The underlying economic conditions that have caused median compensation for CEOs at the largest U.S. corporations to dip more than 15 percent nearly the past two years even as executive compensation in the plastics industry has remained steady and even risen slightly are triggering a number of changes in how companies compensate their executive teams:
* There is greater use of relative and not just absolute measures for calculating long-term incentives. That is, how a company performed relative to its peers can lead to long-term incentive awards for executives even if the company or the executive didn't achieve targets set for performance.
* Companies are requiring executives to hold LTI incentives options longer before they can cash them so the holding period is long enough to maintain a long-term alignment. In addition, the percentage of the LTI award that comes from performance-based stock now often equals the amount that comes from stock options.
* Boards have been given more discretion to use their own judgment to award both one-year bonuses and long-term awards when targets aren't met, or to deny them even if performance levels have been achieved.
* For annual one-year bonuses, more and more companies continue to shift to measures such as cash flow, working capital and return-based measures like the return on assets, equity or investment.
In trying to react to the downturn, companies are putting more and more short-term emphasis on operating profit, cash flow and balance-sheet items such as return on invested capital, efficiency, closing unneeded plants and selling unneeded assets to make companies more productive, said James Reda, founder and managing director of James F. Reda & Associates LLC in New York. Their logic is that if they get the short-term right, then the long-term will be right logically.
Joe Mallin, managing partner and head of the Atlanta office of New York-based compensation firm Pearl Meyer & Partners LLC, agreed. There is more of a private equity mindset. I see it as a positive thing. I think you have to generate more cash than you spend.
Long term, in an effort to keep executives focused on where the company wants to be in the future, more companies are making executives hold options longer, said Christine Oberholzer Skizas, senior consultant and practice leader for executive compensation in the Chicago office of New York-based Towers Watson & Co.
Companies are making sure that the tail on the long-term compensation program is long enough to maintain alignment with goals, she said. They want to remind executives that they are being granted equity to create shareholder alignment and to keep the long-term in mind because the impact of the decisions they make today may not be known for two-to-three years.
We are now talking about a totally different environment and new changes in how companies set performance goals, added Oberholzer Skizas. The most significant changes we are seeing are being made around performance measures. The increased scrutiny of pay and sluggish corporate performance has further focused boards on the calibration of performance goals and accelerated the need to rationalize the business decisions that are made to drive executive compensation.
That pressing need and pressure for companies to explain why they are doing things and how pay programs are aligned with stock price performance will ratchet up yet another level again in 2011 as the financial reforms in the Dodd-Frank financial reform bill approved by Congress in July go into effect, starting as early as January.
Among other things, Dodd-Frank mandates shareholder votes on golden parachutes, requires non-binding shareholder votes on compensation plans (say-on-pay), and mandates that companies com- pare CEO pay to both average worker pay and to corporate performance (see story, Page 7).
But whether the emerging trends will temper compensation, improve the links between performance and pay, or simply lead to different formulas that pay similar or greater sums remains to be seen.
Most compensation experts expect that total compensation will begin to mount again in 2010 and 2011, though not at the rate it did from 2000-08.
I think the increases will be more reasonable, Reda said. I don't see executive compensation doubling again in 10 years or skyrocketing like it did between 2000 and 2008.
He said that LTI awards in 2010 which provide roughly 70 percent of total annual executive pay will most likely return to the levels of 2008. But you will not see LTI awards tripling like they did between 1999 and 2008.
Mallin agreed: I think plastics companies and manufacturers will continue to restrain compensation, particularly in salaries and in annual incentive awards. I don't see huge changes because manufacturers still don't know what the future holds relative to the economy. There will be some snap-back in long-term incentive awards but I don't see them going back up 20-25 percent.
Even with the expected tempering of increases, another potential public relations and image problem is lurking around the corner. The reason? Experts say another backlash could occur if the stock market continues to rebound and executives get what is being labeled as rebound pay when they cash in on their 2009 stock options many granted in March 2009, when the stock market was at a 20-year-low.
Companies granted more shares, but at lower values, said Aaron Boyd, research manager for Equilar Inc., an executive compensation research firm in Redwood City, Calif., that provided the data for Plastics News' ranking. What's more, since many of those options don't expire until 2013, CEOs are looking at big gains, he said.
Even if stock prices stay [where they are now] for the next couple of years, some of these executives are going to get a large payout. If people are struggling financially and can't pay their bills and see executive pay quickly rebounding, they will start getting upset that executives are walking away with all this money, Boyd said.
You could have a whipsawing effect as stock prices and markets go up, Pearl Meyer's Mallin noted.
Two other contentious issues involve the proliferation and use of relative performance measures to grant LTI awards and the trend to give boards more discretion over whether to grant compensation awards.
In 2009, we saw discretion assuming a bigger role since there was a great deal of difficulty in setting targets in an uncertain economy, Mallin said. Some companies even went to a completely discretionary annual incentive plan so they could come back at the end of the year and make a decision based on what happened.
Compensation committees didn't feel comfortable just blindly following the program and the goals they set with their best judgment for 2009 because of the economic uncertainty, agreed Oberholzer Skizas of Towers Watson.
That practice of board discretion is not just confined to a handful of companies. More than half the companies now have a discretionary component in their compensation plans and are paying bonuses based on the judgment of the board of directors, Reda said. That is a big change from five years ago.
Not surprisingly, the trend doesn't sit well with everyone.
To say that in a down year that it wasn't their fault and we will give you more pay is like having your cake and eating it, too; because in a good year, boards are more than willing to award CEOs pay when corporate performance is boosted by factors unrelated to CEO performance, said Paul Hodgson, senior research associate for executive and director compensation with the Corporate Library in Portland, Maine.
Justin Levis, senior research associate with the Council of Institutional Investors in Washington, agreed. If companies are going to use discretion, the onus will be on them to prove to the public and shareholders that a discretionary bonus is tied to performance and not just an impulse, or a tactic to award bonuses when targets aren't met.
But others argue that an analysis of how compensation committees exercised that discretionary power in 2009 shows that their judgments were fair.
For example, an Equilar analysis showed that the median value of discretionary cash awards in 2009 for CEOs at Standard & Poor's 500 companies declined 20.5 percent from $860,000 in 2008 to $683,323 in 2009.
Negative discretion was used in many cases, said Oberholzer Skizas. At the end of the year, many compensation committees felt that the goals they set didn't reflect the actual business environment.
Another analysis, by Pearl Meyer, found that 63 percent of companies used downward discretion in 2009.
Even though discretionary judgment is traditionally viewed negatively, in reality, the judgment has been pretty even-handed, Mallin said. A lot of committees did the right thing, and didn't give executives a payout in 2009 because they looked at results and decided a bonus wasn't appropriate. It wasn't my observation that it was always a win for management.
It makes sense to look at targets within the context of a changing economic environment.
A second concern is that companies are hedging their bets with payouts on LTI plans by changing the targets more frequently and adopting relative measures that pay executives when targets are not met, as long as the company performs better than its peers.
Faced with the realization that the performance goals set in 2008 and in early 2009 would likely be unattainable, a number of companies adjusted their existing incentives, Equilar said in its analysis of 2009 pay trends among CEOs on the S& P 500. In some cases, old performance awards were amended to provide for shorter or longer performance periods. Other companies adopted relative measures so they can compare performance with similar companies.
Mallin agreed. Many companies did not have a clue as to what the future looked like, so you saw some companies reduce the time frame for adjusting long-term incentives to every six months so they could be reviewed and updated and the appropriate adjustments made.
George Paulin, the Los Angeles-based founder and CEO of Frederick W. Cook & Co. Inc. in New York, doesn't think that makes sense.
Having one-year or shorter goals in a three-year LTI plan makes it more predictable, which is not what you want in a long-term compensation plan, Paulin said at a recent Equilar conference on executive compensation. If you want executives to manage for the long-term, you have to establish long-term goals and stick to them.
Philadephia-based Hay Group's Irv Becker agreed. There is some concern over companies going to one-year and shorter metrics for long-term incentive plans, Becker said at the same conference. That is too much emphasis on one-year performance. I hope that trend reverses and companies go back to a three-year cycle for LTI.
Hay's national practice leader in executive compensation, Becker also questions using measures to gauge performance relative to competitors. A lot of companies are now splitting LTI incentives 50-50 between absolute performance and relative performance to hedge their bets in the eventuality that performance turns sour, he said. That undermines the need for executives to hit specific goals to be rewarded.
That trend like granting boards discretionary power to make bonus awards is also growing at a rapid pace.
An analysis by Reda & Associates found that 53 percent of the 200 largest U.S. firms use a relative measure in their LTI plans. Similarly, an Equilar study found that 32 percent of the largest S&P 500 firms used relative goals, 50 percent used absolute goals and 18 percent used both.
What is causing that shift to relative measures? According to Equilar's Boyd it is a function of people realizing how difficult it is to set goals as to where they are going to be in three years.
And, if you look at performance from an absolute standpoint, you might conclude they are not doing a good job, he said. But you have to ask yourself, did the company do well in relation to its peers, because the executive might have actually done a good job to minimize the impact on the company from outside factors. It is a more valid analysis of the company's position in the marketplace.
Reda agreed: You should get some payout if you outperform your peers in a downtown, because, in theory, you have put your company in a better position to prosper, profit and grow when the economy recovers.
If you outperform your peers, you will get a payout. If you don't, you won't. In my mind, if you do better than your peers, you are using my investment dollars better.