The Advisors' Blog

– Broc Romanek, CompensationStandards.com

Here’s the intro of this article by Arthur J. Gallagher’s Jim Reda & David Schmidt:

Like Richard Wagner’s epic opera, “Parsifal”, which depicts King Arthur’s knights in the quest to find the Holy Grail, companies strive heroically to find the right performance measures to improve corporate performance. Based on our recent analysis, we discovered two very interesting points. First, the companies that used the same performance measures in each of the past five years outperformed others that changed measures. Second, the best performance measure is Earnings per Share (“EPS”), followed by Capital Efficiency, and Total Shareholder Return (“TSR”) is the worst measure. These results are not surprising since providing a consistent and “line-of-sight” performance goal is always the best way to provide incentive to management. The era of using stock options, which was more like a “lottery ticket” (as described by Warren Buffet), has come to an end.

“In all instances, we pursue rationality. Arrangements that pay off in capricious ways, unrelated to a manager’s personal accomplishments, may well be welcomed by certain managers. Who, after all, refuses a free lottery ticket? But such arrangements are wasteful to the company and cause the manager to lose focus on what should be his real areas of concern. Additionally, irrational behavior at the parent may well encourage imitative behavior at subsidiaries.”

— Warren Buffett, commenting on stock options in The Warren Buffett CEO: Secrets from the Berkshire Hathaway Managers, by Robert P. Miles, published by John Wiley & Sons

“We seek to design our executive officer compensation programs to attract, retain and motivate key executives who drive our success and industry leadership.” Versions of this statement can often be found as the lead-in for a public company’s Compensation Discussion and
Analysis (“CD&A”) section of their proxy statement. Following closely behind this statement is a declaration that executive pay that is market competitive and reflects performance is key for accomplishing the goals of the compensation program while also being in alignment with shareholders.

An important question coming out of this is — what sort of compensation really motivates top executives today? And, can companies be assured that whatever motivates top executives will also drive company performance? If these two factors are not connected, motivating executives the wrong way could potentially harm company performance.

For example, if a company provides short-term and/or long-term incentives to executives with payouts tied primarily to revenue growth, it will likely motivate executives to increase the size of the company in ways that could reduce profit margins and perhaps stock price growth. Understanding the interaction of incentive measures with each other, and with other company measures of performance, is critical in designing an effective incentive program.