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A New Mind-Set for Executive Pay

Two recent studies focusing on incentive compensation shed light on the state of executive comp plans today-and what employers might want to do differently going forward.

Thursday, April 2, 2015
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The bottom-line success of organizations, both large and small, publicly and privately held, depends on many moving parts that can drive business excellence. While most organizations' executive-compensation plans are designed to do that-both in the short- and long-term-some are more successful than others.

Until relatively recently, experts say, it was extremely difficult to glean insights on compensation-based business drivers, even among publicly held firms. Indeed, before the Security and Exchange Commission released new requirements on executive compensation disclosure in late 2006, companies were unlikely to disclose details about their incentive programs, says Ted Jarvis, global director of executive compensation data, research and publications at Mercer in Washington.

"Even after the new rules were first promulgated, many companies took the position that any disclosure of financial metrics, or especially of financial goals, would cause competitive harm," he says. "Now, for the first time, we can get a really clear view of what companies' incentive plans really look like."

That view, while now empirical, generally mirrors commonly held anecdotal beliefs. Jarvis, along with Peter Schloth, a principal specializing in executive compensation with Mercer in New York, recently conducted an analysis of executive compensation at companies in the S&P 100.

Their internal analysis uncovered two important trends: that short-term incentives typically focus on performance metrics, such as revenue and operating income, while long-term incentives focus more on market-related metrics such as total shareholder return and stock price appreciation; and that LTIs are generally less complex than STIs, incorporating fewer performance metrics and fewer special conditions.

Meanwhile, as CEO pay has skyrocketed in recent decades, there has been pressure on organizations to more clearly tie pay to performance in ways that are meaningful to shareholders.

To that end, a recent study on CEO compensation titled "When Less is More: The Benefits of Limits on Executive Pay" conducted by Peter Cebon of the University of Melbourne (Australia) and Benjamin Hermalin of the University of California, Berkeley, takes a look at another element of these plans: the payouts.

Their modeling suggests that capping and regulating CEO pay-including incentive pay-can positively impact organizations' profitability in the long term. The study was recently published in the Review of Financial Studies.

Indeed, Cebon and Hermalin's work suggests that tying bonus payments to results can create an unsuitably "simple" relationship between executives and boards.

Instead, they suggest, organizations need to drive senior leaders' and the CEO's efforts toward the pursuit of strategies that may yield results which are more difficult to measure, such as building organizational capabilities and pursuing innovation.

But too often, says Jim Sillery, a Minneapolis-based principal at Buck Consultants at Xerox, organizations really have no idea what executive behaviors are driving performance results.

A singular focus on the numbers can leave money on the table, he says.

For example, Sillery says, one of his client organizations had a plan in place and, based on results attained, concluded that it had a good year with good payouts. The plan apparently worked. But, when Sillery did a study of competitors, it found that they did even better. While they had a good year, he says, competitors had a better year, meaning they didn't capitalize on market opportunities as well as their competitors.

"If you're looking at face value," he says, "you may not be getting the full story."

Another issue involves identifying which behaviors drive which results. Plan participants, says Sillery, tend to know clearly what numbers they are attempting to reach, but they often don't know what their role was in terms of driving the numbers.

"There's no line of sight," he says. Executives need to clearly understand how their actions drive results and, in addition, need to recognize how short-term operational actions lead to longer term, more strategic gains.

"STI and LTI programs need to complement each other," says Schloth.

Properly designed plans, he says, will motivate executives to develop strategies and policies that achieve long-term growth and increase organizational value. If well-designed, Schloth explains, these plans will "motivate executives to execute on strategies and policies, and make good operating decisions to maximize performance over the course of a year."

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There's a role for HR in helping to make this happen.

The way plans get designed and managed says a lot about the culture of an organization, says Dave Hofrichter, partner and leader with executive compensation and governance practice at Aon Hewitt in Chicago. "I think that's something that the HR function ought to take very seriously."

Hofrichter asks rhetorically if the message of the incentive plan and the way it was put together are consistent with the espoused culture of the organization.

"For example, if we say customer satisfaction and our customers are the most important thing, is that reflected in our plan in any way? Is there a way to trace that value back through the plan? The big values of your culture, whether innovation, or efficiency, or customer satisfaction, or whatever need to have a linkage," he says.  

If the linkage isn't there, he adds, "you can say all you want about them being part of your culture, but no one will believe it because you're not putting your money where your mouth is."

HR can also play a very important role in how plans are communicated, in ensuring they are understood and-most importantly-in ensuring that the organization operates within the plans, Hofrichter says. One of the missteps that he often sees that can derail even the most well-developed plan, is the tendency to stray from the plan if the results aren't as expected.

"Frequently," Hofrichter says, "[organizations] get into this conundrum of, 'Gee, the results aren't there and we're going to have lower payouts [so] people are going to be demotivated-what are we going to do?' " He notes that this often results in people working outside of the plan, making exceptions to keep everyone happy and thereby undercutting the plan.

"When you do that," he says, "you're basically communicating to people that the plan doesn't matter and the rules we set up don't matter: there will always be a safety net for you. That's when plans start to disintegrate."

The fact that you don't always get the maximum-or even the target-payment is the reality of any incentive plan, he says.

"The world," he says, "doesn't always work out as you hoped it would."

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