The Conference Board Governance Center Blog

JAN
26
2015

Getting Off The Wrong Executive Compensation Road

By Jon Lukomnik, Executive Director, IRRC Institute

When you are traveling down the wrong road, changing lanes doesn’t help very much. Yet that’s what we’ve been doing about executive compensation for years, as we tinker with stock options or restricted stock or add performance hurdles.

Sometimes, it’s necessary to stop, remember the destination, and recalibrate your route.

That is admittedly an overworked metaphor, but it is where we are today with executive compensation. Few, if anyone, is pleased with the direction executive compensation is taking or the road traveled to date. Investors worry that top executives are paid too much for too little in way of accomplishments. Boards fret that their judgment is constrained by the perceived need for formulaic pay to satisfy investors and proxy voting agencies. CEOs and other executives feel short-termism in their pay formulae and wonder if they can really suggest that their boards allow them to invest for the future.

It’s time to remember the destination for virtually every company in America: Create value, sustainably, over the long-term. How are we doing in reaching that goal? The report card is mixed, at best. Nearly half of large public companies in America (47.6 percent) destroyed economic value – they earned less than their cost of capital – over the five year period ended 2012, according to a recent study from Organizational Capital Partners and IRRC Institute. But surely all the emphasis on alignment at least means that pay and performance are coordinated? Not really. The study reveals that only 12 percent of the variability in executive compensation relates to the creation of economic value.

Today, the single most common metric for long term incentive plans (LTIPs) is total shareholder return, or TSR and its variants. TSR measures the alignment of executive compensation to share price movement (plus dividends), and is usually figured over a 1-year period. While TSR may be an adequate post-hoc measure to understand which constituencies benefited from a company’s increase in value, it’s a miserable metric to incent senior management. To understand why, consider a sports analogy. In any game, the winner is determined by the score. But watching the scoreboard is a losing strategy; it’s not how you win the game. You win by making shots or rebounding or scoring or playing defense. The fact of the matter is that TSR is a scorecard: Using TSR as an incentive metric is like saying we’ll win by having more points. It ignores strategy, effort, and execution.

Moreover, too many extraneous factors influence stock market prices, from the policies of the Federal Reserve to the price of oil to geopolitical crises, for senior executives to have precise influence over TSR.

Despite that, more than half the large companies in America use TSR (or its variant, relative TSR) as an incentive compensation metric. That is more than any other measure. By contrast, only a quarter of those companies use any type of capital efficiency metric, such as return on invested capital or economic profit. That’s important, because the laws of finance require a company to earn more on its capital than the cost of that capital. As obvious as that sounds – for example borrowing money at five percent and earning four percent on it is probably not a good idea – the fact is that three quarters of companies don’t include the cost of their capital in their performance measurements.

Equally disturbing, only about 15 of companies include measures of the types of things that drive future growth – such as innovation or research and development achievement – in their LTIPs. Future value is important; it accounts for from 25 percent to 70 percent of a company’s enterprise value. Perhaps because of the lack of innovation metrics, spending on research and development has declined from 2.9 percent of revenue in 1998 to just 1.7 percent in 2012. That may not seem like a lot, but it represents a 41 percent decline in revenue-adjusted dollars. We should not be surprised. That is a logical result of executive compensation programs that measure short-term stock market results but not innovation to spark future value.

Finally, the report notes that only 10 percent of companies have LTIP performance periods of more than three years, despite the fact that directors and CEOs generally think strategic plans should cover four years or more. Exacerbating the disconnect between the desired strategic planning horizon and the LTIP performance period used, about a quarter of companies don’t even use multi-year performance periods, preferring instead to use multi-year stock options. In effect, that just doubles down on the TSR metric, without any explicit non-stock-price related incentive.

What’s to be done? We need to rethink our incentive metrics to:

• Add measures of capital efficiency to long term incentive compensation plans (LTIPs);

• Add measures of innovation and other drives of future value;

• Rethink the performance measurement periods so they are truly long-term.

Of course, we also need to recognize that companies don’t exist in a vacuum. Investors and proxy advisory firms also over-rely on TSR. A second Organizational Capital Partners/IRRC Institute study reveals that there is no material difference in say-on-pay advisor recommendations or institutional investor voting based on a company’s economic value creation (or destruction) history. While there are historical reasons for this, the positive is that the disconnect between the desire for long-term value creation and how we compensate senior executives is starting to hit home. Since the reports were published, investors representing more than $1 trillion have told us that they are considering how to refocus on economic fundamentals.

However, the institutional voting pattern does mean that companies need to add a fourth bullet point to the action plan above. A coherent, energetic communications program to explain how the LTIP will henceforth measure the right things over the right periods of time, so as to create sustainable value, is an absolute necessity. While being forced to explain why a company is doing the right thing is annoying, in the end, everyone, from investors to Boards to CEOs, will benefit.

About the Guest Blogger:

Jon Lukomnik serves as executive director of the IRRC Institute. A columnist for Compliance Week, Mr. Lukomnik previously chaired the executive committee of the Council of Institutional Investors, co-founded and served as a governor of the International Corporate Governance Network and is co-author of the award-winning “The New Capitalists: How Citizen Investors Are Reshaping the Corporate Agenda ” (Harvard Business School Press, 2006).