The economic downturn that began a year ago didn't just trigger pay freezes and pay cuts that extended to the executive ranks.
You also saw reductions in staff, closing of plants, and bonuses not paid, said Jim Aslaksen, global sector leader of the performance materials practice in the Chicago office of Korn/ Ferry International.
The economic nose dive also prompted companies to quickly alter the measures they had been using the past few years for both short-term annual performance payouts and long-term executive compensation. Instead of revenue growth, profit and earnings-per-share targets, many companies switched to working capital, cash flow and return on invested capital to get executives to focus on stability, cost reduction and the efficient use of resources.
Companies are focusing on different measures and drivers, said Andy Goldstein with Washington-based Watson Wyatt Worldwide Inc.
The big one is cash flow, rather than revenue growth or profit growth, because cash is king and because credit and capital markets are tight, said Goldstein, central division practice leader for executive compensation in Watson Wyatt's Chicago office.
James Reda, founder and managing director of James F. Reda & Associates LLC, a compensation consulting firm in New York, agreed.
Companies have shifted short-term incentive-plan performance measures away from capital efficiency and non-financial performance goals to profit and cash flow, said Reda, who analyzed the proxy statements of 200 large companies listed on Standard & Poor's 500 Index.
The analysis, completed in August, also found companies are using more restricted stock and performance shares for long-term incentives rather than stock options, and that they are linking payout of long-term incentives to measures such as capital efficiency, cash flow and total shareholder return.
Companies went to cash flow as a goal for short-term incentives because they are trying to survive, said Reda. On long-term incentives, they went toward encouraging executives to use capital more effectively, which makes sense because that is something more under the executives' control. They can do things like sell underperforming assets, shut down a plant or give people three weeks off without pay.
But while he understands why companies made those changes, Reda said that short-term focus dictated by financial and operating realities isn't necessarily the best way to achieve solid corporate performance long term.
The greater focus on short-term results is counter to the direction [that is needed] to encourage a long-term perspective, said Reda. Companies instead need to subject more compensation to stock-price risk and change the long-term incentive mix away from restricted stock and restricted stock units to a more performance-based program that vests over time.
Executive compensation firm Equilar Inc. in Redwood City, Calif., echoed that sentiment in its 2009 CEO Pay Strategies report.
Improved links between long-term performance and compensation are a critical component of restoring confidence in executive pay programs, said the report. Performance shares are an increasingly attractive equity vehicle because [they] appease shareholders by tying a greater percentage of compensation to specific performance goals, forcing executives to take a long-term perspective and linking more pay to equity.
But that is not what is happening right now. The difficulty with predicting business sales and profit instead has caused many companies to put into place quarterly or semi-annual short plans.
Companies are struggling to set performance standards that remain relevant over the course of an entire year, [so] rather than use annual incentive plans, some firms have adopted quarterly or semi-annual plans that allow for the adjustment of performance targets as prevailing conditions change, the Equilar report said. That allows companies to conserve shares if stock prices improve and, conversely, avoid a situation where entire annual equity grants are severely underwater if stock prices continue to move downward.
At the same time, companies are setting broader ranges for short-term performance targets and lowering the threshold that needs to be reached for an initial payout, said Joe Mallin, the managing director of the Atlanta office of New York-based compensation firm Pearl Meyer & Partners.
Companies had a great deal of difficulty in setting target plans this year because of the uncertainty in the economy, he said. So most companies widened the range and moved the target for the first payout under short-term incentive plans lower because the potential range of outcomes was so wide and difficult to forecast.
If a company in the past set a range of $40 million to $60 million for an operating-income performance metric, he explained, it would be prone to change the range to $30 million to $70 million, with the first payout under the plan occurring at $30 million.
But that type of change doesn't sit well with compensation critics, who see it as simply a way to guarantee that executives meet performance targets.
A lot of companies just put in place umbrella goals to cover every circumstance when they found it hard to develop preset goals when the economy was unsettled in the first three months of the year, said Carol Bowie, who heads RiskMetrics Group Inc.'s Governance Institute in Rockville, Md.
Those types of goals may be 'challenging' in the minds of managers and executive compensation committees; but, in reality, they are easily achievable, she said. It just makes 'performance' pay less performance-oriented because too many programs are set up with easily attainable goals to ensure that there will be compensation for executives in addition to their base salaries.
Charles Elson, director of the John L. Weinberg Center for Corporate Governance at the University of Delaware, agreed.
It appears that many boards have adjusted formulas to keep compensation levels at what they were originally intended to be because the boards are still dominated by the executive team, said Elson, who also is an advisory board member of the Washington-based National Association of Corporate Directors.
With long-term incentives, compensation experts applaud how companies are adding or considering adding vesting provisions so a payout, though fully realized, is parceled out over a longer period of time, or the executive has to stay a specified period of time to receive the payout.
In an effort to force executives to account for long-term corporate performance, many companies are considering increased use of deferred bonus payments, in which bonuses earned over a one-year period are held in escrow for periods of up to five years, Equilar said in its pay strategies report. Considerable pressure is mounting to expand these types of programs.
The other change a number of companies made to 2009 long-term incentives was to grant more stock options, performance shares or restricted stock units, albeit at less nominal value, to compensate for lower stock prices.
Companies are granting more shares, but the incentive has an overall lower value because boards are sensitive to the fact that shareholders have seen their investment shrink, said Goldstein of Watson Wyatt.
Indeed, the value of long-term incentives are down anywhere from 20-40 percent because companies are concerned about share dilution and stockholder anger, and therefore hesitant to offer the number of shares that would be needed to maintain the same value of awards as in previous years.
There is a huge amount of pressure not to be providing a windfall to management, said Aslaksen of Korn/Ferry.
But the strategy of granting more shares, even if they currently have a lower value because of stock price declines, could backfire, compensation experts acknowledge.
There is the potential for a bonanza when stock values return to pre-crash levels, said Goldstein. But boards figure that if that happens, investors will be happy and it won't matter.
But compensation critics scoff at that notion.
Absolute levels of pay need to fall back, said Elson. We need to change the way bonuses and compensation packages of executives are put together.
What is taking place doesn't make sense from my view or from a shareholder's standpoint, said Paul Hodgson, senior research associate for Corporate Library, an executive compensation research firm in Portland, Maine. In many cases, we saw a board say that this is the level of value for compensation we want an executive to achieve in his long-term incentive, so we have to give him more shares, since the stock is devalued.
That allows executives to benefit very handily when the stock rises again, and that is very inappropriate, he said. When the market recovers and stock prices rebound, CEOs will potentially make millions of dollars' worth of profits. This does not align the interest of executives and shareholders. It divorces them.
If the performance isn't there, pay should go down to base salary, contended Hodgson. But few companies do that because those other pieces have come to be expected as part of their compensation.
Compensation consultant Reda concurred.
If many executives don't get their bonus, they are 'sunk' because then they don't have enough money to satisfy their lifestyles, he said. Cash awards are what it takes for them to live the lifestyles they have created. Long-term incentives awards are their wealth creator. Corporate America needs to deflate [its] compensation packages because now that incentive pay far outweighs salary, there is a higher risk associated with pay.
As Reda pointed out, 20 years ago a good long-term payout was twice the executive's base salary and a good short-term payout was roughly 60 percent of his base salary. Today, the typical long-term payout is eight times base salary and the typical short-term payout is 200 percent of salary.
Do we really need to give them the chance to earn these huge incentive bonuses to get them to work? Reda said.
Yet others argue that pay-for-performance plans are working.
Executive compensation is unfairly painted with a dark brush in the United States, and I disagree with that assessment of it, Pearl Meyer's Mallin said. In general, I think the plans worked. I think most companies do compensation pretty well. There is a lot more pay for performance in the business world than the business world is given credit for. Unfortunately, it is the pay for non-performance that winds up getting the headlines.
Goldstein agreed. The conventional wisdom is that executive compensation is broken that there is no alignment or that there is misalignment with pay for performance, he said.
Bonuses have come down. Total compensation has come down. But because of the wealth gap in the U.S. between executives and workers, it is not seen as coming down enough. But that is a socio-political issue. If someone wants to attack absolute levels of pay, there is no answer to that.
Copyright 2009 Crain Communications Inc. All Rights Reserved.