Executive Compensation Plan
Design Trends & Recommendations
by Mae Lon Ding, President, Personnel Systems Associates Inc.
Year after year, we see articles in the business press indicating that executive compensation is overly generous, poorly linked to performance, and poorly controlled by public boards. Nothing has changed in that regard, but now because of events at Enron, WorldCom, and the like, the SEC and the accounting standards board are much more interested in affecting change in this area. Boards are caught in a difficult dilemma. On the one hand, they must assure that they approve a plan that effectively attracts, retains, and motivates the CEO and other top management. On the other hand, they must not appear to be giving away the store and must exercise due diligence in assuring that pay and performance are properly tied to each other. Following is advice for the executive compensation committee when reviewing the salary, bonus, and stock option plans for officers of the company.
- Tie bonus primarily to measures of both profitability and growth. Investors have come to realize companies who have growth without profitability or who have profitability without growth are usually less desirable investments. Stockholders want both profitability and growth.
- Total compensation should reflect the difficulty of the performance objectives set relative to peers. If objectives are set aggressively high, then compensation should match this aggressive stance. For example, top 25% performance deserves top 25% compensation. If financial objectives are set at industry average, then it is a good practice to set total compensation at a level that is not much more than the industry average. Many companies set objectives that are average for the industry, but set compensation levels which are well above average because of executive attraction and retention concerns. The board must take a realistic look at whether there are special circumstances that might merit this treatment such as attracting key executives to a turnaround situation or labor market conditions that make attraction and retention of desired talent unusually difficult.
- Analyze expected management compensation level as a percent of expected profits when reviewing bonus formulas. Compare percentages to companies of similar size and industry.
- The management team should put significant effort into developing or obtaining a database to measure financial performance against peers. This data should be presented to the board to consider in discussions about future objectives for the company. Sources that we use to assist clients in this area include stock analyst reports, trade association surveys, consulting firm surveys, analysis of financial statements for peer public companies, etc.
- There is a tendency of companies to overweight recent history of the company in setting future financial objectives. The financial objectives should reflect a balance of many factors including:
- recent financial history of the company – desired improvements must be realistic relative to past performance
- recent history of peer performance in the industry – objectives should be set at a level to improve performance relative to peers unless you are already the top performing company.
- industry forecast for growth – objectives should reflect at least the industry average forecast for growth
- major changes in business strategy, new products/services, and operations that could significantly impact growth and profitability – these types of changes can change the model for doing business and make historical financial figures much less relevant in setting future objectives.
- Avoid canceling and reissuing underwater options at a lower strike price. Management should be in the same boat as the shareholders.
- Put management stock ownership guidelines in place. In order for management to be in the same boat as the shareholders, management should have a downside financial risk as well as an upside opportunity.
- When setting the level of stock options analyze both the expected value of options as a percent of the total compensation package as well as in relationship to competitive peer company stock practices. Stock option value which focuses management on both long term and short term results should be balanced with bonus plans which focus only on annual results. There has been a recent trend to increase the emphasis on stock option compensation because of IRS million dollar limits on tax treatment of cash compensation, because of board and management perception that options do not receive as close scrutiny by stockholders as cash compensation, and because of lower impact than bonuses on the P&L statement. This can lead to an imbalance in the executive’s perspective on the importance of managing stockholder perceptions versus managing company operations.
- Cutting heads is often viewed as an easy way to improve profits. Downsizing is a growing trend even in financially health companies. It is difficult to keep the work force energized, positive, and focused when this occurs. Executive bonuses should be consistent with employment and compensation of other employees in the company. It sends the wrong signal to company employees, when top executives receive large bonuses while large numbers of employees are being laid off or when bonuses below the executive level are not being granted. If layoffs are needed or a tightening of the compensation structure for the company overall, then the executive will likely find his/her rewards in the impact of those actions on stock option value. It may be best for the company if the CEO and the top management team forego their bonuses and perhaps even accept a cut in base pay. The long-term rewards for the executives and the company should outweigh short term compensation loss.
- It is easy to be generous and complacent when times are good. The board and the compensation designer need to consider what safeguards are in place in the compensation plan should financial results take a quick downturn or should the financials need to be restated in a downward direction.
- Executive employment contracts are a good idea. They are like premarital agreements and should state the terms for separation from the company in a way that balances the executive’s security with the safeguarding of stockholder assets in case of either a voluntary or involuntary termination.
- Remember that it is always more motivational to pay above average incentive and an average salary, than to pay above average salary and an average incentive. Often it is a good idea to adjust the balance between these elements when they are found to be out of alignment. A competent and confident executive will welcome such a rebalancing because it should result in higher compensation for top performers.