Pay-for-Performance has been the watchword of executive compensation for several years. But if we want to pay “for” something, shouldn’t that something be defined? From the outset of the P4P era, the assumption was that "performance" was merely total shareholder return. This assumption ended up in practitioners skipping an essential step in compensation design: defining the desired business outcome. A consequence is the rise of the TSR-based incentive. (In practioners’ defense, this outcome was driven largely by Committees’ fears of being misaligned with groups like ISS.)
But, the business outcome can be very different from TSR, which is an investor outcome. So if the executives are working toward an investor outcome, who is watching to be sure the long-term business outcomes are being met?
First and foremost, top management should be keeping tabs on strategic goals of the company. That trickles up to the CEO, who is responsible for setting that business strategy. This, in turn, trickles up to the Board of Directors which is responsible for the review and approval of the overall strategy.
But let’s be honest, if we default to TSR as the sole or majority metric for incentive payments (which many companies have done), it’s possible or even likely, that the long-term business strategy is put in the back of each executive’s mind, while whatever happens to be driving the stock price in the short-term is at the front of mind. That’s not an outcome that is good for the company in the long-term.
In a recent study Pearl Meyer did in conjunction with Cornell, we found little correlation between long-term company performance and TSR-based incentive plans. This is a good illustration that, while TSR might be a good reward alignment mechanism, it’s not necessarily a good incentive to take actions that increase company financial performance.
So what can you do, as a Director or executive?
- Be sure the company has a thorough and robust strategy development process.
- Allocate plenty of time for the Board to review, critique and approve the strategy.
- Integrate the approved major strategic goals into the incentive plan design by drawing clear lines from incentive metrics to strategic goals.
- At regular intervals (quarterly?) review the progress toward strategic goals as well as stock price performance.
- Use discretion, if necessary, to correct compensation outcomes that do not reflect the strategic progress of the company.
It’s simple as outlined here, but it’s more complex in practice when we try to convince shareholders that strategic progress isn’t reflected in TSR in the short-term. In a recent NACD panel discussion that I moderated, I asked a question of the participants that reflects on this process: “Should strategic metrics be making a comeback in incentive plan design?”
Our expert panelists, who all have much experience in incentive plan design, each answered with an emphatic, “YES!”