One-year incentive plans questioned

Published: September 13, 2011 6:00 am ET

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Topics Public Policy

WASHINGTON (Sept. 13, 12:05 p.m. ET) — Payouts to executives for meeting 2010 performance goals were accompanied by improvements in stock prices, earnings and total shareholder return.

But the ease with which many executives exceeded their one-year performance targets in 2010 has some compensation experts questioning the approach boards and companies take to one-year incentive plans.

In addition, there is greater concern over setting goals and targets for long-term incentive plans on an annual basis, a growing use of relative measures in those LTI programs, and a trend toward using the same measures to reward executives for short- and long-term performance.

“The increases in compensation were directionally consistent with the bounce-back in performance and stocks of companies,” said Mick Thompson, a Chicago-based principal in the human capital consulting business of New York-based Mercer Inc. “The average payout was 122 percent of target. That shows that companies and executives were performing better than their budgets in 2010.”

Deb Nielsen, the Boston-based director of data operations and executive compensation for Kenexa Compensation, agreed. “One-year bonuses came back, and the increases, for the most part, were in line with performance.”

Yet, the question remains whether firms set targets that were too soft after two consecutive years of declines in corporate performance and pay, and whether the use of relative targets has made it easier for executives to collect incentive rewards — both short- and long-term.

“Many of the practices associated with pay for performance are improving. But whether there is a strong alignment of pay with performance is hard to tell in this environment,” said Carol Bowie, head of compensation policy development for proxy advisory and corporate governance firm, Institutional Shareholders Services Inc. in Rockville, Md.

ISS believes companies set “modest goals” for executives in 2010 to obtain payouts, she said. “We saw high payouts because the bar was low” and companies and stocks recovered more quickly than had been anticipated,.

In addition, payout targets often can be vague or moving, Bowie said. An ISS study of Securities and Exchange Commission filings over the past four years found 66 percent of the firms either did not specify targets or provided ambiguous disclosure.

“While companies are disclosing the type of performance measures they use, they are not routinely disclosing the performance levels [that is, the numerical value] that needs to be achieved in order to receive threshold, target or maximum awards,” said James Reda, managing director of James F. Reda & Associates LLC in New York.

“It is troubling to see companies providing few or no metrics at all in situations where non-discretionary short-term incentive plans are in place,” Reda said. “This makes it difficult to determine whether bonus payouts are consistent with the pre-established goals.”

Reda’s study of Standard & Poor’s top 200 found that 78 percent of those companies allow their boards to use “some degree of discretion in determining bonuses” — often to pay out bonuses where targets aren’t met on the grounds of circumstances that were beyond the executive’s control.

“There are too many ways around situations where executives miss targets,” said Paul Hodgson, senior research associate in the Portland, Maine, office of New York-based GovernanceMetrics International. “There are a lot of awards of discretionary bonuses where boards say, ‘I think you deserve an award anyway because it was a tough year.’

“But the purpose of compensation is to reward performance and punish failure,” Hodgson said. “So when companies take action to reverse that effect, they are basically undermining the whole purpose of awarding performance-based pay.”

ISS also has found numerous instances of discretionary awards. “Boards have paid out discretionary bonuses to executives because there has been some backsliding in executive pay the last few year and they believed some of the things that happened in the economy was beyond the control of executives,” said Bowie.

“So boards have paid executives discretionary bonuses because they felt that they needed to maintain pay at certain levels in order to retain them,” she said.

With regard to the design of LTI plans, Bowie said it’s “a good sign” that in the last few years, some companies have put in place long-term performance plans that “only pay based on meeting some preset performance goals.”

At the same time, she said, there is also growing concern over how companies design long-term incentives. The reason: The uncertain economy has prompted companies to use relative measures that pay out as long as they outperform peers and competitors, and to set goals at the start of each year for three- to five-year long-term incentive plans.

“Because of the economic uncertainty, many companies are pulling back and setting goals at the beginning of each year” for a long-term incentive plan instead of setting them just once at the beginning of the entire length of the long-term incentive period, she said.

“Companies are in an extremely unusual economic situation and that is understandable,” she said. “But that is an unfortunate trend because institutional investors and [other] investors are interested in long-term value. I have a little bit of uneasiness with that approach, but that is the current landscape.”

That uncertainty is also why more companies now use relative measures to determine long-term payouts — even though the use of relative measures has its pros and cons.

“It has become an underlying fundamental problem that companies are finding it difficult to set out meaningful performance targets with any certainty beyond one year, so it has become the norm to do that with both short-term and long-term incentive plans because it helps frame the company’s performance vs. its peer or sector,” said John Ellerman, a founding partner of Pay Governance LLC who is based in Dallas.

“The theory is that we are in a volatile period and even if the market had less than adequate returns, if the company did better than its peers, the executive team did a good job and needs to be rewarded as long as the total shareholder return is positive.”

“One advantage of relative measures is that it helps with the goal-setting process,” agreed Mercer’s Thompson. “Shareholders are rewarded for absolute increases and for how well a company performs relative to the median in their industry.”

Joe Mallin, a managing director and head of the Atlanta office of Pearl Meyer and Partners LLC agreed — but with a caveat.

“Having relative measures can be an aid in getting compensation appropriate as setting the numbers is what is really difficult,” he said. “But at the same time relative measures was one of the crutches companies fell back on” when they found goal-setting to be an exasperating endeavor.

Reda said some companies have switched to relative measures for reasons related to disclosure, not performance. “Companies have switched to relative measures and total shareholder return compared to a peer group for long-term incentives because it is an easier target to disclose” in the proxy statement, Reda said.

Another trend that concerns some experts is using the same measures for short-term and long-term performance plans — because it gives executives the opportunity to double-dip, that is to be rewarded twice for meeting a single-target.

“Attaching metrics to annual bonuses and long-term awards is essential for measuring executive performance,” Hodgson said. “But, unfortunately, it has become relatively common practice to use the same performance metrics to feed both incentives.”

In developing LTI compensation plans the last two years, “companies took advantage” of the stock downturn in 2008 and 2009 “to grant huge numbers of options knowing that their executives would profit from these bargain-basement prices,” he said. “While equity grants serve a purpose, they can also be a source of potential abuse when granted in large numbers at times of historically low stock prices. Market-priced stock options granted during stock market dips will be profitable as long as the stock price returns to level, regardless of an executive’s performance.”

Others have a different view.

“When the stock market was going down, executives were being hurt financially because the majority of their pay is in equity, said Aaron Boyd, research director for executive compensation firm Equilar Inc. in Redwood Shores, Calif. “So the concern that executives will always be paid isn’t true.”

Boyd also pointed out that the value of those options can be “very volatile.”

“It is always hard to tell with equity,” he said. “Right now, all of the stock market is volatile and has dipped down. So the value depends on when they exercise it. But if the executive can increase the value of the firm, they are — and should be — rewarded with a greater degree of equity.”

“To be sure, some shareholders have been up in arms that CEOs got the benefits of grants when stocks were low,” said Andrew Goldstein, a practice leader at Towers Watson of New York. “But there wasn’t any sinister motivation of trying to time the market. It is just that the stock options were made at the depth of the low point of the stock market, so they turned out to be pretty valuable.”

But Mercer’s Thompson pointed out that companies initially went to standardized stock grant dates — usually in the first quarter of the year —- “to avoid charges that they were manipulating grant dates so the executive could benefit.”

“Having standardized consistent dates for when they make their equity awards is a good practice,” Thompson said. “You have to remember that it is not the grant value that goes into the bank account. The value is going to be based on the performance of the company and you need to look at the actual payout to assess pay and performance.”

Goldstein added that “there is more variability to CEO compensation than to shareholder compensation.”

“People look at the large increases year-to-year and forget that the reductions in CEO compensation were pretty steep in 2008 and 2009, and that CEOs got punished more in compensation in 2008 and 2009 than did shareholders.”

The contentious issues with goals and targets for short- and long-term incentive compensation plans underscore the difficulty of the task, said Mallin of Pearl Meyer. “The problem with setting performance objectives is that you are always looking in the rear-view mirror. Companies are always trying to rub the scales together to enhance the linkage between compensation and performance to get their performance they want to achieve,” he said.

Hodgson noted there is a need for “more sophisticated measures” to tie pay to performance; but pay incentive plans should also be uncomplicated, because otherwise “you can’t figure out for what you are being rewarded or why,” he said.

“I am against instruments like stock options that go up and down in line with the stock market and not performance,” Hodgson said. “Basically we need to pull executive compensation down to a base salary and only add on what is absolutely needed to drive the business.”

Mallin doesn’t share that view but he agrees that there can be a disconnect between shareholder value and stock prices.

“Stock prices and shareholder value don’t always move in tandem, as share prices move for reasons other than performance,” Mallin said. “That’s why companies are always looking for that Holy Grail that links to shareholder value. But a single solution doesn’t exist.”

Like it or not, the amount of executive compensation will likely continue to revolve around changes in performance at companies from year-to-year until the economic situation improves.

“Until such time as there is strong evidence of an improved U.S. economy, gains in CEO pay year-over-year will be driven principally by changes in annual bonus tied to changes in company profitability,” said both Ellerman and Ira Kay, managing partner of Pay Governance, in a viewpoint posted on the company’s website in August.

“Long-term incentive compensation will remain flat year-over-year unless there is a strong movement in stock prices, and there appears to be no evidence that capital markets are showing increases in investor confidence that would drive up share prices on a sustained basis,” wrote Ellerman and Kay.


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One-year incentive plans questioned

Published: September 13, 2011 6:00 am ET

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