More incentives hang on long haul

James Reda: Long-term pay keeps management focused on long-term value creation.

 “How 2009 bonuses will compare to 2008 bonuses is questionable,” said Mick Thompson with Mercer LLC of New York. “It depends on what happens [with the economy and the stock market] during the last four months of the year.” However, 2009 bonuses probably will be lower than they were in 2007, said compensation specialist Thompson, who is based in Chicago.

As for salaries, “companies are already talking about unwinding salary reductions when we recover and how to do it,” according to Joe Mallin, managing director of the Atlanta office of New York-based Pearl Meyer & Partners.

In fact, most compensation experts expect companies to restore executive and worker pay cuts, lift wage freezes and boost pay by about 3 percent for 2010.

Regardless of what unfolds, one thing is clear: There will be unprecedented scrutiny of executive pay, prompted by the collapse of financial markets in September 2008 that triggered the economic recession.

“A year ago, we thought that executive compensation was under the microscope,” said Andy Goldstein of Washington-based Watson Wyatt Worldwide. “But, in looking back, we had no idea of what under the microscope meant, or of what was coming,” said Goldstein, a practice leader for executive compensation in the firm’s Chicago office.

Now, with a federal pay czar and a slew of proposed reforms from the Securities and Exchange Commission, it is almost certain that Congress will pass a bill to require non-binding shareholder votes on executive compensation packages — known as “say-on-pay.” The measure already has been approved by the House of Representatives.

“Public opinion has been condensed into a general resentment of chief executives’ huge pay packages,” said Dennis Gros, president of Gros Executive Recruiters in Brentwood, Tenn., which focuses on recruiting executives for the packaging and plastics industries.

“Moving forward, all the rules will change,” said Gros. “Investors, singed by catastrophic losses, are vigilant. They will demand that CEOs produce bang before they pay out the buck.

“With every move companies make between now and the next annual report, they will have to ask themselves how shameful could it appear when they have to disclose it,” he said. “Executive pay will be a hot potato for the next year or so.”

Sean Luitjens, marketing vice president at Salary.com in Needham, Mass., agreed.

“There will be more scrutiny of who is getting what and whether it is working,” Luitjens said. “More disclosure rules and say-on-pay will put more of an eye on executive pay. Times are changing, companies must adjust, and there has to be more clarity.”

The SEC is expected to require public companies in their next proxies to include an analysis of risks created by their compensation programs. The SEC also plans to have companies report, in the “Summary Compensation Table” of their proxies, the value of stock awards on the day they were granted as opposed to the accounting value they list now.

Goldstein called that “a positive change and a step in the right direction.”

“But it only partially fixes the problem,” he said. A more accurate calculation would show “realized pay” from the stock grant compared with a company’s performance for that year, he said.

As the recession recedes, more changes may be coming.

Aaron Boyd, a research manager for Equilar Inc., thinks that companies will readjust or review their metrics to see what works best and to make sure that their plans are aligned to company goals. Equilar of Redwood City, Calif., provides the data for Plastics News’ executive compensation ranking.

An area certain to draw attention is whether the incentive compensation package creates too much risk for a corporation, since such packages were fingered as the villain in the financial markets’ collapse.

 “People are going to focus more on the risks around compensation packages — things like too much pay for not enough performance and the risks of rewarding behaviors that are not in the best interest of the shareholders or the corporation,” Mercer’s Thompson said.

Companies must be careful not to set the wrong goals, grant large amounts of pay unconnected to performance, create windfall compensation with large severance payouts or give cash bonuses for a short-term performance that actually causes stock price to drop over time, said James Reda, founder and managing director of James F. Reda & Associates LLC in New York.

To reduce compensation risks, he suggested firms cap bonuses and maximum payouts, require executives to own stock so they have “skin in the game,” and hold executives’ equity gains earned until retirement to keep them from unloading during periods of growth, he said.

But most critical, Reda said, is the need to increase the emphasis on long-term pay.

“Unlike short-term incentives, long-term pay keeps management focused on the long-term value creation and protects shareholders from paying compensation based on short-term results,” he said.

“Companies will have to analyze the risks and ask themselves what aggravates risk and what mitigates risk,” Watson Wyatt’s Goldstein noted. “They don’t want to give shareholders anything extraordinarily different or controversial which could lead to a negative say-on-pay vote.”

Increased scrutiny will likely lead to efforts to tie long-term incentives to performance, and spread payments for achieving long-term goals over an extended period of time.

“Executives will earn bonuses, but companies will hold on to them for a couple of years because they don’t want the executive to walk away with a huge bonus for something that backfires down the road,” as happened with financial institutions, Boyd explained.

Luitjens of Salary.com agreed: “You may see companies try and move vesting out over two or three years with a carrot at the end.” Or, he said, they may put part of the incentive earned into escrow for three years, with the payout hinging on company results down the line.

“A lot more firms are going to make certain that executives do the things that will help the corporation long term and not just cause a short-term payout,” Reda added. “More and more companies are going to use restricted stock for long-term incentives.”

Indeed, for Standard & Poor’s 500 CEOs, restricted stock made up a larger portion of 2008 aggregate pay than stock options for the first time — 33.3 percent compared with 32 percent, according to Equilar research.

But not everyone is sure such changes will be long-standing.

“I think compensation will eventually become a race again sometime in 2010, 2011 or 2012,” Gros said. “Greed has not gotten out of style. When that pot of gold reappears, people will resume chasing it.”

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