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Doing the Heavy Lifting

Part of the HR leader's role is ensuring executive compensation communicates to all stakeholders that the company is "doing the right thing" -- and, more and more, that's going to mean paying for performance.

Friday, November 17, 2006
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Fast forward several months. An HR leader is communicating to the general workforce about freezing benefits and terminating the company's qualified defined-benefit pension plan, due in part to recent changes to federal legislation. She states the business case for the change as one of competition from lower labor-cost providers, and the reasons for change seem sound.

An employee in the audience asks why the executive officers' retirement package is so large, and increasing considerably in comparison to his own retirement nestegg, which will be decreasing. He had just seen in the most recent proxy the top officers' dollar values in their supplemental executive retirement plan.

If you head HR at a public company and think this scenario won't happen, think again. It's going to play out more frequently with the increased executive-compensation disclosure requirements unanimously approved by the U.S. Securities and Exchange Commission in July 2006.

The future will demand increased alignment of the messages of compensation between the workforce and executives, and an emphasis on truly paying for performance. For executive compensation, this means a more holistic focus on total rewards or total compensation rather than specific individual elements. Also required are a reinforcement of the pay-for-performance linkage and a stronger role for HR leaders in influencing the CEO on executive-compensation direction.

The SEC disclosure rules will no doubt help push the holistic approach. Meanwhile, performance shares, a long-term compensation tool, can enhance the pay-for-performance relationship. HR leaders wanting to contribute in a strategic way must take on the "heavy lifting" of dealing with the compensation of company leaders.

Total Compensation Perspective

SEC's proxy disclosure rules about executive compensation will enable investors, employees and other interested parties to review a named executive officer's total compensation, creating a transparency previously unavailable.

Pundits view its impact differently. On one hand, Jeffrey Pfeffer, professor of organizational behavior at Stanford University's School of Business, believes pay should be more private because, with disclosure, executives will want to match other executives' higher total compensation.

We believe, on the other hand, that greater transparency is positive. Compensation should be reviewed not piecemeal by each element -- but as a whole. This increases understanding not only of the total value, but also of how the elements are balanced -- e.g., the proportion of performance-based versus nonperformance-based compensation and long-term compensation versus short-term compensation.

The new disclosure rules will also result in a stronger focus on performance-based compensation in the future. Among other changes, companies will now include in the summary total compensation calculation, the annual change in the actuarial present value of accumulated pension benefits from all executive and qualified retirement plans and the above-market or preferential earnings on nonqualified deferred compensation of each of the five named executive officers.

Another chart will show the actuarial present value of each named officer's accumulated pension benefits instead of their estimated annual retirement benefits. Even though retirement value varies based on an executive's circumstances under the same retirement plan, this added disclosure will likely prove eye-opening.

The pressure on limiting SERPs will increase, especially since the Pension Protection Act of 2006 will likely result in most qualified pension plans having benefits frozen and being terminated within the next 10 years (except for government, union and small, closely held companies' pension plans). As employees no longer participate in defined-benefit pension plans, SERPs, particularly those that increase benefits for executives rather than restore retirement benefits lost from qualified plans due to limits imposed by the IRS, will start to look incongruous.

Although it could be argued that a CEO's tenure has shortened over the years, the pressure of paying for performance will mount as an alternative to burdening the corporation with future costs from an underfunded SERP. Executive compensation that pays for performance is key to creating a performance culture that battles entitlement and facilitates a high-performance organization.

Pfeffer also has spoken about the gap between knowing what to do and doing it -- company leaders and HR champions know paying for performance is the route to follow; it is perhaps time to lead and define new best practices.

Performance Shares Lead the Way

Improved tools for determining executive compensation exist. In the future, the buck must pass to performance shares -- plans that set pre-established performance levels for earning granted shares, so they require more than just the tenure and "breathing" of time-based restricted stock to vest and earn long-term compensation.

Performance shares are a key strike against executive-compensation programs that provide value to the executive when company performance goals may have been missed. Common measures for these shares involve absolute financial growth and relative financial performance compared to a published index of relevant companies. Time-based restricted stock is an entitlement; performance shares and performance-based restricted stock are not.

HR leaders should expect shareholders as well as boards to demand a stronger pay-for-performance relationship. They can educate both executive leadership and the board of directors on long-term compensation tools, showing the different impact from time-based restricted stock compared to performance shares. Performance shares are granted to an executive contingent upon two criteria -- time and results compared to measures of company performance.

If a combination of both time and performance goals is achieved, the performance shares vest, and stock is transferred to the employee on a taxable basis, with a U.S. tax deduction for the company. Compensation expense is recognized over the vesting period.

If the performance measure does not have market conditions (i.e., is not based on the stock price like total shareholder return), compensation expense, based on grant-date fair value, is trued up at the end and is deductible to the company based on the actual number of shares earned and awarded at the end of the period. No expense is incurred unless threshold performance is achieved under FAS123(R). Typically, upside opportunity exists for outstanding performance.

The advantage of performance shares is that the company does not have dilution from larger stock option grants with the same grant value, or from issues of underwater stock options or surprises resulting from inflation in stock price that may be unrelated to company performance. Yet the executive benefits from stock-price appreciation because performance shares vest at a higher market value when stock has appreciated.

Performance shares or performance-based restricted stock will replace time-based restricted stock among companies that have gotten the message about paying for performance. And the pay-for-performance linkage will continue to strengthen in annual cash incentives, as companies improve and refine measurement to include not only financial and operational measures, but also measures that strengthen the relationships between the company and both its customers and its workforce -- as well as forward-focused measures that position the company for long-term success.

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HR Leader's Advising Role

To be sure, most CEOs and the HR leaders who advise them on rewards want to do the right and fair thing for all concerned. Laws or regulations are unlikely to change the minority who might want to do wrong by their companies, shareholders, customers and workforce.

In a "free-agency economy," we assume that if HR leaders are asked to do something inconsistent with a basic code of conduct, they should and will move on to better things. The best consultants do this, and we believe top HR leaders have more important issues than to worry about paying CEOs more than is justified. The time is now for HR leaders to step up to the plate.

Executive compensation is controversial regardless of what you do, but becomes a lightning rod when executives win and the company, shareholders, workforce and customers lose. Studies show that companies that pay for performance outperform those that don't. HR leaders must take a stronger role in guiding and educating the executive team on executive-compensation direction and its impact on the rest of the organization and other interested parties.

Addressing the following is a start:

* Is executive compensation aligned with the long-term health and success of the company?

* Are performance levels calibrated appropriately to levels of executive compensation?

* Is executive compensation sending messages that conflict with the messages sent to the workforce on compensation?

* Are messages about executive compensation aligned with performance initiatives that executives are sponsoring and championing throughout the organization?

* Are the board and the board's HR committee connected with the messages about compensation that the rest of the workforce gets?

* What would employees think of the executive compensation program?

Executive-compensation tools, measures and messages need to be under the microscope and viewed from the standpoint of reasonableness and governance. With more understandable disclosure, compensation and performance should be put in line so you are proud of the current executive compensation in your company and don't need to fear what employees and local newspapers will say about it.

The Future Is Now

In the near future, some important changes will occur in workforce rewards, including executive compensation. Enlightened self-interest, on the part of company leaders, boards and shareholder activists, as well as stakeholders such as customers and the general workforce, will make this a reality. First, top-to-bottom pay for performance will become more widespread.

Next, performance shares will continue to grow in popularity for executive rewards because they have all the features true pay-for-performance tools need. Finally, the notion of entitlement will be replaced by a performance culture as the realities of competing for the high-performing 20 percent of the workforce become clearer and we understand what employees want in order to work in our companies.

This is a great time to raise the bar on executive compensation in companies where it's too low and keep it high where it is already high. In our estimation, HR leaders are up to the challenge.

Patricia K. Zingheim and Jay R. Schuster are partners in Schuster-Zingheim and Associates Inc., a compensation and total rewards consulting firm based in Los Angeles. They are recipients of WorldatWork's 2006 Keystone Award, the highest honor in the compensation, benefits and total rewards profession. They also are the authors of the books, Pay People Right!, The New Pay and the soon-to-be-published High-Performance Pay. Their Web site is www.paypeopleright.com.

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