The recession — and pressure from stockholders and large proxy advisory groups — has triggered a significant change in how companies are evaluating executive performance and also in how they are structuring long-term incentive plans.
“Since 2009, there has been a dramatic increase in plans where stock grants are tied to performance, and how much CEO pay is in the form of LTI,” said Christine Oberholzer Skizas, a partner in the Chicago office of New York-based Pay Governance LLC, an independent executive compensation consulting firm. “In 2010, roughly 50 percent of CEO pay was in the form of LTI. In 2011, it was closer to 60 percent.”
The numbers from Mick Thompson of New York-based Mercer Inc. are even higher. “In 2009, 58 percent of companies were tying LTI directly to performance,” said Thompson, a Chicago-based principal in Mercer's human capital consulting business. “In 2011, it was 68 percent.”
“Companies are continuing to move toward performance share plans,” agreed James Reda, managing director of James F. Reda & Associates LLC, an independent compensation consulting firm in New York. “They are trying to align pay with performance either because they feel compelled or forced to do that, or because they think it makes sense.”
The drivers behind the changes in LTI plans the past five years include new disclosure rules from the Securities and Exchange Commission, changes triggered by the Dodd-Frank reform bill, the economic downturn and the non-binding shareholder say-on-pay votes, now in their second year.
“Many companies are reviewing their incentive programs to ensure there is a link between performance achievement for the company, and executive and performance achievement for the shareholders, [because] a pay-for-performance disconnect ... exposes senior management and the board of directors to unwelcome scrutiny,” Reda said.
“What we've seen in the last three to four years is that executives are getting shares, but to get them they have to hit their performance goals — whether it is earnings-per-share growth, growth of the stock price, or some other sort of achievement,” said Aaron Boyd, research director at executive compensation research firm Equilar Inc., based in Redwood Shores, Calif.
As for determining what those performance goals should be, firms are shifting more and more toward relative measures, with relative total shareholder return (TSR) rapidly moving up the list.
“Any element of relative performance was certainly less prevalent back then than today,” said Andrew Goldstein, a practice leader for executive compensation in the Chicago office of New York-based Towers Watson.
“Relative total shareholder return is growing in popularity,” Goldstein said. “The other long-term metric that seems to be getting a lot more attention is return on capital, because it incorporates both the income statement and the balance sheet and is key to delivering improvement in the stock price.”
Thompson agreed: “Ten years ago, LTIs were almost exclusively stock options, and financial measures were tied to absolute performance — now it is performance-oriented financial measures and relative performance measures.”
That has had the net effect of making LTI plans “more complex and diverse,” said Reda, who examined the 2012 proxies of the top 200 Standard & Poor's public companies. “Companies are using more measures than they did five, six, seven years ago, as well as more relative measures.”
His analysis found that 68 percent of companies used two to four performance measures in 2011, compared with just 41 percent in 2008.
Reda's analysis found that the most-used LTI economic measures are earnings per share, TSR and some type of capital efficiency measure — such as return on invested capital, return on equity, return on capital, return on net assets, economic profit and economic value added.
Slightly more than 0.03 percent of the LTI incentive pay mix in 2011 was stock options or stock appreciation rights — down more than five percentage points from 2008, according to Reda. Another 41.6 percent of the LTI pay mix was performance-based stock or cash and 23.7 percent was restricted stock units — both up from 2008
“Stock options are now the smallest part” of the weight of the LTI mix, he said, with the percentage of firms that made stock option grants shrinking in 2011 to 69.1 percent, down from 76.4 percent in 2008.
Conversely, companies providing performance-based grants increased significantly in that same three-year time. About 61.8 percent granted restricted stock in 2011, up from 48.2 percent in 2008; and 65.5 percent granted performance-based performance shares, up from 54.9 percent in 2008.
Relative TSR, for example, is becoming more popular because “it can be used to gauge whether a company is performing better than its peers and because it is self-adjusting and not tied to budgetary or business condition concerns,” he said.
“If the company does well against its business plan, but underperforms in its industry, the incentive payout [based on relative TSR] will fairly reflect overall performance,” Reda said. “If a company does not hit its internal goals, but outperforms its peers and/or the broader stock market,” there will be some level of payout that will be deserved, he said.
“If you do well, you get paid. If you don't, you don't,” said Joe Mallin, head of the Atlanta office and a managing director of Pearl Meyer and Partners LLC of New York.
Using relative TSR also means companies don't have to worry as much about forecasting how earnings, stock price or other measures will end up in the long term, he said.
Perhaps even more significant is that shareholders — who now vote on executive compensation packages — view relative TSR as a measure that drives stock prices higher and rewards executives only when companies perform well.
“Companies have recognized that what stockholders care about at the end of the day is stock price, because the only way investors make money is if the stock prices goes up,” said Equilar's Boyd. “It is a relatively simple measure; people get it.”
It protects an executive's pay when overall market conditions hurt stock prices but a company does better than its peers, which shows “alignment” to both shareholders and the executive, Boyd said. “That lower stock price could be because of external factors beyond a CEO's control,” he added.
Others, however, warn that using TSR is not a panacea and must be used with caution.
Using either absolute or relative TSR “falls short of fulfilling one of the basic tenets of an incentive plan: line of sight,” Pay Governance said in a recent statement.
“TSR does not necessarily assure strong line of sight, as relative TSR can be significantly affected by macro/external factors — but not necessarily by financial/operational performance results.
“The use of relative TSR as a performance measure creates a critical, unusual trade-off: strong pay delivery [which pleases shareholders], yet a weak incentive for executives who cannot directly affect the stock price of the company over the short term or ... the TSR results of companies” in the peer group against which the company is being judged.
Reda agreed: “Using relative TSR has some advantages, but also has potential drawbacks compared with a more traditional mix of equity with other long-term performance measures.
“The management team has no control over the outcome of relative TSR, [so] there is little or no incentive for executives. So it doesn't focus the management team,” he said.
He also pointed out that relative TSR “can be at odds with long-term performance goals” and a company typically must outperform just a third of its competitors for the management team to get some type of reward.
“You don't want TSR to be your only measure,” Reda warned. “You also want to have something more intrinsic to the company, such as return on invested capital, because you want a measure that the executive can influence.
“Stock price performance typically follows financial performance,” Reda said. “That is, demonstrated earnings growth will result in stock price performance — not the other way around. Relative TSR plans provide very little direct motivation for executives to achieve financial performance.”
Mallin said, “The downside of relative TSR is that an executive doesn't have total control and can't always influence the stock price.”
Despite that, the consensus is that relative TSR is here to stay.
“The use of relative TSR is likely to increase in prevalence as companies continue to review their executive compensation programs to ensure the strongest possible relationship between pay and performance outcomes and to minimize potential external criticisms,” Pay Governance said.
To deliver long-term TSR, companies must balance the goal of “retaining and maintaining a highly qualified, committed executive team” with projecting a positive sense of their compensation plans.