Despite the fact that the last five years have challenged the global markets to deal with such unexpected events as the Covid-19 pandemic, the war in Ukraine, the Great Resignation, and not to mention tax and accounting law reforms across the US and the EU, turning the operational strategies of most companies upside down, the performance-based long-term incentive grant prevalence has never been more stable.
According to the FW Cook 2021 Report, 92% of the companies use performance-based awards in their LTI plans. This is just 2% down from 2019 and 2016. In fact, the average CEO’s long-term incentive package consists of 58% of the performance awards - up from 55% in 2016.
Since the performance-based LTIPs are pretty much universally present across most companies’ CEO compensation packages and they form quite a substantial part of the executive’s remuneration, the selection of appropriate performance metrics is a critical decision for compensation committees of virtually every company.
The right choice of performance metrics can not only align the executive decisions with those of shareholders but be a primary driver behind the successful business strategy, create a unique company culture, and secure the long-term position of the enterprise.
This is the first article in the three-part guide, in which I detail the entire process of the performance metrics selection for the executive long-term incentive plans. In this part, I discuss what indeed pay-for-performance is, define the performance compensation metrics, and suggest 9 basic questions you should consider before approaching the metric selection process.
Currently paying for performance is the most popular way to evaluate an executive’s accomplishments.
The performance-based compensation, especially in the context of long-term incentive plans, has been steadily increasing over the last 15 years across all types of organizations and all sectors. According to 2021 FW Cook Top 250 Report, in 2009 50% of LTI plans of CEO’s at S&P 500 companies were based on performance. In 2021 already 92%. The widespread adoption of the pay-for-performance plans is not limited to the publicly traded enterprise-size companies, but the trend trickles down also to the smaller family-owned businesses and start-ups.
But what exactly do we mean by pay for performance in the context of executive compensation?
We can think of it as a type of compensation that links the executive’s pay to the company’s success as measured with certain pre-determined metrics. The metrics, especially in the long-term incentive plans, can be carefully designed to encourage the C-suite to make the moves that will ultimately benefit the shareholders and help achieve particular goals.
If the executive does not hit those benchmarks they forfeit the award. On the other hand, if they exceed the goals, the payout is proportionately larger. The board can also instill metrics that make relatively small adjustments to the payout based on their completion.
Variable pay in executive compensation has been steadily rising
In fact, the amount of variable pay in the executive compensation at the privately held companies has been rising with the median CEO annual incentive pay level in 2021 hitting 65% of the total salary and the median for the target long-term incentive award opportunity increasing to 100% of the total remuneration. For the public companies, these numbers are yet higher, with median long-term incentives for the emerging entities equal to 150%, middle-up to 240%, and stable amounting to the whopping 325% of the base salary.
There is a number of performance-based variable bonuses that we commonly see in executive compensation packages, including:
The key to performance-based pay is the right choice of metrics followed by a rigorous methodological approach and backed by inter-departmental analysis and accountability. If these conditions are satisfied short-term incentives, LTI plans, and other performance conditions incorporated in CEO contracts can successfully stimulate the executives to achieve the company’s goals.
On the most basic level, compensation metrics are vehicles used to measure the effectiveness of the executive’s work.
Depending on the metric, the CEO’s performance may be measured against the company’s profits, in the case of financial metrics, or against any other policy whose fulfillment is in the organization’s interest - the so-called non-financial metrics.
If picked correctly, metrics will let you analyze the person’s performance with respect to the set standards and longitudinal schedules, help to make adjustments to the plans and goals, and direct towards possible improvements of the company’s practices and policies. The incentive metrics also provide information on how the particular executive fairs against his or her peers.
The compensation metrics are the core element of the variable performance-based component of every executive compensation package and the key to providing effective and attractive pay structures within the organization. Therefore you should choose the right amalgam of metrics with utmost care and understand those choices well so that they can be clearly explained to the recipients, board members, and stakeholders alike.
Below I discuss 8 basic questions that should be taken into consideration during the performance metrics selection process:
Nothing will be more valuable in helping you choose the right incentive metrics than a solid and wide understanding of various aspects that influence the organization of the firm and in the end drive its success.
Those factors are typically wide-ranging and affect multiple departments. Assembling a team of cross-departmental experts and analysts to focus on the metric selection and compliance with executive compensation laws will not only help you gain a deep understanding of the core matters of the company but allow you to see those from different angles, from the unique perspective of each department.
In order to determine the LTIP performance metrics correctly, the team responsible for their selection must be aware of all this activity. Only in this way, you will be in a position to carefully balance the executive and investor interests. And to be able to provide a detailed rationale behind the LTI plan design and communicate those justifications with both groups in a fair and transparent way. The strong inter-departmental collaboration will assure that your team is well prepared to create effective incentive metrics for the executive compensation package.
Since the main role of the incentive plans is the alignment of the executive interests with those of stakeholders, it’s crucial to determine the firm’s business strategy. Short-term strategies will form the basis for selecting metrics for the short-term incentive plans, spot bonuses, and project completion plans, while long-range goals must inform the decision-making with respect to annual and long-term incentive plan metrics.
The metrics should be possibly closely correlated to the success measures of the company as defined by the board and the management, and they should complement the internal communication of the firm’s performance. In the case of the publicly traded companies, the selected performance metrics should also match the messages provided in the investor presentations and securities and exchange commission reports, especially the say-on-pay and the proxy statements.
Strong company culture promotes the establishment of strong processes.
Top-down control and rigid management won’t foster the right behaviors, these emerge naturally when the processes, culture, and metrics are aligned. Hence, consider the inclusion of non-financial metrics and metric modifiers that support the development of best practices within your particular organization. In this way, you will build the C-suite with a strong sense of ownership, commitment, and long-term vision.
Executives who act like owners, not only will coordinate key decisions with the myriad of organizational choices needed for their implementation, but also by setting the right example will instill a sense of ownership throughout the company, making others feel equally responsible for the firm’s fate and accountable to shareholders.
When considering both financial and non-financial metrics to measure the performance for the long-term incentive plan and executive pay as a whole, choose those that will ultimately encourage long-term value creation.
This is particularly important for the companies that are new or in the phase of fast growth. Certain metrics, in detail discussed in the 2nd part of this article, can be used to encourage profit allocations towards goals that won’t bring immediate rewards but will create value long-term, for example, investments, innovation, acquisitions, etc. If you also assign the larger part of the executive compensation package to LTIs, rather than STIs or the base salary, you will additionally strengthen that effect.
This is the strategy taken by Exon Mobil, which invests in a wide range of projects with a variety of assets and technologies. The LTI plans with longer restriction periods encourage the executives to keep the long-term outlook, especially in a cyclical commodity price environment.
This is actually a new concept raised by the researchers Pierre Chaigneau, Alex Edmans, and Daniel Gottlieb, who call into question the common practice of tying performance-based executive compensation to metrics that actually measure the value of the firm and not the one added by the CEO to the firm.
Typically the metrics in performance-based deferred compensation plans such as LTIPs affect the number of shares received by the executive, provided the targets are hit (if they aren’t, the reward is not granted). However, these researchers argue that the number of shares is not the only variable element that can determine the total compensation outcome.
In fact, they see the strike price of the share as the one that is more closely correlated with the actual effective performance of the executive. This is because the strike price affects the level of pay and not the pay-performance sensitivity defined as the change in the CEO’s pay associated with the change in shareholder’s wealth.
Chaigneau et al. believe that if the CEO has a limited influence on the stock price, by working in a heavily regulated industry for example, or the stock price is quite volatile and we cannot eliminate the macroeconomic noise that disturbs the accurate performance measure, then the executive’s pay-out should not be sensitive to the stock price, meaning a number of shares should be limited.
Instead, if the performance is compelling, it’s the strike price that should be lowered - effectively increasing the CEO’s payout. Hence, when you use performance measures such as earnings, margin, return, or any ESG incentives you may use them to determine the share’s strike price instead of the number of vesting shares.
As Chaigneau explains: “The number of vesting options should depend on performance measures that don’t actually measure CEO performance. Our analysis shows that vesting should depend on factors that affect the accuracy of the stock price, such as industry or market volatility, which have very little to do with the CEO. Any ‘performance measure’ that is truly an assessment of the CEO’s effort should affect the strike price. [...] Most performance measures should affect the threshold required to trigger a payment, rather than how fast pay rises with performance if the threshold is hit.”
By making the threshold of the strike price variable you effectively stimulate the executive to increase the stock price long-term. This is also quite beneficial to the shareholder value, whose TSR in that case will ultimately increase. And if the stock price is low, the executive pay is low as well, preventing the situation where the company would have to provide a large cash compensation despite the unfavorable market conditions - as is the case with cash bonuses.
Linking executive pay to the strike price solves also the problem of share dilution - you can still provide solid earnings and ownership without actually giving away a large number of shares. Just because of these benefits, it is worth considering granting executive compensation incentives paid out on the variable strike price.
Long-term incentive plans with correctly set metrics are particularly well suited to embedding the stakeholder within shareholder value. The longitudinal outlook resolves the apparent tension between the executive management and the shareholders. In fact, from the perspective of several years, the strong corporate purpose manifested in the stability, employee up-, and re-skilling, high efficiency of the processes, and other factors outweigh any negative short-term effects caused by the long-term investments.
Actually, it is the firms with such visionary mindset that outperform their peers with low company purpose by a 20% advantage in annualized TSR and double their market value four times faster. The right mix of financial and non-financial incentive metrics will help you achieve just that.
For example, NVidia requires its named executive officers to hold on to meaningful amounts of granted stocks in order to maintain the long-term perspective.
Proxy Advisory firms research, gather data, and make recommendations concerning the preparation of the proxy proposals voted on by the shareholders on the annual basis. In the USA, the two leading firms are Institutional Shareholder Services (ISS) and Glass Lewis & Co, while in Europe the main proxy advisor is Manifest, as well as French Proxinvest which operates as a part of the European Corporate Governance Service (ECGS) providing analytics for more than 600 publicly traded corporations in Europe.
These firms focus on testing other companies with respect to their financial performance and TSR relative to their competition. They most commonly focus on the so-called generally accepted accounting principles (GAAP) financial metrics including return on equity, assets, and EBIDTA (earnings before interest, tax, depreciation, and amortization).
You may consult such an organization to see how your company’s metrics relate to those tested by the proxy firm. If you don’t, you can be sure that the shareholders will. Hence knowing and understanding how your choice of metrics and peer group relates to that of the proxy firm is a must if you want to stay current in the performance-based executive compensation market.
This information, either following the proxy guidelines or deliberately going against them, can be extremely useful in explaining the purpose behind your incentive metrics and their relation to your company’s value story. And it can ultimately help harness high shareholder approval on the organization’s say-on-pay.
Companies such as Merck and NVidia also hire independent compensation consultants that report directly to the compensation committee.
Investors and shareholders are ultimately the ones who vote on the approval of the chief executive compensation packages.
If they do not understand or believe that the metrics and benchmarks will produce the expected result the say-on-pay vote may harness low support or even not pass. This is especially important if the company is going through a period of significant change. In order to gain the investors’ trust keep communication clear and offer ongoing discussions between the top human resources, investor relations executives, and the shareholders themselves. For some companies, like JPMorgan Chase, this is actually part of their compensation policies philosophy listed on the proxy statement.
Most of these discussions concentrate on linking the specific performance metrics with targets relevant to the shareholders, commonly with an underlying focus on the absolute and relative total shareholder return (TSR) with respect to the comparator groups. However, if you’d like to choose a less common set of incentive metrics provide a clear rationale and explain the benefits and implications of the new approach thoroughly.
The understandable, clearly defined, and well-thought-out processes are the cornerstones of a successful company’s mindset. Performance compensation metric selection should be one of the first such processes to be mapped and carefully followed. Unfortunately too often the lack of plan and preparation results in a haphazard amalgam of choices that will not deliver the expected results.
The mere ubiquity of the performance-based deferred compensation and its considerable effects on the company’s future demand for due diligence. Carefully designed long-term incentive plan with the right set of metrics has turned the fate of many organizations.
Moreover, the compliance with executive compensation laws and clear communication concerning LTI compensation to shareholders and the stakeholders alike fosters the climate of transparency and credibility through which firms can attract the kind of investors who will support their value story.
The more trust the management gains the more flexibility it receives from the owners. And that will just benefit your company. As Doug Giordano, Senior Vice President, Business Development at Pfizer, sums up: “If investors see you as prudent stewards of capital and you’re actually beginning to reap some current benefit from past investments, they will give you more of an opportunity to invest for the long term. If you start to lose that credibility, investors are going to want their money back sooner, in the form of dividends and repurchases.”
For this reason, I discussed here a list of questions each executive compensation committee should answer before proceeding to choose the particular financial and non-financial performance metrics. The next step is to indeed pick the right type of metrics and the benchmarking peer group, which you can do with our guide in Part II of this article. Or if you already know what metrics are the right choice for your company learn about the potential challenges and concerns you may face when setting performance-based long-term incentive plans, in Part III of this series.