HRMN 395-Week 7: Putting it all together
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Groysberg-CompensationPackagesThatActuallyDrivePerformance.pdf
COMPENSATION
PHOTOGRAPHER
KEVIN TWOMEY
AUTHORS
Principles for designing executive pay
Compensation Packages
That Actually Drive
Performance
Boris Groysberg Professor, Harvard Business School
Sarah Abbott Research associate, Harvard Business School
Michael R. Marino Managing director, FW Cook
Metin Aksoy Managing director, FW Cook
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When it’s managed poorly, the eects can be devastating: the loss of key talent, demotivation, misaligned objectives, and poor shareholder returns. Given the high stakes, it’s critical for boards and management teams to get compensa tion right.
Many struggle with this challenge. One problem is that only a few best practices work in all situations. So it’s imper ative for companies to start with clear strategies and for their leaders to understand the basic elements of compensation and ways to link it to desired outcomes.
In this article we’ll describe how rms approach execu tive compensation and how some have used it to improve performance, sharing insights from our research and expe riences. Two of us (Boris and Sarah) have studied compen sation for over a decade. The other two (Mike and Metin) have more than 30 years of combined experience advising a broad range of companies on executive compensation.
We’ll draw on FW Cook’s analysis of executive comp at companies in the Russell 3000, an index of the top 3,000
U.S. stocks by market capitalization, from its 2019 Annual Incentive Plan Report, and from its 2018 Global Top 250 Compensation Survey. We’ll also draw on Harvard Business School’s extensive research on boards of directors, including quantitative data from a survey of 5,000plus global board members. We’ll share some perspectives we gained from indepth interviews with more than 100 directors of public and private companies from over a dozen countries. Last, we’ll discuss how the recent pandemic and economic crisis will inevitably change the thinking on compensation.
How Boards Approach Executive Compensation When making decisions about compensation, many directors look at the large amount of data available on executive pay. U.S. regulations require every publicly traded company to disclose the amount and type of compensation given to its CEO and CFO and other highly paid executives, as well as the criteria used in setting it.
IDEA IN BRIEF
THE FINDING When executive pay is structured to align with corporate strategy, it can drive better performance.
THE CHALLENGE Many rms strule to achieve this alignment, and only a few best practices work in all situations.
THE RECOMMENDATION The company must start with a clear strategic objective and then consider several trade-offs as it designs compensation packages.
Decisions about executive pay can have an indelible impact on a company. When compensation is managed carefully, it aligns people’s behavior with the company’s strategy and generates better performance.
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Thirty-three percent of companies with formulaic annual incentives incorporate a performance modier, which provides a check on the primary metrics by adjusting payouts up or down. Some modiers only tweak results (increasing or decreasing payouts by 5% or less) while others have a meaningful impact (altering payouts by 20% to 25%). They’re commonly based on nonnancial metrics—like safety, customer service, and employee engagement—and often incorporate elements of individual performance.
As organizations work their way through the Covid- related economic crisis, we fully expect to see changes in approach. Many companies, for instance, have cut pay for senior executives—though these cuts are largely temporary and apply just to base salary. More pressing will be how to think about the goals embedded within incentive plans. Many targets won’t be achievable given the new nancial realities and thus will no longer serve as eective incentives.
In light of this, companies have begun considering a range of moves: adjusting performance metrics but capping pay- outs, revising goals for the year, and committing to monitor the situation but not take action yet. For multiyear plans, the options being discussed include deemphasizing 2020 results in award calculations, adjusting the payout curve, shortening the performance period, instituting new awards with relative performance metrics, adding relative total shareholder returns as a modier, and paying out awards in cash rather than shares. Discussions about whether or not to reprice options, a controversial practice, have also taken place.
The silver lining here is that the crisis oers companies an important opportunity to revisit incentive programs and incorporate metrics that serve stakeholder interests in a broader and more meaningful way.
The Four Dimensions of Compensation Design Modern compensation systems can generally be analyzed along four dimensions: xed versus variable, short-term versus long-term, cash versus equity, and individual versus group. The factors that drive choices include the rm’s stra- tegic objectives, ability to attract and retain talent, ownership structure, culture, corporate governance, and cash ow. Within the Russell 3000 Index, companies focus on aligning pay and company performance—something stakeholders
expect. But particularly outside the United States, companies may have to take into account other factors, such as seniority. Fixed versus variable.Total direct compensation is made
up of a base salary (set in advance and paid in cash) and short- term and long-term incentives. Both kinds of incentives are variable or at-risk elements and may be contingent on the achievement of certain organizational or individual goals. Awards can be based on an established formula or at the dis- cretion of management or the board’s compensation commit- tee. Our analysis of the compensation of the ve highest- paid executives at Russell 3000 companies shows that on average 82% of their compensation is variable; the rest is base salary. The mix of xed and variable components is driven primarily by company size and industry, and to some extent, company- specic factors like culture and risk appetite.
The breakdown between xed and variable comp is relatively consistent across industries, although telecom, technology, and energy companies pay a slightly higher percentage of variable compensation. Financial services, materials, and utility companies pay a slightly higher percentage of xed. The balance is also relatively consistent across U.S. and non-U.S. companies. But there are notable dierences across market caps: Small-cap companies put 69% of compensation in the form of variable payments, and large-cap companies 87%.
The directors we interviewed insisted that variable pay was an important component of executive compensation. As one commented, “I’m a strong believer that CEO compensa- tion needs to be in large part at risk. I would like to see at least 70% to 80% of the CEO’s pay at risk, with less emphasis on building too high a base salary that insulates the CEO from the eect of poor performance.” Short- versus long-term.A second dimension is the
extent to which variable compensation is paid out in the year it is awarded or deferred and paid over some future period. This applies to awards where the amount (a specied cash payment or a xed number of shares) is established up front and where it’s based on meeting specied future hurdles. Short-term variable compensation generally takes the form of cash; long-term generally is delivered in equity, through instruments such as stock options, restricted stock, and performance shares. (See the sidebar “The Elements of Long- Term Compensation.”)
Because of the Covid-related economic crisis, many performance targets won’t be achievable and will no longer be effective incentives.
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On average, 28% of senior executives’ variable compensa- tion is paid the year it’s awarded (or immediately thereafter), and 72% is paid in future years. At the high end of the spec- trum, technology companies pay 83% of variable comp in long-term awards, health care companies 81%, and telecom companies 80%. At the other end, nancial rms pay only 60% of variable compensation in long-term awards.
Long-term compensation generally involves multiple overlapping cycles. Awards earned in 2018 may be payable in 2018, 2019, and 2020, but the executive receiving them may also get payments in 2018 from plans put in place in 2016 and 2017. Some companies, however, choose to make all grants up front (for example, giving three to ve years of awards upon hiring or after another signicant event without subsequent annual grants).
Companies undergoing a transformation usually empha- size short-term rather than long-term compensation to encourage fast change. The mix may also reect other busi- ness practicalities. Companies with less cash, for example, may focus on long-term compensation.
Business cycles are another factor. A director we talked to described his experience with designing executive com- pensation at his company this way: “It’s a long-cycle capital business, and most of the management team’s compensation is three to ve years out.” He added that while executive compensation is to some extent set by market practice, the makeup of it should be determined by the company’s strat- egy. “Is the compensation incenting sustainable long-term behavior that gets the organization where it wants to go, or is it really short-term-oriented?” he said.
Cash versus equity. Our analysis showed that on average 41% of senior executive compensation is paid in cash, and 59% in equity. The mix is often determined by business matu- rity. Young companies tend to rely a lot on equity to attract and retain key employees if cash is scarce. The percentage of equity compensation is notably higher for large-cap compa- nies (63%) than for small-cap companies (48%), however. Technology, telecom, health care, and energy companies put the largest percentage of pay in the form of equity.
One director we interviewed noted that equity compensa- tion encourages executives to think like owners. He detailed two experiences he had—one with a CEO who had a signi- cant equity stake in the company, and one with a CEO who
ABOUT THE ART
Kevin Twomey photographs the complex inner workings of antique calculators, using his training in theatrical lighting to discover the objects’ emotive appeal.
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benet if the turnaround succeeded and the stock price hit certain targets. Thanks to the cost reductions and cash gen- eration rewarded by the annual incentives, the company was able to hang on until oil prices rebounded. Meanwhile, the stock option plan helped it retain and engage employees in a dicult and demotivating business environment.
Note that in certain turnaround scenarios, when condi- tions are highly volatile or a company is in distress, it may make sense to move to semiannual and quarterly goals, to align incentives with critical short-term objectives.
PRIMARY OBJECTIVE
Transform the Business A public company was pursuing an aggressive new growth strategy after a recent business reorganization. But it was risky, and the rm wanted executives’ incentives to reect that. So it made a large amount of management’s pay contin- gent on successfully executing the strategy, which included entering new product markets, changing sales channels, and expanding geographic reach. The compensation committee dened success as a signicant increase in shareholder value over three years. In other words, the market would determine whether the executives had implemented the strategy well.
When setting long-term incentives, the committee decided to deviate from the norm in three key ways. First it chose to front-load three years of awards and forgo future annual awards. Second the awards were delivered only if the rm hit certain share-price targets. Third the awards were based on a scale, and the targets and vesting schedules were set so that average performance resulted in minimal awards. However, under this plan executives would be rewarded for the risks they took because they could get more compensation sooner than they would have under a traditional approach.
PRIMARY OBJECTIVE
Compete Effectively with Public Companies as a Private Organization Private companies are often in a war for talent with public rivals that have a powerful tool at their disposal: equity. To address this challenge, one private rm explored two
Because long-term incentives make up the majority of executive compensation and have the most variations, they deserve special attention. Key vehicles include:
Restricted stock. Restricted shares are essentially common shares that cannot be sold immediately. They become sellable according to a vesting schedule, which encourages retention. However, the benets of stock ownership (such as dividends) often accrue from the time of the award.
Stock options. These give employees the right to purchase stock at a predetermined price (the exercise price) during a set period (the term). The stock price must improve for the award to have value.
Stock-appreciation rights. Like options, these increase in value if the stock price rises, and may expire. Unlike options, they don’t have to be exercised. Instead employees receive the value of the appreciation in shares or in cash.
Performance shares. These are stock allocations that are distributed only when preestablished goals, such as operating or nancial results or stock or shareholder returns, are achieved. The goals may be absolute targets or based on performance relative to peers’.
Phantom equity. This cash- based award is structured to mimic an equity award. The value of a company’s equity is tracked over time and determines the amount executives receive.
The Elements of Long- Term Compensation
potential solutions. First it considered paying above-market cash compensation (base and bonus). But that would have increased annual cash costs signicantly without fostering a sense of ownership, linking compensation to better perfor- mance, or creating multiyear accountability.
Next the company considered three long-term incentives that could compete with public competitors’ packages: real equity (which the company ruled out because it intended to remain private and therefore had no simple liquidity mech- anism), phantom equity (ruled out because of complexities in design, administration, and communication, particularly around valuation methodology), and multiyear cash incen- tives, which it ultimately adopted.
The chosen plan used three-year cumulative EBITDA as a performance metric, and awards weren’t vested and paid out until the end of year three. To maximize retention, the payout was back-end-weighted: 20% in year three, 30% in year four, and 50% in year ve.
While a multiyear cash-incentive plan doesn’t create an ownership mentality, it is a highly eective, easy-to-
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understand way to tie compensation to achieving agreed- upon objectives or performance superior to peers’ for several years. This approach encouraged executives to remain at the company and served it well.
PRIMARY OBJECTIVE
Foster Alignment with Owners and a Long-Term Orientation When Traditional Equity Is Unavailable At a private family business that wanted to strengthen the alignment between employees and the owners, the existing compensation program provided base salaries and annual incentives only and no long-term incentives. That reinforced short-term thinking, which conicted with the risk-seeking entrepreneurial focus of the company’s founders. To remedy this, the compensation committee worked with management and family members to redesign the rm’s approach to pay.
After considering phantom equity (which oers employ- ees the benets of stock ownership without giving them company stock) and long-term-performance cash bonuses, the company settled on an economic-prot-sharing program. Each year the compensation committee looked at prots, subtracted the cost of capital, and put 20% of the resulting amount into a prot-sharing pool for employees. To lengthen the time horizon, the pool was not paid out in the year it was earned but instead was put into a “banking” system. Each participating employee had his or her own bank, and the annual contribution to it was based on a formula that allowed adjustments for performance. If the economic prot in a given year was negative, the bank’s balance would fall. If it was positive, the balance increased. Employees received
a third of their banks every year, and two-thirds were rolled forward. The plan helped employees adopt a long view but didn’t require management to set specic long-term goals.
Challenges and Opportunity Norms for key aspects of executive compensation clearly exist, but as the data shows, they vary to some degree by industry, geography, and company size. In addition, under- lying any norms are individual decisions and solutions tailored to company needs and strategies.
In the immediate future, we expect business condi- tions to remain uncertain and changeable, complicating the design of executive incentives. How this will all play out is anyone’s guess, but we know that employee health and safety have taken on new signicance to virtually all companies. Enterprisewide liquidity also has new impor- tance. In the past liquidity concerns arose primarily when external capital became scarce. Now they spring more from internal cash-ow issues. Liquidity and employee health are just two of the areas we expect incentive plans to start tying metrics to. Indeed, the current environment oers an opportunity to revisit plans with an eye toward incorporat- ing measures that serve stakeholder interests in a broader and more meaningful way. HBR Reprint R2101J
BORIS GROYSBERG is the Richard P. Chapman Professor of Business Administration at Harvard Business School, a faculty
afliate at the HBS Gender Initiative, and the coauthor, with Michael Slind, of Talk, Inc. (Harvard Business Review Press, 2012). Twitter: @bgroysberg. SARAH ABBOTT is a research associate at Harvard Business School. MICHAEL R. MARINO and METIN AKSOY are managing directors at FW Cook.
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