he doesn't believe they've been interpreted to tell an accurate story. By limiting itself to metrics measured in compensation packages, Passin says, the research fails to account for metrics that companies are measuring outside of performance-based pay.

"It's a conversation that we have with our clients all the time," he says in regard to what metrics organizations should include in their compensation packages, as not everyone in an organization can be included in such pay programs, and those who are left out can, and often are, still monitored.

What's more, HR leaders would be aware of what's being monitored, whether part of compensation or not. They would already be in conversations with finance, the CEO and other senior executives about the company's strategic performance-the very same sort of dialogues that Van Clieaf is calling for.

Passin agrees that TSR is a measurement that's prevalent "globally" in performance-based compensation, but adds that compensation packages often couple TSR with metrics that reveal a company's true economic performance and improve executives' line of sight to value creation.

But, he says, it's difficult to generalize about how to structure performance-based compensation packages because each company's size, industry, competitive landscape, strategic goals and countless other individual factors go into determining its parameters.

Still, HR leaders would be remiss not to consider Van Clieaf's recommendations, as they are based not only on data, but best practices too.

For a data-based recommendation, Van Clieaf points to his finding that three out of four S&P 1500 companies fail to use a balance-sheet measurement in compensation. Return on invested capital is one of-if not the best-of the bunch, he says.

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The IRRCi report also calls for companies to measure innovation and its impact on long-term value creation, and Van Clieaf advises HR leaders to look at how other companies are doing it, adding that companies such as Abbott Laboratories, 3M and John Deere all measure revenues and other results from products and services that had not existed a few years ago in order to determine performance-based pay. That should send a clear signal to any organization's senior leadership that they ought to be focused on not just the current business, but where future growth will be coming from, he says.

At the very least, HR executives may want to consider rejiggering their performance-based pay structure simply to generate greater effectiveness.

In a recent blog post, management consultant Andrew Jensen at the New Freedom, Pa.-based Sozo Firm Inc. cites research from Michael Beer and Mark Cannon that shows how compensation programs in place for long periods of time can generate complacency and entitlement, rather than improved performance.

"The reason behind this is that, when faced with an ongoing performance-based pay system, many employees adjust to it very quickly," Jensen writes.

What's the potential downside to not reviewing a performance-based compensation system?

Van Clieaf says he strongly believes the world is changing, regardless of whether companies are changing alongside it, and boards and investors will only continue to ask "uncomfortable but right questions."

Sooner or later, he says, all underperforming companies will be put under the compensation microscope.

His question to HR leaders is a simple but proactive one: "So why wait for that [to happen]?"

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