Last week, Dave Schmidt blogged about the challenges of disclosing metrics. Based on my experience, trying to establish a three year financial target to be used in a long-term incentive plan (LTIP) can be very challenging. Some companies will use – or consider – using relative financial performance, figuring “if we perform at least as well or better than our peers, we deserve to be paid our LTIP award.” While the use of relative financial performance is very appealing – as it avoids the need to (a) establish three year financial targets and (b) disclose targeted financial results in the CD&A – there are many practical challenges, including:
1. What measure(s) should be used?
2. Who is the relevant peer group?
3. Do we rely on reported results or make adjustments for unusual items?
Relative financial measures – such as EPS and revenue growth, 3-year average ROIC and ROE, etc. – may all provide a useful gauge about how well the company is doing relative to peers. However, depending on a company’s particular strategy, relative results may fall below the peer group median.
For example, a company may be willing to give up a little ROIC to attain higher revenue growth. Similarly, a bottom quartile ROIC performer may need to focus on profit improvement to exit the profitability cellar. As a result, revenue growth may be negative. Thus, the selection of the right relative financial measure must support the company’s business objectives.
Also, relative performance – particularly EPS growth – can be significantly impacted by your starting point. For example, if a company barely broke-even last year, any improvement will yield a large percentage increase in EPS, vaulting the company to the upper quartile of its peers. Not many compensation committees are willing to pay maximum incentives for an increase in EPS of $.03 to $.06, even though it represents 100% growth and 90th percentile relative performance. More thoughts to come…
As investors seek to rein in “pay for non-performance”, change in severance benefits payable after involuntary termination has become more commonplace. A review of the Fortune 250 found that one in ten changed their severance benefits in the past 12 months.
One creative tool for change in severance is a “sunset provision”. As the name implies, sunset provisions are designed to reduce benefits from a potentially high level and have them settle at a lower level at a set time in the future.
I have found sunset provisions in executive severance programs useful, not as a severance policy in and of themselves, but rather as an effective way to deal with special cases, while preserving the integrity of the existing, or planned, severance guidelines.
There is potentially a sound logic to this approach which recognizes that an individual executive’s greatest income risk from involuntary termination is during the early period as an executive, before he/she has an opportunity to accumulate wealth and/or build saleable skills in the executive role. That risk is presumed to go down over time.
However, in my experience, if applied as a policy to a large group of executives, a sunset provision will over time create a sense of inequity and confusion. Few, if any, can remember the different circumstances that created the different levels of individual severance benefits, and with a significant number of similarly-leveled executives covered at more than one level of severance there is a mixed signal on what is the intended level of severance benefit.
Two examples I have experienced where a sunset provision has worked well for a client include:
– A large employer, who had an assortment of individual severance agreements, was targeting to establish a guideline of 1 times salary for its executive leadership team, while retaining a benefit of 2 times salary for the CEO. At the same time, a COO was being recruited from outside the organization and sought a 2 times salary severance benefit, similar to his contract with his current employer. The organization offered the candidate a sunset severance program, with 2 times salary as his severance benefit during his first two years of employment, followed by a decline to a 1 times severance after that time. The sunset provision helped in resolving the potential conflict between the candidate’s requested severance protection and the Company’s planned severance guidelines.
– The Compensation Committee of a public company that had been criticized by institutional investors for providing generous severance payments during a time of poor stock price performance, decided to move forward with a reduction in its executive severance guidelines from 2 times salary and bonus to 1 times salary and bonus. However, in light of its difficult business climate and risk of unwanted turnover, they used a sunset approach and stepped the benefit down over two years, first to 1.5 times and then to 1 times salary and bonus. This sunset approach allowed them to establish the longer term standard for severance of 1 times cash pay, but not increase the risk of voluntary turnover while the company improved its business performance.
The level of executive severance benefits for involuntary performance will likely remain under pressure to decline. A sunset provision may be one tool for companies to use in attracting or retaining talent during a period of transition.
As noted in the memo, Senator Clinton’s bill is a broad response to concerns over executive pay, and it is currently unclear if it will be voted out of Committee (there are no co-sponsors so far). However, it’s realistic to expect that similar legislation will be introduced next year under a new Administration.
The “bottoms up” approach is indeed a useful starting point for assessing directors’ pay at small and large organizations. But the potential liability and exposure fall virtually all on the outside professional advisors, who always run some risk of being sued successfully for malpractice and who therefore build the costs of that risk into their hourly rates.
The potential liability and exposure of directors have been badly overexagerated. As long as directors do these four things – (i) make decisions on a rational basis, (ii) use a rational process for making these decisions, (iii)act in good faith, and (iv) have no conflicts of interest – the business judgment rule will insulate them from liability. Of course, anyone can sue anyone for anything – and that’s why directors need D&O insurance to cover the costs of litigation.
But I do not know of a court decision where the court found that the directors met this four-part test and still were found liable. The business judgment rule gives directors the right to be wrong. Outside professional advisors do not have this right.
Our recently released study of 2006 performance metrics at the top 300 public companies – now being updated for 2007 data – revealed that 37% of companies with long-term incentive plans used total shareholder return (TSR), a market measure. All but five of these companies based their payouts on TSR relative to a peer group. On the other hand, for the majority of plans using a performance-based or internal financial measure, relative designs were the exception. Indeed, of the performance-based long term incentive plans, less than 20% used relative measures. To be compliant with Item 402(e)(1)(iii), disclosure of the measures, including threshold, target and maximum values, would be required.
Short-term incentive plans rarely use relative measures. This same study estimated just 8% of companies with short-term incentive plans used relative measures as part of these plans. Moreover, the reporting of metrics in 2006 was woefully short of expectations with just 16% of these top companies providing complete information on short-term goals and accomplishments. Clearly, there was great hesitation in disclosing this information.
For companies that would prefer not to disclose this information for competitive reasons, an easy solution would be to base payouts on performance relative to a set of peer companies. As with a TSR design, payouts could be based on percentile performance over a multi-year period. Reporting would consist of listing the applicable measure(s) and the percentile performance that triggers vesting/payouts. Equity-based plans would retain all the features of any other performance-based plan such as fixed expense per share and reversible expense for sub-threshold performance.
Using a relative design is also a better way to measure performance. With a relative measure, changes in the economy and industry are reflected in the performance of comparator companies. Consequently, if a company is falling short of its EPS goal, it is possible that the company can outperform its competitors and be rewarded accordingly. Alternatively, if the company goal is more easily achieved as a result of external factors rather than astute management, a relative goal can prevent an unwarranted windfall.
Of course, one downside to relative measures is the potential payout of incentives in cases of poor company performance but strong relative performance. Having minimum financial hurdles can be designed to prevent ill-timed payments.
One of the beauties of having so many experts participating on one blog is the dialouge it will create among them, as well as with their audience. For example, George Ince of Davis Polk & Wardwell notes: Peter Hursh’s blog on the “bottom’s up” technique of establishing director pay is a useful starting point – but I would suggest that it undervalues the director’s services since I think there should be some additional pay for directors to account for their fiduciary duties and potential liability and exposure in performing the role of a
director, which are not present for the other types of advisors he uses for the fee measurement.
More Performance Target Disclosure Stats
Back in early April, Equilar released a study regarding how many of the Fortune 100 disclosure their performance targets (compare the stats in Watson Wyatt’s survey, noted on April 10th in this blog):
– From 2006 to 2007, the prevalence of Fortune 100 companies disclosing actual performance targets for their executives under all types of compensation plans increased from 55.8% to 66.4%.
– Among Fortune 100 companies with annual bonus plans for executives, 68.3% disclosed the actual performance targets which must be achieved to generate payouts. Last year, 44.4% of Fortune 100 companies with such plans provided a comparable level of detail.
– The study also finds that 81.0% of awards which measure short-term performance, benchmark results solely against internal company goals. Conversely, 60.9% of long-term performance awards use relative measures as a component in determining payouts.
I’m often asked by directors of smaller publicly-traded, or even private companies whether I think their pay for board service is competitive. Most directors, like your boss and your spouse, are of course overworked and underpaid.
I respond by taking them through what I call the “bottom’s up approach” to setting pay for directors. I ask the director to estimate the number of hours he or she spends each year on different board activities – – mosty, participating at board meetings, at committee meetings, at a board retreat, on conference calls, and in individual meetings, as well as in preparing for these sessions (although I tell them to exclude travel time). Say that serving as a director of ABC Company takes about 100 hours per year. Then I ask the individual: what is the average hourly rate of the senior outside advisors to the Company and its Board – – that is, its attorneys, accountants, business consultants, marketing specialists, etc.
The answer is often, for smaller companies, about $350-$400/hour. Then I say, “Well, for you that’s 100 hours times $350-$400/hour, or $35,000 – $40,000 per year as an independent contractor – – i.e., as a non-employee director of ABC. How does that compare to the sum of your retainer, meeting fees and annualized stock opportunity?” The answer, in every case I’ve had so far, is that what the inquiring director is getting paid – – usually about half in cash retainers and meeting fees, and half in stock – – is very close to the bottoms-up answer. My experience is that (i) this reassures the director that his or her pay is fair and (ii) once an individual thinks that the pay for his or her job is fair – – and this is especially true for outside directors – – then that person does the job for other reasons.
Recently, we issued this “Early 50 Filers” report, which analyzes executive compensation disclosures by 50 companies that filed proxy statements early in 2008 and that had two years of experience under the SEC’s expanded reporting rules. The data covers disclosures related to: corporate performance metrics; benchmarking practices; consultant independence; corporate governance; readability; and length.
For purposes of having a little fun – and putting aside the fact that NBA players are paid based due to business decisions just like any other decision to invest in an asset to earn more (which is very different from the process by which CEO pay is set – check out my recent article that imagines if NBA players were paid like high-performing executives. I use the article to make some points about how properly designed pay packages would result in more pay-for-performance.
Interesting article from the Washington Post last week speculating on what the future may hold for “Say on Pay” votes in light of a fairly low success rate this season. Some pundits speculate having a simple “yes” or “no” vote on pay packages is too much of a blunt instrument – and suggest these votes may need to be retooled to focus more clearly on the elements of the pay package.
From our perspective, when advising clients to do a better job in their CD&A explaining how their program accomplishes their goal of “pay for performance,” we suggest they be mindful of a future that could involve “Say on Pay.” Our point to them is: Why wait until the vote is pending to make your arguments to shareholders? Why not be doing the analysis every year to prove the point?
Of course, performing an analysis of how the pay your executives ultimately earn stacks up to that of your peers – and then comparing what your executive’s earn versus how the company performed versus peers – is time-consuming and may yield an answer the client might not like. But without doing the analysis, in our view, it is impossible to make a statement that your plan pays for performance.
In a recent symposium we attended on the issue of “Say on Pay,” each of the proxy advisory firms who spoke on this issue acknowledged their “yes” or “no” recommendations would be based on many different factors, the most predominant of which will be . . . wait for it . . . pay for performance. There is still time for companies themselves to help define what this means, and by doing so in their CD&As, perhaps Corporate America can drive the definitions rather than the advisory services.
Let’s not forget, both Barack Obama and Hillary Clinton have proposed legislation to mandate a non-binding “Say on Pay” vote, so this issue will continue to be debated throughout the upcoming election season – and perhaps beyond that.