For about the last three decades, strategic alignment has been the core principle for designing effective incentive plans, and that principle is still relevant today. By and large, considering total shareholder return as a metric for executive compensation is becoming an unpopular strategy. The general and broad consensus within the marketplace is that total shareholder return as a compensation plan isn’t the best plan for today or the future. Let’s look at ways to balance shareholder interests and compensation committee goals.
One of the primary benefits of total shareholder return is that it’s easy to explain it to shareholders. At the same time, it lacks transparency and understanding among many executives. In the past, shareholders have strongly supported total shareholder return as a key metric for success. The shareholders’ stance in support of total shareholder return is a new issue that boards and executives need to be sensitive to when designing new incentive plans for executives.
There are many others who dislike total shareholder return as the primary feature of executive compensation plans. They reason that executives can’t control it directly. Some feel that it makes more sense to link executive pay to the company’s strategic priorities and base it on such things that executives can control, like growing revenue, fostering innovation, margin management and return on investment.
Shareholders acknowledge the benefits of aligning executive pay with strategic priorities, but that is just part of what they want. They also want to see a component of the compensation that has meaning that is related to results. This is a strong perspective shared by large groups of shareholders. Many board directors believe that by putting a large amount of executive compensation in the form of equity, they have alignment with the shareholders. To achieve a better balance, executive compensation should include a portion that’s related to strategic priorities and another portion that’s based on performance.
Creating True Alignment Between Boards and Shareholders
Many factors make it complicated to design a balanced and fair executive compensation plan. Research shows that companies that grant a lot of time-based restricted stock have somewhat limited alignment between rewards that were actually realized by executives and stock performance for shareholders. In an unusual turn, the same research demonstrates that companies that move away from stock options have decreased the sensitivity to shareholder returns in compensation for executives. Compensation programs that favor stock options tend to align more closely with shareholder results.
This may be an opportune time to develop new models for executive compensation. Semler Brossy Consulting Group favors incorporating three elements: pay for delivery, pay for performance and pay for results.
The pay delivery component would offer certain guaranteed elements of pay in exchange for the expected value for a job well done. The pay for performance, or incentive, element, would be linked to explicit, uncontrollable, elements of performance, such as financial results. The pay for results portion would be tied to shareholder returns and could be linked to total shareholder returns or through share price changes.
New incentives would include some combination of the following:
- Base salary
- Original grant value of time-based restricted shares
- Annual cash incentives
- Long-term cash incentives
- Grant value of performance-based shares tied to financial results or other controllable factors
- Grant value of performance-based shares explicitly linked to total share returns or share price goals
- Stock options
- Impact of share price changes on other equity vehicles linked through share price changes
Only time will tell what new executive compensation models develop and how they fare overall. Also, there are bound to be some differences as they pertain to various types of industry.
Digital Tools Keep Boards Updated on Compensation Models
When we attempt to put all the pieces together, it’s important to consider the 2016 study that showed that the proportion of total compensation delivered in long-term incentives doesn’t have any meaningful relationship on the degree of shareholder alignment. Considering this, some people may be inclined to scrap their incentive-based programs and go back to 100% stock options. Others may be inclined to make all compensation contingent on total shareholder returns. An effective executive compensation plan needs to include a balance between incentives for clear and controllable results that are also aligned with the company’s business strategy and aligns with shareholder interests.
It’s clear that change is on the horizon for executive compensation models in the coming months and years. As time goes on, companies will have much to learn from each other. The difficulty will be in keeping up with the components of each model and how effective they are. With that in mind, Diligent Corporation designed Governance Intel. Governance Intel fulfills the need for boards to have customized governance intelligence at their fingertips because it gives them the opportunity to easily monitor and catalog news outlets to track companies, competitors and topics like executive compensation. Board directors can use the tool to access and share business intelligence via mobile devices, automated emails, curated newsletters, reports and other information.
Without any decent benchmarks to rely on, it’s difficult to ascertain the relative degree of alignment with shareholders. The consensus is that those who believe that all compensation that’s delivered in equity is automatically aligned with shareholders is an overstated view of the issue and one that should be reconsidered across the board. Executive compensation is in a state of evolution at this time, and it’s crucial for boards to understand how their pay practices compared to those of their peers and to those of other companies within their industries. Boards need to believe in their executive compensation strategies and be able to communicate and defend them to shareholders and others. Having a good understanding of what makes a good and fair executive compensation package that also meets the needs of all constituencies, means that the incentive and performance needs of the company and the alignment of rewards with the actual results for shareholders will satisfy everyone. Governance Intel provides the insight that boards need for valuable decision-making as the issues of executive compensation continue to evolve.