Fair Pay, Fair Play: Aligning Executive Performance and Pay

F A I R P AY F A I R P L AY Aligning Executive

PERFORMANCE and

PAY

ROBIN A. FERRACONE E x e c u t i v e C h a i r , Fa r i e n t A d v i s o r s

“I like the way that Ferracone tells real-world stories on executive compensation, as recounted by board members and executives on the front lines, and she backs up these narratives with wellresearched statistics. Her way of looking at performance-adjusted pay is highly innovative and offers insights that we had previously not seen.” —Roy J. Bostock, non-executive chairman of the board, Yahoo! Inc. “This book is the best authoritative source on executive compensation today. It takes an extremely complex topic and boils it down to its simplest terms: alignment between pay and performance. Ferracone’s Alignment Model gives us a way to test and analyze alignment in our companies. In a word—it is superb! The Alignment Model is a tool that boards, executives, and investors alike can use. This book is required reading for every compensation committee member, CEO, head of HR, and institutional investor in America.” —Alexander L. Cappello, chairman and CEO, Cappello Capital Corp. “Ferracone provides a set of principles combined with actual accounts of how companies can achieve pay-for-performance alignment on a sustainable basis. Making this happen is critical to building trust and a high-performance culture.” —Richard Floersch, chief HR officer, McDonald’s “Ferracone does an excellent job of describing how executive performance and pay should be aligned. She combines quantitative research with qualitative commentary from those who are on the front lines in determining executive compensation. This combination makes the book eminently readable and a very useful guide.” —Ed Lawler, author, Rewarding Excellence

“By constructing a highly fact-based and thoughtful road map, Ferracone has taken the emotion and fear out of executive compensation decision making. Following the recommendations and analyses contained in this book will enable struggling boards and compensation committees to execute better, and well-performing boards to flourish.” —Anne C. Ruddy, CCP, president, WorldatWork

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Fair Pay, Fair Play Aligning Executive Performance and Pay

Robin A. Ferracone

Copyright © 2010 by Robin A. Ferracone. All rights reserved. Published by Jossey-Bass A Wiley Imprint 989 Market Street, San Francisco, CA 94103-1741—www.josseybass.com No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-646-8600, or on the Web at www.copyright.com. Requests to the publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-7486008, or online at www.wiley.com/go/permissions. Readers should be aware that Internet Web sites offered as citations and/or sources for further information may have changed or disappeared between the time this was written and when it is read. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. Jossey-Bass books and products are available through most bookstores. To contact Jossey-Bass directly call our Customer Care Department within the U.S. at 800-956-7739, outside the U.S. at 317-572-3986, or fax 317-572-4002. Jossey-Bass also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. Cataloging-in-Publication data on file with the Library of Congress. ISBN-13: 978-0-470-57105-7 Printed in the United States of America first edition HB Printing

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Contents

Preface

vii Part One: Fair Pay

1

1.

Same Problems, Different Context

2.

Shareholder Value: A Good Indicator of Long-Term Success

23

The Anatomy of Performance-Adjusted Compensation (PAC)

41

4.

The Performance and Pay Alignment Zone

57

5.

The Alignment Report

73

6.

From Maligned to Aligned

83

7.

Patterns of Misalignment

91

3.

Part Two: Fair Play

3

111

8.

The Root Causes of Misalignment

113

9.

Aggressive Target Pay

125

10.

Turbo-Charged Upside

145

11.

Conventional Goal-Setting

157

12.

Short-Term Gain; Long-Term Pain

187

13.

Flattening the Curve

199

vv

vi

CONTENTS

14.

Ad Hoc Decisions

205

15.

Decision-Making Influences

217

16.

Creating and Maintaining Alignment

231

Epilogue: Holding Companies Accountable

241

Appendix A: Analytic Methodologies

253

Appendix B: GICS Sectors

255

Appendix C: List of Interviewees

257

Notes

261

Acknowledgments

265

The Author

267

Index

269

Preface

The subject of CEO and senior-level compensation is all too often a hot-button issue. It meets with outrage, jealously, condemnation, and, occasionally, admiration. More recently, it is meeting with government scrutiny in the aftermath of the worst financial crisis since the Great Depression. For companies in the United States that received federal bailout money, the government is overseeing, at the time of my writing this book, the pay practices of these firms through an appointed “pay czar.” The role of the pay czar is to ensure that the institutions that are supported by taxpayer money are not unduly passing these dollars along to executives through excessive pay and also to ensure that the pay system is not causing these executives to take undue business risks. After all, taking on risks that, in retrospect, were not well-understood, or worse, that people were not paid to care about, is to some extent what got us into this financial mess in the first place. But while executive pay is receiving intense scrutiny, our fixation on the subject is still not offering us a way to think differently and gain new insight about it. Nor does it give us the ability to separate truth from myth. To be sure, we’ve gotten a bit smarter about how to design and govern executive pay. The external pressures have forced some reform. But at its basic level, we still are not only nipping around the edges of real and lasting solutions but also still defining the problems. As I see it, executives should be paid on the basis of how well they perform for their shareholders, relative to the external vii

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PREFACE

market, within contemporary standards of fairness and propriety. This is what I call “fair pay.” This compensation objective meets with general agreement and seems relatively simple, at least in concept. But when we drill down just one level, the controversy begins. This is where we get into debates about the definition of performance and pay, and what we mean by the standards of propriety, which have their roots in both a free market economy and societal norms. The devil is truly in the details. So this is why I decided to write this book. In my view, investors; boards and their compensation committees; executives with line, human resources, financial, and legal responsibilities; government officials; and the public in general do not need another “how-to” book on best practices or on the technical aspects of compensation. Rather, they need new perspectives, not conventional wisdom; they need facts, not fiction; and they need to gain an understanding of the real issues, not the imagined ones. They also need practical, not theoretical, ways to analyze and solve problems. They need processes to avoid the common pitfalls. And finally, they need ways to bring people together on ideas and direction, rather than to further fractionalize an already divided corpus. In other words, we all need to see some convergence on this topic. I set out to write a book that would meet these needs. To develop new thinking, including my own, I reflected on the various roles I’ve personally played over the years as a line executive of a large-scale, publicly traded, global organization; as a board member and compensation committee chair; as a strategy and executive compensation consultant; and as an investor. These roles have helped me to look at the issues from all vantage points. In addition, I reflected on the thousands of consulting engagements I have conducted and the hundreds of clients I have served. I worked with my colleagues at Farient Advisors LLC, a premier executive compensation and performance advisory firm, to analyze extensive performance and pay data over a fifteen-year

PREFACE

ix

time frame. The Farient team and I also collaborated with Steve O’Byrne, managing director of Shareholder Value Advisors LLC, a firm that works in the performance and incentive arenas. We worked with Steve to create a top-flight database and analytic capability around the alignment of executive performance and pay. Finally, Joel Kurtzman, my collaborator on this effort, my partners from Farient Advisors, and I conducted nearly two dozen interviews with board and compensation committee members, executives, shareholder advisory leaders, lawyers, and well-respected academicians to ascertain their views on all aspects of executive pay, as broad ranging as the societal norms around executive pay, the motivational value of pay, and pay as a way to align outcomes for shareholders with those for executives— a concept that we call “alignment.” From this work, we developed a proprietary fact-base on what constitutes reasonable compensation—“fair pay,” and grounded perspectives on how to achieve it—“fair play.” The core of this book centers on the objective for executive compensation about which I spoke earlier—executives should be paid on the basis of how well they perform for their shareholders, relative to the external market, within contemporary standards of fairness and propriety. Rather than putting forth theoretical “how-to’s,” I have developed methodologies and guidance on how boards, compensation committees, and executives can think through and achieve reasonable executive compensation that is appropriately aligned with performance. These same methodologies can be used by investors to evaluate executive compensation from their vantage point as well. The issues that I have attempted to resolve include • • • •

What is fair pay? How much is enough? How much is too much? How much is too little? What is good performance?

x

PREFACE

• How much is good performance worth? • How can we maintain a fair relationship between performance and pay, particularly when the market for executive talent is tight? It is my hope that this new, collective wisdom on performance and pay alignment will help all of us • • • •

Converge on common standards of fairness and propriety Act out of conviction, rather than out of fear Mitigate the need for government intervention Rely more on inspiration and talent development, rather than on compensation, to attract, motivate, and retain executives • Develop a more efficient and disciplined market for executive talent To sum it all up, I am hoping that “fair pay” and “fair play” will help us truly create and maintain alignment between executive and shareholder interests that embodies the highest levels of rationality and integrity.

Part One FAIR PAY

1 SAME PROBLEMS, DIFFERENT CONTEXT A Case in Point When I walked into the boardroom, I saw four compensation committee members staring at me, eager to hear my presentation on how to retain the CEO of this publicly traded, high-flying company. The CEO had enjoyed meteoric performance, but he was threatening to quit if he didn’t receive a generous helping of restricted stock1 as part of his new employment agreement. Weeks earlier, I had been called by the chairman of the compensation committee to provide advice to the committee regarding this matter. And while the members of the committee said they wanted my opinion concerning what they should do, my hunch was that they really wanted me to bless the CEO’s requested grant. Like most board and compensation committees, this one wanted to be supportive. It would be easier to say “yes” than “no.” Further, the compensation committee thought that the CEO was doing a splendid job. The stock price had risen more than 50% since the CEO had taken charge three years prior. They figured that the company would be at considerable risk if they lost their “rock star” leader. After all, there was no successor in sight. On the other hand, the committee realized that what the CEO wanted was “over the top,” and that they could be subject to undue criticism if they approved the requested package, particularly without an outside, objective opinion. My report was not a surprise. I had telegraphed my preliminary findings well in advance of the meeting. My analysis showed that the requested grant would put the CEO’s compensation well above the market, even considering the company’s 3

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high performance. As a result, I recommended a more modest grant, contingent on performance. I delivered my report to the compensation committee in the executive session, with the CEO absent from the meeting. The compensation committee heard my report and asked a few questions, and then the committee chairman excused me from the room. A few days later, I called the chairman to see what had happened. He said, “The compensation committee was extremely pleased with your work, but decided to give the CEO what he wanted.” In fact, the board had penned a lucrative new employment agreement, complete with generous severance, change-in-control, tax gross-ups, and other bells and whistles. Of course, the news media had a heyday when the agreement was disclosed, and shortly thereafter, one member of the compensation committee even resigned from the board, although I suspect that it wasn’t only about CEO pay. Fast forward to a year later, when the demand bubble for the company’s services burst and the financial performance collapsed. The CEO was asked to resign in return for the large severance deal that had been provided by his employment agreement. As the consultant who had given the compensation committee advice to pare back the sought-after restricted stock grant and apply performance hurdles, I felt vindicated that my advice had been sound, but not satisfied that it had been dismissed. Is this a story out of today’s news? It sounds like it is, but it’s not. It actually took place a decade ago. But in a fundamental way it doesn’t really matter. Getting the pay-for-performance equation right is a long-running issue that remains an issue today. But why should we care? Does pay for performance really matter? Do incentives really motivate good performance?

The Role of Compensation Among academics there is a great deal of debate regarding the motivational power of incentives. Some, such as Dan Ariely, James B. Duke Professor of Behavioral Economics, Duke University,

SAME PROBLEMS, DIFFERENT CONTEXT

5

think incentives are not good motivators. “In experiments, we’ve seen that in some cases, people’s performance actually was lower the larger the bonus they got,” Ariely said. As a result, stock bonuses, stock grants, and other incentives are “probably better for creating loyalty than performance,” he said. Among other academics, some agree with Ariely; some disagree. My own view from working on matters of compensation over the years is that good people, and top executives in general, are intrinsically motivated, but incentives provide a powerful messaging and focusing device. In addition, the market for executive labor is generally willing to pay more for an executive who produces great performance versus one who does not. For these reasons, incentives matter. As for the question “Why should we care?” investors have said that they care. In a study conducted by the Center on Executive Compensation in 2008, twenty of the top twentyfive institutional U.S. equity investors were interviewed regarding their views on executive compensation. Investors resoundingly reported that the most important issue of concern was the alignment between executive performance and pay. Correspondingly, their second most important concern was having a compensation committee that they could trust and rely on to represent their interests. For this reason, we should care. Nearly every board in America states that its philosophy for executive compensation is to align pay with performance (or words to this effect). This is not without reason. Not only is paying more for better performance intuitively appealing, it also has motivational value to executives and seems fair to investors. And although I have not proven causality, companies whose pay is more sensitive to performance also have better performance (as I’ll discuss later in this book). Further, corporate leaders are not living up to their pact with investors and employees if they don’t put real meaning behind the mantra “our objective is to align our executive pay with performance.” Finally, pay for performance has become a biting social issue. The populist view is that executive compensation is the root of

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all evil. In fact, some blame the largest financial collapse since the Great Depression on egregious executive pay. While I have not met anyone sophisticated in business and finance who agrees with this view, the fact of the matter is that it has built up a head of steam and is implicitly shaping public policy. According to a study conducted by Farient Advisors, the executive compensation and performance advisory firm I founded, the vast majority of board directors and executives feel as though greater government intervention will not only not solve the pay-forperformance issue, but could make matters worse. Except for requiring clearer disclosure, there are almost always unintended and negative consequences to government intervention in matters of executive pay, the most famous of which was the decision made to cap the deductibility of non-performancebased pay at $1 million for certain executives in public companies. As a result of this governmental decision made in 1993, early in the first Clinton Administration, CEOs began receiving less in the way of cash, but more in the way of stock options2 and restricted stock. Ultimately, rather than pushing down CEO compensation, the result of this action was to raise CEO pay levels. But if we come back to our question, “Should we care about linking pay to performance?” the answer is a resounding “yes.” Short of inviting the government to do our work for us, it is incumbent upon boards, their advisors, and management to crack this code. Charles M. Elson, director at the John L. Weinberg Center for Corporate Governance at the University of Delaware, sums it up nicely: “Government will only make it worse. If you didn’t like what they did in 1993, then you’re really not going to like what they’re doing now.” It is something that we all need to get right.

Old and Persistent Problems For nearly thirty years I have worked on solving vexing issues around performance and pay. I certainly am not the first or only one to tackle these issues. Many have gone before me and

SAME PROBLEMS, DIFFERENT CONTEXT

7

acknowledged the difficulty. As far back as the 1980s, Robert A. G. Monks, founder of Institutional Shareholder Services, Inc. and cofounder of The Corporate Library, was practically inventing the shareholder rights movement when he took on Sears, Roebuck for the way it generously compensated its top team, made poor investments, and developed an ill-fated strategy. From Monks’s point of view, the compensation system is far too arcane. In fact, he calls it “complex, difficult, remote, and virtually inaccessible to anyone without a lot of experience.” At about the same time, Graef “Bud” S. Crystal left the world of compensation consulting to become the bête noire of American CEOs by widely publishing articles with extended tables showing how CEOs compared to each other with regard to pay and performance. Crystal’s analysis led to a great deal of finger pointing. What he did was to tally CEO salaries, bonuses, stock options, restricted stock, and other types of compensation. He then compared what CEOs received relative to the performance of their companies and created tables comparing who got what, when, and what for. Crystal’s 1992 book In Search of Excess: The Overcompensation of American Executives became a best-seller and for many people a reason for outrage, since so much of the information Crystal uncovered was hidden in proxy statements that were difficult to decipher. Crystal is still at it and publishes a weekly newsletter not surprisingly called The Crystal Report, but let’s pick up where Crystal’s book left off.

What Exactly Are the Problems? What exactly are the problems? Is it that executive compensation is simply too high? Or are there executive pay outliers that attract undue attention and create a media feeding frenzy? Is the problem that there are too many instances when executive pay is high but performance is low (including cases in which executives take lucrative stock option gains off the table right before the bottom falls out of company performance)? The short

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answer is “all of the above,” although my view is that the most significant issues are outliers, which I am defining as companies paying at the 95th percentile or higher, and high pay coupled with low performance. Median executive compensation is not really the issue. On the surface, performance-adjusted CEO pay (to be defined later in this book) increased threefold since 1995. This seems like a lot. But if we take into account (1) inflation (as measured by the Consumer Price Index) and (2) the increase in median company size (larger size begets higher CEO pay) over this same time period, then real size- and performance-adjusted CEO pay has increased approximately 1.6 times the 1995 level. This implies a compound annual increase in real performance-adjusted CEO pay of 3.6%. Because Gross Domestic Product rose by 2.6%, productivity gains account for all but $400,000 of the total compensation increase. As a result, I conclude that the absolute level of executive compensation is not the issue on which to focus. The real issues are about outliers and performance and pay alignment. Investors agree with me. About 75% of the investors surveyed by the Center On Executive Compensation in 2008 said that they had no real concerns about the levels of executive compensation in the United States.

How Investors View Pay According to Patrick S. McGurn, vice president and special counsel to RiskMetrics Group, Inc.

“There are some investors and obviously other interested parties for whom the numbers are very important, and I think there are some people who simply would like to see pay go down. However, I can’t remember having too many conversations with our clients with that as the ultimate goal. The conversation is generally not about how much you pay them but how you pay them. How much you pay

SAME PROBLEMS, DIFFERENT CONTEXT

9

them does come into play, particularly when boards do an absolutely terrible job of calibrating those pay programs and get these huge outsized payouts that I think, even from a board perspective, were never intended when they designed the programs. They simply didn’t take adequate care in either setting maximums or multiples or whatever it is they’re going to use to stop those payouts from going into uncharted waters.”

Outliers Let’s consider outliers. They shock the senses. They’re the stuff that headlines are made of, and for good reason. As shown in Exhibit 1.1 (page 20), there are always a few outliers—companies that generate performance-adjusted compensation that looks “off the charts,” regardless of how high performance might be. For CEOs, these outliers can range anywhere from 15 to over 250 times median performance-adjusted pay in any given threeyear rolling period. Moreover, outliers are powerful contributors to public perception. As you can see from the chart, the outlier issue is not new. It’s been going on at least as far back as the database will take us. Outliers often are the result of runaway pay programs that weren’t intended to pay out that way in the first place. For example, take Cisco Systems, Inc. in the mid-1990s. The company was on a roll, generating an annualized average total annual shareholder return of 96% in the last half of the decade. I’m sure that the compensation committee thought it was doing the right thing when it bestowed upon John Chambers, chairman and CEO, five to six million stock options per year during this period, along with a modest annual salary of $300,000 and an average bonus of $400,000 per year. However, this equity-laden package resulted in three-year average PerformanceAdjusted Compensation of approximately $300,000,000—that’s

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right, $300 million.3 Other employees’ compensation rose too because of stock options. As one Silicon Valley observer said, “What I saw was entitlement. It was worse with options than with an annual bonus because people started living on their options. They could do this because options vested monthly. These people would say to the CEO, ‘You have to give options now. The price is only going to go up.’ They were living it up.” Today, Cisco has moderated its CEO pay package to be more in line with the market. Total cash compensation (both salary and bonus) is targeted to be below the 50th percentile of peer companies, including a continued modest salary level of $375,000, combined with a target bonus of $2.5 million, such that a greater percentage of Chambers’s total cash compensation is directly tied to Cisco’s operating performance. Long-term incentives are targeted at the 75th percentile of Cisco’s peers, and equity grant sizes are considerably more modest than those of ten years ago. In addition, the company has shifted away from relying solely on stock options as a long-term incentive vehicle, to a combination of stock options, performance-based restricted stock units, and timebased restricted stock.

Why Pay Level Is in the Spotlight According to Jay W. Lorsch, Louis E. Kirstein Professor of Human Relations, Harvard School of Business, and chairman, Harvard Business School Global Corporate Governance Initiative

“The people who are complaining in many respects are the people who have a political or some kind of moral reason for being upset, and I’m even talking about the shareholders. Why did the people at the AFL-CIO get so upset?

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11

They’re not getting upset because the investment is in some way damaging their return. They’re getting upset because the union guys don’t like it. Or the media get upset because it sells newspapers.” According to Stephen W. Sanger, retired chairman and CEO, General Mills, Inc., and director of Wells Fargo & Company, Target Corporation, and Pfizer, Inc.

“I would say with the general public and the politicians that you could make a case that executive pay level is the main issue—’Nobody needs to be paid that much’ kind of mentality. I don’t think the big shareholders look at it that way. The big shareholders want to talk about other things.”

Fair Pay and Alignment Now, let’s consider the issue of high pay despite low performance. This question is one of misalignment, that is, the extent to which pay is high when performance is low, or vice versa. In mining our database, we found plenty of examples in which executive pay was too high for the level of performance delivered. In fact, approximately one-third of the “cases” (to be defined later in the book) in our database fell outside of what we consider to be an acceptable range for the relationship between performance and pay. In my work with boards, I have developed a simple definition of fair pay, which I am also calling alignment. Fair pay, or aligned pay, is when total compensation, after performance has been factored in, is • Sensitive to company performance over time • Reasonable relative to the relevant market for executive talent and for the performance delivered

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In my explanation of fair pay, or alignment, I’ve deliberately kept it simple. I’ve excluded caveats, footnotes, measurement information, and definitions. But while my definition may be succinct, I believe it is powerful because it makes an important philosophical point: executives ought to earn compensation on the basis of the performance they generate over time relative to others in the marketplace. I believe my definition of fair, aligned pay is simple enough that an outside observer would be able to discern when a CEO’s pay is fair and when it is not. As such, it is the kind of definition that can be written on the back of an envelope or committed to memory, and by being kept in mind, can keep boards and executives from getting unwanted calls from the press. For most of us, the concept of alignment is intuitively appealing. As shown schematically in Exhibit 1.2 (page 21), executive compensation is aligned with performance when company performance and executive pay both are high or low over a sustained period of time. Conversely, executive compensation is not aligned with company performance when executive pay is high and performance is low or executive pay is low when performance is high over time.

Searching for Alignment Why do companies pay high when performance is low? There are a number of reasons, but the one that tends to crop up the most is when compensation committees want to retain and sustain executives through difficult economic times, in other words, when poor performance is a result of a tough environment and not because of poor leadership. It is in times like these when beefed-up pay packages are particularly painful to investors, as well as to employees who are not doing as well. It is in times like these when the social agenda of wealth redistribution builds a new head of steam. It is also in times like these when boards are jittery and in the mood for buying some “insurance” to retain their top talent.

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Jill S. Kanin-Lovers, former senior vice president of human resources at Avon Products, Inc. and director of Bearing Point, Heidrick & Struggles, First Advantage Corporation, and Dot Foods, shared her perspectives with me about what tends to happen in the marketplace in general. “When performance is poor, everybody involved with certain companies—their boards, executives, employees, and shareholders—are in an uproar. Some of the executives in these companies get paid numbers that are lightning rods. I don’t believe they were based on any kind of analysis.” In most of these instances, compensation committees and management think that they are doing right by shareholders. After all, retaining good executives when the going gets tough is ultimately good for shareholders, isn’t it? But this not only is shaky logic, it also undermines the pay-for-performance objective that is clearly stated in most proxy reports. Further, one wonders why in the first place certain elements of the pay package weren’t designed to tide executives over for a rainy day. And one also wonders whether executives are coming to work for more than just the money. Finally, what is the psychology driving this fear of losing a good leader? Are the executives instigating this fear? Or are the compensation committees just an overly cautious bunch? The evidence is that the retention issue is generally overblown, particularly for the CEO. “I think the retention issue is grossly overstated in most companies,” says Robert A. Eckert, chairman and CEO of Mattel, Inc. and chairman of the compensation committee of McDonald’s Corporation, “because people aren’t really leaving. If somebody says, ‘Well, we have to do this for retention,’ I say, let’s look at the retention track record. How many of your top fifty people have left in the last three years? If nobody has left in the last three years, why do you think they’re all going to leave now? So I think the retention argument is a weak one and is frequently abused.” Now, don’t get me wrong, most compensation committees aren’t deliberately paying high when performance is low.

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When this happens, the transgressions are usually much more subtle, and may not show up right away. They come in the form of such things as a handsome dollop of low-priced stock options in lieu of no bonus payout. These low-priced options will hardly even show up in the target pay numbers when assessing competitive pay. But most assuredly, these options will show up in performance-adjusted pay once the company’s fortunes turn around, and likely will show up as excessive pay at that time. It’s important to point out that upward discretion isn’t the only game in town during tough times. Compensation committees use downward discretion as well. Kanin-Lovers witnessed acts of restraint following the 2008 financial debacle. “Several of the companies that I was on the board of in 2008 didn’t feel the impact of the economic downturn until later in the year. They were sort of humming along, and then the economic downturn hit. So when we looked at their annual numbers, they didn’t look as terrible as we thought they would. But then, we had to consider how to pay these people, because coming into 2009, we knew these companies could potentially crash further. So we had this situation where we were supposed to pay bonuses in early 2009 for 2008 performance, but we had to use downward discretion because the downward momentum in 2009 was so awful that it would look like we were drunk and disorderly if we paid large bonuses at that point in time.” As you can see from these examples, the list of the types of “system overrides” that are used is long.

Analytic Tools Needed In making these types of decisions, most compensation committees and management lack the proper analytic tools needed to understand the subtle shifts in alignment that are taking place. For that reason, when I started Farient Advisors, I built it around three important elements: people who have a deep understanding of executive talent strategies, corporate

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performance, and executive pay; a set of proprietary analytical tools designed to assess pay and performance, as well as other things such as risk; and our ability to provide objective, fact-based advice. The analytics that we developed and will be described in this book are quantitative in nature. They are based on an evaluation of executive pay and performance in the S&P 1500 companies over rolling three-year periods since 1995. From nearly 50,000 data points, or “cases,” we have been able to determine the relationships between executive pay and company size, industry sector, and performance. Most of the data in this book are shown for the CEO, although we also analyzed data for the top five named executive officers (NEOs). I feel comfortable using the CEO data to make my case because it is an easy way to illustrate the issues: • CEO pay is generally the highest among the executives, so it carries the most exposure for companies while also giving us the most demanding test for alignment. • The data show that companies generally pay other executives in a way that is consistent with the CEO. In other words, if the CEO is paid relatively high, then there’s a good chance that other NEOs will be paid relatively high as well. So showing the CEO data is indicative of how other members of the executive team are paid. Farient’s Alignment Model was constructed for the entire S&P 1500, covering all industry sectors. We also can model industry groups (which make up a sector), subgroups, select peers, and even individual companies. It represents the first time that compensation committees, executives, shareholders, and the media have access to a tool that can objectively assess whether their company is paying fairly over time. In addition, the alignment model represents the first time executives and compensation committees are able to determine whether certain programs, or actions that they intend to take, will create

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FAIR PAY, FAIR PLAY

more or less alignment, making it both forward and backward looking. As a result, all constituencies evaluating executive pay will be able to determine, on an objective, analytically grounded basis, whether pay actions and design are within an appropriate range for the performance delivered (or to be delivered).

Fair Play and Alignment If I’m making all of this sound formulaic and shrink-wrapped, this isn’t the intent. The intent is to provide more meaningful benchmarks and guidance than what has been offered to date. To be sure, resolving thorny issues will still consume time and require judgment. But my hope is that stronger guidance from our Alignment Model, coupled with insights from years of experience, my own as well as that of the people we interviewed, will help strengthen and streamline the decision-making process surrounding pay. This process is where fair play comes in. To make use of the Alignment Model, companies don’t just need fair pay, they also need fair play. What do I mean by fair play? In its most basic terms, I mean having an overall pay philosophy, analytic methodologies, and decision-making processes in place to test and ensure alignment. In other words, boards and management need to ask and be able to answer the following questions: • How much compensation is enough for our executives for the performance delivered? How much is too much? • How have our pay system and actions affected the relationship between executive performance and pay in the past? How will our pay systems and actions affect this relationship in the future? • What program designs or actions might cause poor alignment between performance and pay? • How can we design an Alignment Model that is right for our company (fair pay)?

SAME PROBLEMS, DIFFERENT CONTEXT

17

• What decision-making processes best support this model (fair play)? • How should performance outcomes be measured and translated into pay decisions? Suffice it to say, without fair play, you are unlikely to have fair pay. Companies need comprehensive fair play methods that consistently result in fair pay outcomes, for the good of investors and executives alike.

About This Book The book is designed to offer practical insights, combined with analytic rigor. Please note that Chapters Three and Four cover performance and pay alignment across U.S. industry, and Chapter Five begins our journey into compensation alignment on a company-by-company basis. Once you break through the definitions and analytics in Chapters Three and Four, you will be rewarded with case studies and useful applications of our Alignment Model throughout the remainder of the book.

The Role of Compensation According to Edward D. Breen, chairman and CEO, Tyco International, Ltd.

“The number one thing to me is to just have the right people on the team and put the right people on the field every day to play the game. That stuff transcends pay. If people are motivated, want to do a good job, are challenged in their job, are promotable, and are excited about what they’re doing, then these things are actually more (Continued)

18

FAIR PAY, FAIR PLAY

important than pay. So you have to get that part right or you pay the price. If you don’t get the people right, the company’s not going to work right.” According to Robert E. Denham, co-chair of The Conference Board Task Force on Executive Compensation; a partner at the law firm of Munger, Tolles & Olson; and a director of Chevron, Westco Financial, The New York Times Company, and Fomento Economico Mexicano, S.A.

“Companies with really good corporate cultures use other motivators, and compensation needs to be aligned with those other motivators. But the enjoyment of the people you’re working with and the level of trust for the people who are fighting the battles with you every day make a lot of difference. If you’re having good results, if you’ve got a team that you’re enjoying working with, and if that team’s winning, it’s really hard to recruit somebody away from that winning team.” According to Vernon R. Loucks Jr., chairman, The Aethena Group LLC, retired chairman and CEO, Baxter International, and director of Emerson Electric Co. and Segway LLC

“Well, let’s put it this way, nobody goes to work because they get a pay offer, and if they do they’re crazy, and there are people who will lob a big number at one of our people, and they’ll look at it, and some pop for it, but most don’t. It really sort of reinforces the point that pay isn’t everything. It’s more about being part of a process and part of a company that’s really successful at what they do. It’s about the process—the process is what produces success, rather than success being an accident. “But, having said that, pay better be right or you’ve got a real problem, because if pay goes awry, then people start talking about it, and then people start feeling like the company that they’re working for is underpaying and is trying to get away on the cheap. You never make it that way.

SAME PROBLEMS, DIFFERENT CONTEXT

19

Pay isn’t everything, but it’s got to be right, it’s got to be fair. People want to feel like they’re being treated fairly.” According to Ronald M. DeFeo, chairman and CEO, Terex Corporation, and director of Kennametal Inc.

“I think there are two types of people when it comes to compensation. Some, where compensation is their primary driver, more is always better than less, and the more they make, the more important they feel and the more value they feel they add. Those are highly ego-driven people where the metric of pay is a direct contributor to their own view of self-importance. Then there is, I think, a much different style of individual where pay is not their primary motivator, it’s the emotional attachment they get from generating a successful environment, whatever that successful environment is, whether it’s a successful business, a successful charitable organization, or a successful town. And people can live very happily without making a ton of money, but having felt like they made a difference. And I think it’s important for people to feel like they made a difference in their lives.” According to Richard E. Boyatzis, professor, organizational behavior, Weatherhead School of Management at Case Western Reserve University

“The whole thing about transactional versus transformational leadership is that the more you make it a transaction, the more a person then puts it on exchange. And this is one place where the economists have helped to destroy the relationship between individuals and their organizations. If you make me feel like you’re going to pay me every time I do something good, then at some point, I’m going to start thinking, well, why should I do something good if I don’t get paid? And if I do something even better, shouldn’t I get paid more? At that point, I’ve stopped thinking about our purpose—our clients, the ingenuity of the products and services—and I’ve started thinking about the transaction.”

1995

$1.1

$2.2

$4.2

$1.2

$2.4

$5.1

$1.5

$3.0

$6.8

$1.5

$3.0

$6.1

1999

$1.7

$3.2

$7.3

2000

$1.8

$3.9

$8.9

$1.6

$3.2

$6.9

2001 2002 Year

$1.8

$4.1

$8.4

2003

$1.9

$4.1

$8.3

2004

$2.1

$4.3

$8.5

2005

$2.2

$4.5

$8.9

$2.3

$4.5

$9.1

2007

$2.3

$4.6

$8.9

$2.2

$3.9

$7.0

$17.6

$62.8

Highest 95th Percentile 75th Percentile 50th Percentile 25th Percentile

2008

$24.3

$289.3

$23.5

$79.2

2006

$25.5

$177.6

$24.6

$169.3

$25.1

$112.1

$19.9

$117.1

$26.2

$215.7

$34.5

$303.8

$33.1

$651.3

$26.3

1998

$20.8

1997

$14.2

1996

$11.5

$57.9

$113.2

$135.8

$767.9

Exhibit 1.1. CEO Performance-Adjusted Compensation (PAC)

Note: Average PAC over three-year periods ending in each year shown.

$1.0

$10.0

$100.0

$1,000.0

Annualized PAC (2008 $MMs) Logarithmic Scale

20

SAME PROBLEMS, DIFFERENT CONTEXT

Exhibit 1.2. Alignment Concept High

Executive Pay

Misalignment

Alignment

Misalignment Low Low

High Company Performance

21

2 SHAREHOLDER VALUE A Good Indicator of Long-Term Success

Shareholders Are Owners The silver lining within the cloud of adversity is that it gives boards an opportunity to reconsider executive compensation. With so much scrutiny from regulators and government, questions from investors, and the loss of trust in the magic of the markets, the topic of executive pay is on a lot of people’s minds. Fortunately, some of us have been thinking about these issues for a very long time. I have spent my career helping businesses generate better performance by designing better business strategies, talent strategies, and pay programs, as well as the processes to make them work. I began advising boards and management on corporate strategy at Booz Allen & Hamilton (now Booz & Co.) in the 1980s, then on corporate performance and pay at SCA Consulting in the latter half of the 1980s and 1990s, then on talent strategies at Mercer in the 2000s. A few years ago, I founded Farient Advisors, an independent executive compensation and performance advisory firm that assists companies not only in designing pay programs but also in implementing the decision-making processes that surround the design. It is clear to me on the basis of decades of experience that boards and management alike fully understand that they are working on behalf of the people who own their businesses—their shareholders. Ursula O. Fairbairn, president and CEO, Fairbairn Group LLC, director of Air Products & Chemicals, Centex,

23

24

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Sunoco, and VF Corporation, retired executive vice president, Human Resources, American Express Company, and 2009 Outstanding Director, designated by Outstanding Directors Exchange (ODX), is crystal clear on this subject. “I always felt that the shareholder was my customer.” The board is elected directly by shareholders to grow the value of the enterprise, and in doing so, to protect their interests. In turn, the board hires CEOs and their top teams to make it happen. These top managers are agents who perform their jobs on behalf of the investors. They are hired to perform, not preside. Moreover, they lead, coordinate, and motivate thousands of employees who help to create value by winning under intense competitive pressures in the market.

The Merits of TSR Given this context, the most important indicator of longterm success, and ultimately of executive performance, is total shareholder return (TSR). Simply defined, TSR is stock price appreciation plus dividends reinvested in the stock. TSR is a powerful indicator of how well a company is positioned for the future. The potential for generating a competitive TSR, relative to the risks taken, is the most important reason investors buy shares in a company. TSR is a good all-encompassing indicator that reflects everything that management does on behalf of the company’s owners to create value over time. In other words, TSR is a good indicator of whether and how much value is being created by a company’s top management team. It also is a good, overall measure of performance outcomes. Rajiv L. Gupta, chairman of Tyco’s compensation committee, director at Hewlett-Packard, retired chairman and CEO of Rohm & Haas Company, and co-chair of The Conference Board Task Force on Executive Compensation, agrees with me. “Boards are clearly representing the interests of shareholders; and the interests of shareholders is to maximize the value of their investment.”

SHAREHOLDER VALUE

25

This is not to say that TSR is the only valid measure for determining executive performance, but it is to say that it deserves to be the primary one because, at the end of the day, success ultimately has to relate to value for shareholders. Because shareholders hire executives through the board to represent their interests and build value in the company, and because our capitalistic system is designed to pay more for more effective talent, all other things being equal, TSR must be the primary way to judge executive effectiveness and how much executives should earn. Patrick McGurn is clear in his views on this topic. “If you tie pay to strategy, and then make sure that a substantial portion of the pay package is directly tied to TSR, then you’ve got a great check and balance in place. There are other measures out there, and people fall in love with them, but the consensus is that TSR is the best one of these.” He goes on to say, “In terms of TSR, investors tend to like a more relative approach. And they tend to like the relative approach with all metrics. They like to see outperformance in order for a company to receive above-market levels of pay. And actually, one of the interesting things over the last twelve months is that we’ve seen a significant number of companies moving from absolute metrics to relative metrics. But obviously, if companies return to absolute measures when they turn around, you might get some squawking at the point.”

Financial Performance Drives Value Let’s look at it another way by breaking down how management affects TSR. Most people would agree that management has considerable influence over the financial results of the company. In turn, the financial results of the company drive TSR. To illustrate the point, I tracked a simple measure of financial performance— growth in operating cash flow (measured by earnings before interest, taxes, depreciation, and amortization, commonly referred

26

FAIR PAY, FAIR PLAY

to as EBITDA)—across the S&P 1500, and looked at how well this measure linked with the TSR of the S&P 1500 over time. As you can see from Exhibit 2.1 (page 37), median cash earnings growth and median TSR track with one another, albeit not perfectly. So when executives work to improve company financial performance, they also are working to improve the price of their company’s stock. This linkage between financial performance and stock price is true, in general. But as with any generality, there are exceptions to the rule. At any given point in time, overall secular trends in the stock market, discount rates, and consumer confidence all may affect a company’s stock price, or valuation, despite waxing or waning financial success. However, over time, these inefficiencies tend to even out, and longterm financial performance generally links to long-term value. If executives are responsible for financial performance, and financial results drive TSR, then holding executives ultimately accountable for TSR makes sense. Both the beauty and the bane of this phenomenon is that it is self-reinforcing. Good cash flow, coupled with increasing TSR, increases a company’s “currency,” and by doing so, allows it to pursue mergers and acquisitions, raise new capital, invest in new projects, hire new people, and gain momentum. By increasing stock price over the long term, a strong leadership team provides the company with the resources it needs to continue building TSR. Conversely, diminishing value closes off strategic alternatives and has the potential to hamstring the company until management “rights the ship.” We saw this phenomenon play out in spades in 2008, when a number of my clients had plans to make acquisitions. By the end of the year, these plans fell off the table when their stock prices, that is, their currency for making the acquisitions, precipitously dropped in value and the credit markets dried up. This was a painful reminder for all of us of how stock prices can act as a double-edged sword.

SHAREHOLDER VALUE

27

Financial Metrics Can Be Too Narrow According to Richard Boyatzis

“My argument is not that there’s something wrong with using shareholder returns to measure performance. I think it’s too limiting. I’m on record on this when I did a review of a book on the balanced scorecard and other measures of organizational performance. When Kaplan and his colleagues did the balanced scorecard, they were in the right direction but they made two mistakes. One, they translated everything into financial terms. Secondly, they were too limiting in the measures they contemplated. So, if we are going to lead people to create pay for performance, which I think makes a lot of sense, we should make sure that performance is a holistic measure and that it does not create collateral damage. And to look for after-tax profit or retained earnings is, I think, too narrow.”

Shareholder or Stakeholder Value? I’ve heard many people say that the role of corporations is to create stakeholder value, rather than shareholder value. By “stakeholder value” they mean that the role of corporations is to improve the fortunes of the company’s shareholders, customers, and employees alike. But there are a few things wrong with this “either or” question. The question of whether the role of the corporation is to create shareholder value or stakeholder value is the wrong question. It’s really a question of what is the appropriate time horizon over which to measure shareholder value. If executives are managing for the long-term (five or more years) enhancement of shareholder value, then they need to build and maintain customer value through reputation, volume, loyalty, customer satisfaction, or any number of measures of customer value.

28

FAIR PAY, FAIR PLAY

And if executives are managing for long-term shareholder value, then they also need to create and maintain an excellent employment brand, as indicated by such measures as employee engagement and retention of the workforce. Trashing customer and employee value in the short run may temporarily lead to improvements in the bottom line but ultimately won’t do anything to enhance the value of the enterprise for shareholders in the long run. So it all still comes back to long-term shareholder value. Those who believe that long-term shareholder value is not a good all-encompassing measure also believe that shareholder value is created at the expense of customers, employees, and communities. However, this is not true. Before I started Farient Advisors, the firm that led the research in this book, my predecessor company, SCA Consulting (which we sold to Mercer in 2001) conducted a study on the impact of high versus low shareholder value creation on customer, employee, and community welfare. The study showed that high-shareholder-return companies not only had more contented shareholders but also had more satisfied customers, paid more to their employees, and paid more taxes. In other words, creating higher shareholder return was correlated with benefits conferred upon customers, employees, and communities, rather than at the expense of them. Ron DeFeo puts it this way: “I tell everybody that we have three constituencies, which I call our three-legged stool. We have our customers, our team members, and our stakeholders, which include shareholders, banks, suppliers, and debt holders. It’s our job to keep all three of these constituencies in balance. If one of these legs gets out of balance, the stool falls down.”

TSR Over Time Given that customers and employees generally benefit along with shareholders, not in opposition to them, and given that companies must pay attention to customer and employee value

SHAREHOLDER VALUE

29

as a means to achieving long-term returns for shareholders, I am a proponent of using TSR, or stock price performance, as an indicator of long-term success. And, just to be clear, I am not suggesting that TSR is a good measure of short-term success. At any given point in time, TSR can be high or low, up or down, due to a dizzying array of factors, including but not limited to the quality of leadership. Moreover, high TSR can be a fleeting phenomenon. Bob Denham agrees with me. “Over a long enough period of time, I agree that total shareholder return is the objective. But to think about total shareholder return over a one-year or three-year period, I don’t know how meaningful it is. It’s driven so much by economic forces. If you’re adjusting total shareholder return for the rising tide, then I think it’s more meaningful.” In fact, TSR varies greatly with the fortunes of the overall secular stock market. As shown in Exhibit 2.2 (page 37), the median (that is, 50th percentile) three-year TSR for the S&P 1500 (which is a reasonable surrogate for the overall stock market) over the past twelve years is a nice, round 10%. Moreover, there is a normal, or bell-shaped, distribution around 10%, meaning that performance is distributed rather evenly both above and below the median. In fact, 25% of the data points fall below −3% TSR (the 25th percentile) and 75% of the data points fall below +23% TSR (the 75th percentile). This TSR distribution reflects the fact that the TSR of any given company is likely to vary with the performance of the overall secular economy. Interest rates, credit availability, raw materials prices, inventories, consumer confidence, unemployment rates, and many other factors all influence TSR. In fact, as you can see in Exhibit 2.3 (page 38), the median three-year TSR for the S&P 1500 varied greatly from a high of 22% for the three-year period ending in 1997 to a low of −7% for the period ending in 2008. This is a large spread of 29 percentage points at the median!

30

FAIR PAY, FAIR PLAY

Because TSR is so strongly affected by secular movements in the stock market and the economy in general, share price performance of any given company likely will not be entirely within management’s control in the short term. However, the stock price reflects the value of the business to its equity holders over the long term, and indicates whether the company has delivered a competitive return to shareholders over time. According to one board director with whom I spoke, “Shareholder return is the best measurement. If you’re not producing shareholder return, there is no basis under which you should be paid, setting aside your base compensation and benefits. I don’t care how difficult it is to run the company. You’ve got to be rewarded when shareholders are rewarded.”

TSR by Industry Sector Not only does TSR vary over time with the vicissitudes of the secular market, but companies also perform differently by industry sector, as shown in Exhibit 2.4 (page 39). This is because each sector is affected by external factors. For example, the energy sector is strongly affected by oil prices, while the technology sector is affected by inventory levels in the IT supply chain. Not surprisingly, TSR varies more widely for technology companies than for utilities. For utilities, three-year rolling TSR between 1995 and 2008 varied from 5% at the 25th percentile to 18% at the 75th percentile, for a spread of 13 percentage points. This is because the demand for power is relatively stable and these businesses are highly regulated. As a result, utilities are able to pay relatively high dividend yields, allowing shareholders to earn a more certain return. Shareholders of utilities usually do not experience the exhilarating runups in stock price, but they do not typically experience the punishing downsides either. Interestingly, the effect of broad market trends over time is more powerful than sector performance. As I noted earlier, there is a 29-percentage-point spread between the median low and

SHAREHOLDER VALUE

31

high three-year TSR over the past fourteen three-year periods, while there is a 9-percentage-point spread—from 6% at the low to 15% at the high—between the median low and high threeyear TSR by sector over this same time period. Industry sector counts, just not as much as broad market conditions.

Not Putting All Eggs in One Basket According to Pat McGurn

“Clearly, investors care about their returns and they believe that ultimately alignment should tie their returns fairly closely to the returns of senior executives of firms. That having been said, there is such a thing as too much of a good thing, and I think that’s what we’ve had as far as the design of some of the compensation programs go, and there were not enough provisions in place to make sure that people were creating sustainable value rather than short-term value or otherwise profiting from the volatility of individual stocks. I think that the goal going forward with the market as a whole is to focus companies more on tying pay to the accomplishment of long-term strategic goals. I think if you talk to any investor, they believe that one of those goals—and perhaps the most important of them—is linking pay to Total Shareholder Return over an extended period of time.”

Portfolio Approach For the reasons I’ve already discussed, TSR is a good long-term indicator of corporate and executive success. However, I am also the first to admit that TSR is not a perfect measure. TSR swings with both secular and industry performance, neither of which is in management’s control.

32

FAIR PAY, FAIR PLAY

The good news is that there are ways to deal with these imperfections. One way is to assess company performance against its cost of equity (or cost of capital). Cost of equity is the return that shareholders can reasonably expect to earn from their investment in the company’s stock given the level of risk in the stock. Another is to assess company performance against its peers in the industry. While relative performance also isn’t a perfect measure, since no two companies are exactly alike, it is a good way to strip out the effects of secular and industry factors. Nell Minow, editor and cofounder of The Corporate Library, puts an emphasis on measuring performance against peers. “One corrective factor is to examine performance against the peer group because that’s what investors want. Investors want companies to be constantly aware of what their peers are doing.” Minow shared an example. “A broadcast network was measuring itself only against the other broadcast networks. But that was crazy. They should have been measuring themselves against cable and the Internet as well. These are forms of media. So companies need to be constantly aware of what the competition is doing and of their need to do better.” Even though relative performance is an attractive supplement to absolute TSR, shareholders “get paid” on absolute stock price and dividend performance. As a result, my experience is that shareholders also want executives to get paid more on an absolute than relative basis. The reality is that if a company’s earnings are down 20% and the industry is down 30%, the company did a good job, relatively speaking. In this scenario, shareholders likely will be tolerant of some level of bonus. But shareholders will not want executives to celebrate with big bonuses, special stock grants, or other sizable enhancements since they won’t be celebrating either. Another way to overcome the imperfections of TSR is to evaluate other factors that capture the sustainability of TSR, that is, the ability to sustain and grow the company’s value over time.

SHAREHOLDER VALUE

33

These factors relate most closely to the company’s business strategy, drivers of value, including customer and employee satisfaction, and areas in which improvements are needed. These factors speak to how a company’s performance is expected to translate into shareholder results, rather than whether it already has achieved those results. Nowhere have we seen the issue of how companies achieve results for shareholders more dramatically play out than in the financial services sector in 2008. During the last half of 2008, the financial services sector took a steep and precipitous fall, and brought the entire economy with it. This happened in large part because companies in this sector had taken on risks that were hidden from view on their financial statements and were not priced into these companies’ stocks. As a result, the values of these financial institutions were not sustainable. Nell Minow says, “Whether you’re putting a premium on market share or cash flow, you’re still trying to achieve sustainable growth in the company over a long period of time. So it’s all a question of how you think your best way of getting there is.” Put another way, the goal is not just to stumble across the finish line, gasping and wheezing, but to sail across it with grace and aplomb in a way that positions the company for the next race. This means that supplementing TSR with strategic measures that indicate sustainability of success—things like customer satisfaction, operational achievements, employee engagement, and risk—is important as well. These factors might not show up in the current stock price, but they likely will over time. TSR gives us strong guidance—a starting point—for determining how an executive should be paid over the long run. While it is a powerful first step, it also needs to be supplemented by considering relative performance (for example, relative to specific peers, the industry, an index, or the broad market), at least over the intermediate term, as well as sustainability of performance, as indicated by strategic factors that are in our shorter-term cross-hairs.

34

FAIR PAY, FAIR PLAY

Ursie Fairbairn calls this the “portfolio approach to performance measurement.” Fairbairn’s idea is that compensation committees need to work on issues from a number of perspectives in order to arrive at an answer. According to Fairbairn, “You can’t have only shareholders win. It’s got to be win-win. You’ve got to have shareholders, employees, and management win. You need a number of indicators.” My interpretation of the portfolio approach, depicted in Exhibit 2.5 (page 40), shows how long-term TSR provides a strong first step in assessing executive performance and pay, since it is most directly aligned with shareholder interests. But it also shows that no one measure tells the whole story.

Alignment Model Given my years of experience, I am a believer in the portfolio approach and have translated it into the performance-pay Alignment Model that I introduced in Chapter One. To take my alignment concept a step further, I have put three-year rolling TSR on the x-axis, shown in Exhibit 2.6 (page 40), indicating that three-year TSR should be the primary driver of performance-adjusted executive compensation. But there is an important addition to this concept, called the Alignment Zone. The notion of the Alignment Zone is that there is no one right answer on what to pay executives based solely on TSR. Rather there are other indicators, such as relative TSR, financial performance, and measures that represent the sustainability of value and strategic attunement, which rightly should modify the pay. In other words, I am suggesting that, within bounds, there is a reasonable range of pay outcomes for any given level of three-year TSR, based on both TSR and other considerations. The Alignment Zone captures the fact that TSR is a good primary indicator of company long-term success, while also recognizing the need for the portfolio approach. In other words, it reflects a system that is centered on TSR but

SHAREHOLDER VALUE

35

is modified by considerations of relative performance and sustainability, and bounded in terms of discretion. The fact that the alignment concept is a zone, and not a line, is a visible reminder of why I believe a good executive compensation system combines art and science. All art, and the system will devolve into a discretionary jumble that will lack credibility with shareholders and motivational value for executives. All science, and it will seem as though the answer never will be exactly right. As a result, alignment, as a concept, is a zone and not a line. It requires judgment to determine where in the zone executives should be paid. Compensation committees are best equipped to apply this judgment. They know and explore the facts and circumstances. They see the performance “portfolios.” As a result, shareholders need compensation committees to work on their behalf.

Simplicity According to Jay Lorsch

“I know people who’ve been around a long time, and they say, ‘why do we need all these complicated things? Why don’t you just pay the way the private equity guys do?’ You give the CEO a share of the company value or profits at the end of five years, or ten years, or whatever period you choose. And you tell them, ‘All you have to do is run this company and make as much money as you can, and build a healthy company, and at the end of ten years, we’ll add up all the economic value you’ve contributed and we’ll give you 5%, or 10% of it. And we’ll give it to you in cold, hard cash. And that’s it. That’s your incentive.’ Now what’s wrong with that?” (Continued)

36

FAIR PAY, FAIR PLAY

According to Steve Sanger

“Each company uses its own particular approach. But each approach is logical in its own right relative to what drives value for that company. There are a lot of factors that go into the approach a company uses, one of which is, ‘Do the employees understand it and does it motivate them to do the right things?’ That’s why I like simple and consistent plans. The other thing you look for is director discretion in case things happen that you could never have anticipated. The approaches are different; the things they measure are different; the time periods are different. But they all have their logic. They represent what the company is trying to do.”

Complexity According to Dan Ariely

“From a decision-making perspective, there’s a lot of noise in getting from the performance of the executive to the performance of the company. You could have a CEO who makes fantastic decisions, but things happen that are outside of the executive’s control. And you can have a fantastic person that makes great decisions given the information available at the time, but result in a bad outcome. “If you write the model for the performance of the company, as measured by stock value, and stock value is driven by productivity, plus regulatory change, plus competitive moves, there would be a lot of factors that would impact performance that would be outside of the CEO’s control. “So in order to evaluate a CEO, we shouldn’t use a variable that is so far removed from their real performance, like TSR. We should reward the CEO based on the quality of their decisions given the information that they had at the time. This is harder to do.”

SHAREHOLDER VALUE

37

30%

20%

Median Three-Year TSR

Median Three-Year EBITDA Growth

10%

0% 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08

Annualized Three -Year Growth Rate

Exhibit 2.1. S&P 1500 Median TSR Versus EBITDA Growth

Year

–10%

Note: Data over rolling three-year periods ending in each year shown.

Exhibit 2.2. S&P 1500 Annualized Three-Year TSR Distribution, Three-Year Periods Ending 1995 to 2008 1,500

Number of Company Cases

1,250

50th percentile = 10% 25th percentile = –3%

75th percentile = 23%

1,000 750 500 250 0 –60 –50 –40 –30 –20 –10

0

10

20

30

40

50

60

Annualized Three-Year TSR (Percentage)

70

80

90 100

38

–20%

–10%

0%

10%

20%

30%

40%

1995

3%

12%

22%

1996

0%

11%

24%

1997

8%

22%

36%

1998

–1%

13%

28%

17%

18%

1999

–5%

6%

2000

–10%

3%

–15%

1%

14%

2001 2002 Year

–5%

6%

50th Percentile

22%

75th Percentile

0%

11%

21%

9%

19%

2004

2005

25th Percentile

2003

–6%

8%

20%

31%

24%

2006

4%

13%

Exhibit 2.3. S&P 1500 Rolling Three-Year TSR, 1995 to 2008

Note: Data over rolling three-year periods ending in each year shown.

Annualized Three-Year TSR

2007

–4%

7%

19%

2008

–19%

–7%

4%

39

Annualized Three-Year TSR

–20%

–10%

0%

10%

20%

30%

40%

Energy

2%

15%

32%

Materials

–4%

7%

16%

Industrials

–2%

10%

23%

Consumer Discretionary

–6%

8%

22%

Consumer Staples

3%

12%

22%

Health Care

–3%

10%

26%

Financials

4%

14%

25%

Information Technology

–12%

6%

25%

5%

11%

18%

Telecommunication Utilities Services

–4%

11%

24%

75th Percentile 50th Percentile 25th Percentile

Exhibit 2.4. TSR by Industry Sector, Three-Year Periods Ending 1995 to 2008

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FAIR PAY, FAIR PLAY

Exhibit 2.5. Portfolio Approach to Performance Measurement Investor Perspective Relative Performance

Overall Management Performance

Total Shareholder Return

Absolute Performance

Performance captured as modifier to Alignment Model

Performance captured as primary input to Alignment Model

Management Perspective

Exhibit 2.6. Alignment Model Revisited High

Executive Pay

Misalignment

Alignment

Misalignment Low Low

High Total Shareholder Return

3 THE ANATOMY OF PERFORMANCE-ADJUSTED COMPENSATION (PAC) Virtuous Circle Going back to the question of whether pay motivates behavior, I have made the argument that pay is an effective focusing device. As the old saying goes, “Be careful what you pay for because you’re going to get a lot of it.” Think of it as a virtuous circle: the pay system motivates executives to perform; performance happens, influenced largely but not entirely by executive efforts; and then executives get paid on the basis of performance outcomes. Further, the pay that comes out of the system reinforces future performance. Of course, it doesn’t always happen that neatly, but this is at least how things are intended to work. Exhibit 3.1 illustrates the point (page 53). Compensation committees, management, and compensation consultants alike all put a tremendous amount of effort into getting the motivational part of the pay system right. Vast resources are put into establishing peer groups and gathering target pay data through proxy reports and surveys. This is useful work. Target compensation is established at the beginning of the process and is the flywheel that gets things started. It represents the amount that an executive will get paid for meeting expected performance levels, and is established before performance becomes known. However, actual compensation that executives will receive will vary from target on the basis of actual performance. This is why it is also critically important to evaluate PerformanceAdjusted CompensationTM, which I refer to in shorthand as PAC.

41

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FAIR PAY, FAIR PLAY

PAC is designed to measure pay outcomes—how much pay will be delivered for a given level of performance after performance happens. This is a tremendously important concept and is almost never touched on by compensation committees, managements, or consultants. Why? Because up until now, it has been difficult, time-consuming, and expensive to calculate performance-adjusted pay, let alone calibrate it to performance across a spectrum of performance outcomes.

Quantifying Executive Pay: Definitions Count There are almost as many ways to quantify executive pay as there are ways of making money. I have seen journalists count all of the gains from an executive’s stock options accumulated over time as a single year’s compensation. That’s hardly fair, since these amounts are sometimes accumulated over a career, and should at least be divided by the number of years it took to earn the awards. Similarly, I have seen executives declare that stock options are not worth anything if they are “out of the money,” which is when the current stock price is below the option’s strike price so that it has no current intrinsic value. But if you ask these same executives to simply forfeit their out-of-the-money, or “underwater,” options, they won’t part with them because they know that the options may have some value someday.4 Likewise, the Financial Accounting Standards Board (FASB), the private sector body that establishes financial reporting standards, has its way of valuing stock options, as dictated by FASB Statement 123(R). And the SEC has its way of valuing options for the company’s proxy statement. The permutations are virtually limitless. Definitions count.

THE ANATOMY OF PERFORMANCE-ADJUSTED COMPENSATION

43

Fairness Doctrine But difficulty in calculating PAC is no excuse. If I go back to the question of why shareholders, the public, the media, and government become outraged over executive compensation, I come back to the idea of fairness. People do not think it’s fair when executives make a lot of money in the wake of low performance. This is why outsized stock option grants and severance payouts when performance is low disturb our senses. Raj Gupta feels strongly about this issue: “When things go well and people are rewarded, I think investors and stakeholders understand. But when it appears that enormous sums are paid out for a low level of performance, I think that really hits people the wrong way. Although this sounds like it’s mostly the financial sector, it’s much more pervasive.” Conversely, when pay is low and performance is high, this isn’t fair either. Executives take it on the chin in such a deal. And while shareholders may enjoy bargain basement pricing on executive talent in the short run, it will leave them vulnerable to the departure of talented executives in the longer run. Just as overpaying for poor performance is not in shareholders’ best interests, underpaying for good performance is not in their best interests either. The trick is to find the right level of compensation for performance—not too high, not too low, but just right.

Calculating Performance-Adjusted Compensation Target pay can only go so far in addressing the fairness issue. The primary reason is that target pay doesn’t consider performance. It simply looks at one company’s pay levels relative to the market and assumes that the performance parameters will be appropriate. As I said earlier, it looks at pay before performance happens. It is for this reason that I developed the notion of PAC. PAC tests whether the pay delivered is within the realm of

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FAIR PAY, FAIR PLAY

reasonableness for the performance delivered. It tests whether pay is fair—fair to shareholders and fair to the executives. It asks and answers the question, “How much is enough?” Or better yet, “How much is appropriate?” As I have defined it, PAC is annualized total compensation after performance is taken into account on the basis of threeyear rolling performance and pay periods.5 For any given executive at the end of any given three-year rolling period, PAC is the average of • Actual salary earned over the three-year period. • Actual short-term incentives earned over the three-year period. • The Black-Scholes value of any stock options granted during the three-year period, measured at the end of the three-year period (vested and unvested) on the basis of actual stock price at the end of that period.6 (In essence, this quantifies the value of in-the-money or out-of-the-money options, including the value of the remaining expected term, or tail, on those options.) • The value of any restricted shares granted during the threeyear period (vested and unvested), calculated at the end of the period. • The value of any performance shares earned and vested during the three-year period, calculated on the basis of the stock price at the time of vesting.7 • The value of any long-term cash incentives paid out during the three-year period. • The value of benefits provided during the three-year period.8 This methodology is shown in concept in Exhibit 3.2 (page 53). I also have provided an illustrative example of how this definition translates into three-year average (annualized) PAC in Appendix A.

THE ANATOMY OF PERFORMANCE-ADJUSTED COMPENSATION

45

Using this methodology, I quantified PAC for each of the top five executives in the S&P 1500 for three-year periods ending 1995 to 2008, and adjusted it for inflation (expressing all of the data in 2008 dollars). I stripped out any data points for which the CEO was not in his or her job for the entire three years so as to eliminate distortions caused by CEOs in transition (such as new-hire arrangements, promotional grants, severance pay, and so on). The beauty of PAC is that it can be applied consistently, so that one company can be compared easily to another. It also removes any discretion given to executives in exercising stock options, thereby separating personal choice from company performance outcomes. Finally, it separates compensation gains from investment gains. In other words, it measures compensation to the executive, not wealth gained or lost through real ownership. This last point is important because we are determining whether executives are being paid appropriately for the performance delivered, not how they are being paid as investors. Also, because PAC measures the average annualized value of compensation at the end of each three-year rolling period, it is important to note that executives could actually receive pay that is much higher—or lower—than that reported by the PAC methodology. This is because executives have the opportunity to hold their stock options beyond any given three-year period, giving them more time to create company value before they actually exercise the options. But once again, when to exercise his or her stock options is a personal decision by the executive within certain vesting and term boundaries, and in the analysis, I wanted to separate out the pay opportunity provided by the company from a personal choice made by the executive. Finally, I have used our comprehensive data set to quantify PAC for the five top executives across the entire S&P 1500. Although I have studied pay among the top team extensively, most of the observations that I discuss in this book pertain to the CEO. I chose to proceed this way because, as described in

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FAIR PAY, FAIR PLAY

Chapter One, my observations of CEO compensation practices generally hold true for the other executive officers named in the proxy, called named executive officers, or NEOs. In fact, there is a high degree of consistency between the way in which companies pay their CEOs and the other NEOs, suggesting that policies within companies are applied similarly to the top group. For example, if a CEO is highly paid for his or her performance relative to the market, then there is an excellent chance that the other members of the top five group are likely to be highly paid as well. A number of directors and executives I spoke with were real fans of the PAC methodology. One director offered, “It would be great to know what the actual compensation was in our peer group and in our own company. We never take the time to look at this.”

Numbers on Actual Compensation According to Laurie A. Siegel, senior vice president, Human Resources and Internal Communications, Tyco International, Ltd.

“We recognize that if you really want to know if you’re paying for performance, you have to look back and look at actual value delivered and actual performance. And that’s not easy to do. We know that the proxy ends up being the record for that, and we do not feel that the proxy is doing a good job of telling that story. We think it’s easy for a reviewer to get a number in their head that’s a point-in-time number. It doesn’t necessarily reflect what the executive is realizing in terms of gains. I don’t think we’ve necessarily cracked the code. I’m really supportive of work I know is being done in the industry to look at better ways to measure what pay for performance really has been.”

THE ANATOMY OF PERFORMANCE-ADJUSTED COMPENSATION

47

According to Steve Sanger

“I think the true analysis that one has to come out with over time, even if it’s a look back in terms of how the system and philosophy are working, is ‘How did I perform versus how did I pay, and how does that compare to others in the marketplace?’ So there’s actual pay to performance. And then in doing this, you might see a dislocation in any given year, either on the performance or the pay side. Doing it over time I think becomes critical because you’re not going to get the pattern results in just looking at one year alone.”

Farient’s Data To be sure, this database gives us a rich view of PAC over time. We’ve already seen some of the PAC data in Chapter One, showing inflation-adjusted PAC moving from $2.2 million (in 2008 dollars) for the three years ending in 1995 to $3.9 million for the three years ending in 2008. A second observation, as shown in Exhibit 3.3 (page 54), is that PAC is driven in part by revenue size. The larger the company, the higher the market pay for a given position. In fact, there is a 30% correlation between revenue size and pay, meaning that 30% of the variance in CEO PAC can be explained by differences in revenue size. Some skeptics argue that because size, at least in part, drives pay, executives are incentivized to do mergers and acquisitions, regardless of whether or not these deals are value accretive. They blame the pay system for why so many bad deals get done. But if this were the case, executives wouldn’t carry out divestitures or spin-offs, which they routinely do. From my own experience in running a division of a $10 billion company, as well as running smaller entrepreneurial organizations, executive

48

FAIR PAY, FAIR PLAY

pay varies with company size for at least three legitimate reasons. First, running a large company is quite different from running a small company. Second, there are fewer people who have demonstrated experience and skills in leading a largescale organization. Third, the economic impact of running larger organizations is higher than smaller ones. As a result, there is a good reason why pay increases with company size. Ron DeFeo explains why in his view size matters. “Size is a surrogate for impact. I’m not sure it’s the only surrogate for impact, but it is one of those surrogates—one of those metrics—that is commonly used. I don’t think it should be controlling, but I think it’s an input. The bigger the organization, the more people’s lives are impacted.” Another observation that we can glean from the database is that PAC for the second through fifth executives tends to run approximately one-third to one-half of the CEO’s PAC. Moreover, this separation in pay has been remarkably constant over the past twelve years. These ratios are shown in Exhibit 3.4 (page 54). Some wonder whether the separation in CEO pay to the next-level executive is too great. They can remember the old days (in other words, the 1980s) when the #2 position was paid about 70% of the #1, when the COO position was used with greater frequency. They argue that less distance between #1 and #2 is not only more egalitarian, but also encourages the #2 through #5 to stay at the company, rather than move to another company for the #1 spot. My view is that companies need to first decide on the right organizational structure and roles for their businesses, then figure out how to pay people on the basis of philosophical, strategic, external competitiveness, and internal equity considerations. To be sure, every company needs a strong succession planning process to maximize its chances of promoting from within. The benefits of identifying strong internal successors are compelling. Internal CEO successors cost less than outside hires;

THE ANATOMY OF PERFORMANCE-ADJUSTED COMPENSATION

49

the replacement costs for external hires are substantial; and most important, internally promoted CEOs have higher success rates than externally hired CEOs (although the cause and effect of this phenomenon have not been proven). So, I am less bothered about the distance in pay between the #1 and #2 as I am about the fact that it might reflect some organizational “shortcuts” we may have taken along the way.

PAC Pay Mix When it comes to the mix between the fixed elements of pay (salary and benefits) and the variable elements of pay (shortand long-term incentives), called the risk profile, it’s common knowledge that the executive pay program has become more risky over the years. It’s the same for PAC, except that the variable portion of the pay package is higher when the stock market is up, and it is lower when the stock market is down. Exhibit 3.5 shows the mix of CEO pay components over time (page 55). Why has the riskiness of the pay package increased over time? I attribute this in large part to an aberration in the tax code, IRC Section 162(m). Section 162(m) was enacted in 1993 to reign in outsized executive compensation by eliminating the tax deductibility of executive compensation above $1 million for the top five executives in public companies unless the excess compensation was performance-based. It essentially disallowed a tax deduction on any compensation above $1 million that wasn’t contingent upon objective performance criteria for any of the top five executives in any public company. Because tax deductions are in the best interests of a company’s shareholders, public companies often capped the CEO’s salary, which did not qualify as “performance based,” at $1 million and let pay levels increase through the performancedriven portions of the package. The unintended result was a run-up in the use of incentives to provide pay increases. And because incentive-based pay is riskier than salary, companies

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FAIR PAY, FAIR PLAY

provided a premium on pay since executives were assuming added risk. This resulted in even higher Performance-Adjusted Compensation levels, driven largely by the heady stock market of the late 1990s, which of course, set off a new bevy of alarm bells around excessive executive pay. Section 162(m) is just one example of the unintended consequences of our government intervening in free market forces (in this case, the pricing of executive talent). In the mid-1990s, approximately 60% of PAC was variable. More recently, approximately 70% of PAC is variable. The bigger change, perhaps, is in the mix of long-term incentive values. In the 1990s, stock options constituted the lion’s share of longterm incentives, with their use dramatically increasing in the late 1990s following the adoption of Section 162(m) and the fact that options generated no accounting expense on the financial statements (both examples of the unintended consequences discussed previously). Now there’s practically an equal mix between stock options, restricted stock, and performance shares. I like this mix change, since stock options can be a driver of runaway pay. Stock options are highly leveraged incentive vehicles, meaning that they produce significant incremental pay for incremental performance relative to other forms of pay. While significant leverage might be considered to be a good thing, there is another issue in that stock options allow executives to accumulate options for a given period, then cash them out when there’s a secular run-up in the stock market. Some people say that this is fine—investors can also accumulate stock and sell their shares when the market is overpriced—but the job of an executive is to protect the interests of all of the shareholders, not just the ones who are cashing out when the price is high. Stock options don’t do the best job of recognizing this. I like the fact that performance shares have, to some extent, displaced stock options in the pay mix. Make no mistake, performance shares can provide just as much leverage as stock options,

THE ANATOMY OF PERFORMANCE-ADJUSTED COMPENSATION

51

but they encourage and reward for more sustained performance since rewards are realized when the performance cycle is complete, not at the discretion of the executives during relatively long window periods for exercise.

Money Is Money According to Nell Minow

“Money is money is money is money. Whether it’s options or restricted stock or cash or gold bullion. I really don’t care very much. What I care about is the basis upon which it’s awarded and the requirements in terms of holding onto it, and so I don’t care, basically, if it’s restricted stock or stock options, but in any event, whether it’s restricted stock or stock options, I’m in favor of requiring the executives and the directors to hold onto all of their stock three years after leaving the company.”

Coming Full Circle We’ve established that target pay and incentives, properly designed, are useful in motivating the right executive behaviors, or at least focusing on the right operating levers and desired outcomes. We’ve also established that Performance-Adjusted Compensation (PAC) should be an essential part of the analytic toolkit for measuring pay outcomes—how much pay is delivered for a given level of performance after that performance happens. As a result, the construct for alignment that I’ve developed shows TSR as the independent variable—the driver of Performance-Adjusted Compensation, and PAC as the dependent variable. Now, armed with a database for TSR and PAC, we are ready to look at the effect of performance on pay and to determine whether performance and pay are truly aligned.

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FAIR PAY, FAIR PLAY

Numbers Tell a Story, but Whose? Few pay packages have been as controversial—or as misunderstood—as Rick Wagoner’s. Having spent a career of thirty-two years at General Motors, Wagoner had risen to become the chairman and CEO, holding the post from June 2000 to March 2009. In 2009, Wagoner was forced to resign as the company slid into bankruptcy and took federal funds to help bail the company out. During his last full year of employment, Wagoner received a “target” total pay opportunity of $14.9 million, comprising a base salary of $2.2 million, coupled with $11.9 million in long-term compensation, and various other benefits. However, his actual Performance-Adjusted Compensation was $3.3 million, since the bonus and equity components of his pay package ended up being worth nothing at the time of GM’s bankruptcy filing. In addition, Wagoner voluntarily reduced his salary in early 2009 to one dollar, as part of GM’s request for government help. This was the second time during his tenure that he had voluntarily reduced his salary, having previously done so in 2006 before it was restored in 2008. Wagoner’s 2008 “reported” pay touched off a maelstrom of protests in early 2009, mainly among news commentators and bloggers, because it reported the target amount of $14.9 million. This was unfair to Wagoner and just plain inaccurate since the performance-adjusted components of his pay behaved the way they were supposed to—they drove the actual value of the total pay package down to a number that was about one-fifth of the target amount. While I don’t know whether the story would have sold as many newspapers, Wagoner should have been talked about as someone who had sacrificed a measure of his compensation, and wealth, for the sake of an ailing firm.

THE ANATOMY OF PERFORMANCE-ADJUSTED COMPENSATION

53

Exhibit 3.1. Virtuous Circle of Compensation Motivation and Focus

Pay System Design

PerformanceAdjusted Compensation Results

Performance Happens

Target Pay Analysis

Alignment Analysis

Reinforcement

Exhibit 3.2. Methodology for Calculating Annualized Performance-Adjusted Compensation1 Actual Salary (S) Actual Short-Term Incentives (STI)

Year 1

Year 2

Year 3

S1

S2

S3

STI1

STI2

STI3

Actual award value when earned or paid

Performance-Adjusted Value of Long-Term Incentives • Stock Options (SO)

• Restricted Stock (RS)

• Performance Shares (PS) Other Compensation 2

SO3

Black-Scholes value at end of three years

RS3

Market value at end of three years

SO1 SO2

RS1 RS2

PS1

PS2

PS3

Other1

Other2

Other3

1 Excludes officers who are not in position during the entire three-year period. 2 Other compensation includes perquisites, other benefits, 401(k) plan contributions,

life insurance premiums, tax reimbursements, and deferred compensation earnings.

Actual award value when earned or paid

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FAIR PAY, FAIR PLAY

Exhibit 3.3. S&P 1500 Company Revenue Versus CEO PAC

Annualized PAC (2008 $MMs)

$12.0 $10.0 Market Pay Line Revenue Only R2 = 30%

$8.0 $6.0 $4.0 $2.0 $0.0 $0.0

$2.5

$5.0 $7.5 $10.0 Company Revenue (2008 $Bs)

$12.5

Exhibit 3.4. Percentage of CEO PAC by Position Rank Position Rank

% of CEO PAC

#2 #3 #4 #5

53% 43% 37% 34%

$15.0

55

0

10

20

30

40

50

60

70

80

90

100

estimate

1995

38%

5%

19%

5% 3%

30%

1996

35%

5%

18%

5% 3%

34%

Salary

1997

31%

4%

17%

4%

5%

39%

1999

30%

5%

18%

4%

5%

38%

Benefits

1998

31%

5%

18%

4%

5%

36%

Bonus

2000

27%

5%

17%

5% 3%

42%

2002

30%

5%

17%

3%

6%

40%

2003

25%

4%

15%

3%

8%

45%

LT Performance Plans

2001

26%

5%

16%

5% 3%

45%

2005

24%

5%

19%

4%

13%

35%

2006

23%

4%

16%

10%

16%

Restricted Stock

2004

25%

4%

17%

3%

10%

40%

32%

Exhibit 3.5. CEO Pay Mix Distribution as a Percentage of Total PAC

Note: Data over three-year periods ending in each year shown.

1 Farient

Percentage of Total PAC

20081

26%

5%

22%

22%

13%

Stock Options

20071

23%

5%

16%

17%

16%

24%

13%

4 THE PERFORMANCE AND PAY ALIGNMENT ZONE Alignment: The Stated Objective Almost every company states, in one way or another, that its goal is to align executive pay and performance. Companies say this in different ways, but it all adds up to the same thing. The compensation committee of every public company is required to issue a report on executive compensation to shareholders in the company’s proxy material. This report is called the compensation discussion and analysis, or CD&A. Most of the CD&As that I have read (and written) state that a primary objective of the compensation system is to gear pay to performance or, put another way, to establish a system that pays executives well when shareholders do well and vice versa. Following are some examples: PepsiCo “Pay levels for executive officers are designed to be competitive relative to our peer group companies and, most importantly, align with the Company’s performance. Pay-for-performance is a critical policy in designing our executive officer compensation.” United States Steel Corporation “A significant portion of an executive’s compensation is delivered in stock with formal stock ownership and retention expectations in place to ensure alignment of the executive’s interests with those of our shareholders.”

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FAIR PAY, FAIR PLAY

Microsoft Corporation “We design our executive officer compensation programs to attract, motivate, and retain the key executives who drive our success and industry leadership. Pay that reflects performance and alignment of that pay with the interests of long-term shareholders are key principles that underlie our compensation program design.” While alignment may be the goal, it is a goal about which few companies are specific. Usually, when a company discusses alignment as its key compensation objective, I am left with a number of questions: • What does the company mean by performance? TSR? Financial performance? Strategic drivers of TSR? Performance on an absolute or relative basis? And if on a relative basis, relative to the broad market, the industry, or a custom set of peers? • What is the relevant time period for achieving alignment? Does the company seek alignment in the long term? The short term? Or both? • What will happen when the alignment objective is in conflict with other objectives for the pay system, such as the attraction and retention of highly talented executives? Which objective trumps the other? • When the company wants pay to be sensitive to performance, does this mean that pay just fluctuates upward and downward with performance? Or does it mean that pay positioning fluctuates relative to a particular performance positioning? I could go on, but you get the point. I would feel a bit better about things if I thought that companies really had the answers to all of these questions—that they were just hesitant to wax on about them in the proxy, since CD&As are already long enough. In my experience, though, most companies haven’t had enough of

THE PERFORMAN CE AND PAY ALIGNMENT ZONE

59

an in-depth discussion to reach true agreement on these issues at the level of granularity that will best serve them. Many just assume that everyone knows what we mean by “pay for performance” or “executive interests being aligned with shareholder interests.” But this assumption gives us false comfort. Everyone doesn’t know what we mean by those terms, giving rise to some of the confusion we see about executive pay.

On Alignment According to Nell Minow

“Obviously alignment is a big issue for me, but let’s start with, alignment with what? Total shareholder returns may be appropriate in some cases, but I’m not sure that it’s appropriate in all cases. To me, clawbacks are an indispensable part of the credibility of any plan. Another indispensable part of the credibility of any plan is indexing, because total shareholder returns can be as much as 70% based on the overall market, and I have no interest in rewarding anybody for rising with the overall market, and I do have an interest in rewarding people for falling less than the overall market, so for me that’s very important.” According to Vern Loucks

“It has to start with management being convinced that alignment is something they want to do, and that they’re willing to set up their compensation to reflect this, and that their expectation is for TSR to follow, because the strategy is right.” According to Steve Sanger

“Investors have a vested interest in alignment. While CEO pay represents a small share of any major company’s expenses, the structure and alignment of compensation can have a powerful effect on executive behavior.”

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The Devil Is in the Details The reality is that the lack of definition of what we mean by alignment can throw us off track from the beginning. As a case in point, a few years ago, I worked with the board of a company in which the compensation committee thought management was doing a great job in a difficult business environment. The compensation committee really wanted to acknowledge and reward the efforts of management for obtaining relatively good results in troubled times. The company’s stock price was flat, and the firm missed its budgeted goals, which in retrospect had probably been set too aggressively in view of the melting economy. In many ways, the committee had more questions than answers about how to pay relative to these results. Should it look at performance on a relative basis, an absolute basis, or both? Should it go outside of the pay plan and pay special retention incentives for good management despite missing budget? Or should it just let the compensation chips fall where they may, dictated by the “four corners” of the plan? If the committee went outside of the plan, would this undermine the credibility and effectiveness of the plan? Was the problem with the goalsetting or with the plan? Did these issues signal that the company needed to scrap the old plan and bring in a new one? The compensation committee did an excellent job in working through these issues. They ended up leaving the program alone for the year that had just occurred—letting the chips fall where they did, generating no bonus, but redesigning the pay plans for the subsequent year. The new plans paid for competitive value growth over the long term while measuring both relative and strategic performance in the short term. All of this was calibrated to a system of paying at the 75th percentile for 75th-percentile performance, the median for median performance, and the 25th percentile for 25th-percentile performance. The answer that this committee came to was right for this company specifically, and the process it went through to answer the questions was right for all companies.

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Alignment Defined Although the preceding story has a happy ending, the confusion that was experienced by the company is not all that rare. This confusion starts with the definition of performance-pay alignment and ends with the fact that few companies measure and monitor alignment over time. Often, companies assume that pay is aligned with performance when the executive pay programs are laden with equity. But equity offers false comfort. A heavy emphasis on equity in the pay mix provides no assurance that performance and pay are going to be aligned. To start us off on the right foot, I developed a standard way to define and measure performance-pay alignment. Simply stated, Alignment is when Performance-Adjusted Compensation fluctuates with TSR within an acceptable range compared to the relevant market over time.

To bring this definition alive, I developed a way to measure performance and pay by using three-year rolling TSR as the primary measure of performance outcomes and PAC as the measure of three-year average pay outcomes. To tease out the anomalies caused by a long passage of time, I adjusted PAC for company revenue size and GICS 9 industry group, and then ran the calculation from the three-year period ending in 1995 to the three-year period ending in 2008 for each of the top five executives. Then I defined the “acceptable range” of PAC for a given level of TSR as the “Alignment Zone” and, conversely, the area outside of the “acceptable range” as the “Alignment NOzone.” The Alignment Zone encompasses both the range of pay outcomes observed in the marketplace and the range of pay outcomes produced by the leverage inherent in a typical executive pay system in a typical company. The zone, in essence, acknowledges that there is a range of acceptable pay outcomes for a given level of TSR

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based on how well a company is pushing on the drivers of sustained value, not just on the value itself. This definition is shown conceptually in Exhibit 4.1 (page 69). Notice that there is an Upper Alignment NOzone and a Lower Alignment NOzone. The Upper NOzone is where pay is high and performance is low. This is the territory in which executives are getting a better deal than shareholders. The Lower NOzone is where pay is low and performance is high. This is the territory in which shareholders are getting a better deal than executives. By my estimate, there are about an equal number of data points in the Lower NOzone and in the Upper NOzone, although we tend to pay the most attention to those companies that are in the Upper NOzone. This is because shareholders seem to pay more attention when their shares are underperforming. I like this alignment framework because • Boards, compensation committees, management, investors, and analysts can understand it. • It relies on standard data and calculation methodologies, allowing us to discern broad market patterns and trends, as well as compare individual company data to the entire public market, industry sector, industry subsector, custom peer groups, or individual companies, as desired. • It is applied over long periods of time, allowing us to analyze the degree of consistency and sustained patterns of alignment. • It provides for a relatively liberal range of pay outcomes, implicitly acknowledging that “one size does not fit all” when it comes to pay outcomes. • It offers a definitive way to test whether companies are putting their money where their mouths are and actually paying for performance, not just talking about it.

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Alignment Questions and Answers As with any good analytic effort, my team and I began to study this data with a series of questions, not answers: • Question 1: To what extent is PAC generally aligned with performance across the broad market? • Question 2: Do alignment patterns vary by industry sector, and if so, how? • Question 3: How much do companies pay for incremental size versus incremental performance? • Question 4: Do high-performing companies have better alignment than low-performing companies? • Question 5: How does alignment vary by company? We tackled these questions one at a time. Question 1: To what extent is PAC generally aligned with performance across the broad market? As mentioned earlier, I tested the extent to which PAC was aligned with performance in the U.S. executive labor market over the past fourteen three-year rolling periods (that is, three years ending 1995 to 2008). I performed this analysis by testing the relationship between size, GICS industry group, and three-year rolling TSR performance. For the top five executives, we had approximately 50,000 cases, or data points, in our overall sample of the S&P 1500. For CEOs, there is a 49% correlation between PAC and performance, controlling for company revenue size and industry sector. This means that only 49% of the variance in PAC can be explained by a combination of revenue size, industry group, and performance. To illustrate the market pattern, the market PAC line is shown in Exhibit 4.2 (page 69) for the CEO of a $2 billion revenue company.10

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This finding is interesting because we know that about 30% of PAC is driven by company size, while 11% is explainable by industry group (both factors directly relevant to a company’s specific labor market for talent), leaving the remaining 8% explainable by TSR, as shown in Exhibit 4.3 (page 70). Further, about 60% of the data points fall outside of the Alignment Zone, which means that over the past fifteen years or so, most companies’ CEO PAC has not been in what I would consider to be a reasonable range around either the performancepay relationships observed in the market or the performance-pay relationships inherent in a typical CEO pay program. Given these results, I am not surprised that investors and boards alike generally feel that it is not pay levels that are the issue; rather, it is pay alignment that is the issue. Bob Monks looked at the performance and pay alignment chart and wasn’t surprised. “I think alignment is the correct objective. The problem is that most companies aren’t anywhere near alignment. In fact, my own wisdom, which is informed by your research, says that there isn’t really any correlation between compensation and rational shareholder criteria in today’s market.” Others in the compensation consulting field maintain that executive performance and pay are aligned. They say this by pointing to the fact that median CEO PAC rises at a similar rate as the stock market over time. This relationship is shown in Exhibit 4.4 (page 70). In looking at this relationship, one is tempted to conclude that CEO PAC does track with TSR over time. However, we need to be careful about drawing conclusions on the basis of averages. It’s like saying, “If a man’s hands are hot, but his feet are cold, then on average he’s quite comfortable.” To crack this code, it’s critical that we evaluate how well companies are aligned with performance, not the total market on average. And we know from the regression analysis that the broad market is in

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a fair amount of disarray, with over half of the variance in pay left unexplained. Bud Crystal agrees with me. He says that “people draw improper conclusions from median data all the time. Besides, companies are making decisions about company pay in response to company performance, not median pay in response to median market performance. So the individual company data points are what matters most.” Question 2: Do alignment patterns vary by industry sector, and if so, how? When we look at the relationship between PAC and performance by sector, we can start to see the differences that are occurring by the types of companies that occupy each sector. These differences are shown in Exhibit 4.5 (page 71). To some extent, these differences reflect the economics of the companies in each sector. For example, companies in the materials sector have a somewhat lower and flatter performancepay curve compared to companies in the health care sector. This means that there is not as much variation in PAC in the materials sector compared to variation in PAC in the health care sector for commensurate changes in TSR. This makes sense. There is more variability in returns among health care companies than among materials companies. Moreover, health care companies on average generate greater returns than materials companies. This means that health care companies tend to put data points on the chart at the upper end of the curve, whereas materials companies tend to put data points on the chart at the lower end of the curve. Because the lower end of the curve is flatter than the upper end of the curve due to the compounding effects of stock price inherent in the three-year TSR calculation, the health care curve is higher and also more steeply sloped than the materials curve.

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Question 3: How much do companies pay for incremental size versus incremental performance? A key consideration for many compensation committees and executives is how much incremental PAC is earned for incremental size and how much incremental PAC is earned for incremental performance. A corresponding question is, “How much incremental pay should be earned for incremental size and performance?” I tested this issue, as shown in Exhibit 4.6 (page 71), and the answer is, “slightly more incremental pay for performance compared to size, but only slightly.” In going from 0% revenue growth coupled with a 0% return, to a 0% revenue growth coupled with a 10% return, a typical CEO of a $2 billion company will earn an additional $680,000 per year for the incremental performance. In going from a 0% revenue growth coupled with a 0% return, to a 10% revenue growth coupled with a 0% return, that same CEO will earn an extra $550,000 per year for the incremental size. I have heard some people maintain that the empirical relationship of pay to size versus pay to performance in the marketplace causes executives to grow companies at the expense of returns. They say that this is why there are so many mergers that don’t accrete value. When I look at these numbers, I don’t see much of an incentive to sacrifice return for size or vice versa. I also wondered why the pay line that is generated by most companies’ compensation systems has a higher slope, at least in theory, than the empirical pay line, in other words, the line actually observed in the marketplace. As far as I can tell, this is driven by two primary factors. First, most short-term incentive plans are “mark to budget” plans that are designed to have the highest probability of payout at target. They are essentially engineered to pay out at target, regardless of how good the performance is relative to competitors or how much TSR the annual goals are expected to create. For example, this

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goal-setting practice has the effect of flattening the pay line. Second, there are a number of decisions that get made outside of plan design, such as making special retention grants when the stock price is down, or paying an extra bonus as a “goodbye kiss” to a retiring CEO. These ad hoc awards essentially flatten the pay line by lifting the line at the low end of the performance curve. These factors not only flatten the observed market pay line compared to the pay program line but also cause scatter in the data, which makes it appear even to the most casual observer that there really is very little performance-pay alignment in the market. Given these considerations, I have chosen to draw the Alignment Zone, which represents a reasonable range of PAC outcomes for a given level of three-year TSR, so that it encompasses both the empirical market line and a typical company’s compensation program line. Question 4: Do high-performing companies have better alignment than low-performing companies? Aside from uncomfortable shareholder meetings and scrutiny from the media, does alignment really matter? To test this issue, I split our sample companies into low-, medium-, and higher-TSR performers. As shown in Exhibit 4.7 (page 72), the higher performers have a higher-sloped line than the low performers. However, the correlation of size, performance, and sector to PAC is about the same for all three groups. This result is not surprising since the low performers tend to occupy the lower, flatter part of the performance-pay curve, while the higher performers tend to occupy the higher, steeper part of the performance-pay curve. While I cannot prove with these data that alignment has a causal effect on performance, the data suggest that alignment brings together the interests of the executives with those of the owners, and supports the notion of fair pay.

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We also know that alignment comports with our notion of fairness, which we all seem to be striving for. Executives agree. Raj Gupta shared his sentiment: “I think it’s important to align the interests of management with shareholders . . . in fact, it’s especially important for shareholders.” And finally, the concept of an Alignment Zone identifies and “calls out” the outliers, and outliers, as we’ve discussed, have a destructive effect on the entire market. So, does alignment matter? Absolutely. Question 5: How does alignment vary by company? My final question, “How does alignment vary by company?” is perhaps the most important. The good news is that our database allows us to plot the alignment patterns of any given company relative to the relevant market over the past fourteen years. You will be able to see from this company data that alignment varies dramatically by company. Is this a bad thing? No. After all, companies are different. They strive to be different to create more value for their investors. Executives are different. So “one size fits all” doesn’t work. The alignment pattern should fit the specific needs of the business. But should this give companies license to live outside of the Alignment Zone? I don’t think so. This is why, at first glance, the Alignment Zone may look broad. It is designed to give companies the latitude to have an Alignment Model that fits their business without going beyond the realm of reasonableness.

THE PERFORMAN CE AND PAY ALIGNMENT ZONE

Exhibit 4.1. Performance-Pay Alignment Alignment Zone Upper Alignment NOzone

PAC

Alignment Zone

Lower Alignment NOzone

TSR

The Alignment Zone

Exhibit 4.2. S&P 1500 CEO Pay and Performance Alignment Alignment Zone

Annualized PAC (2008 $MMs) $2B Revenue

$15.0 Upper Alignment NOzone Alignment Zone

$10.0

2

eR

Lin t Pay

%

= 49

e Mark

$5.0

Lower Alignment NOzone $0.0 –30% –20% –10%

0%

10%

20%

30%

Annualized Three-Year TSR

40%

50%

69

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CEO PAC Explanatory Variables (R2)1

Exhibit 4.3. Drivers of CEO Compensation Regression Analysis 100% 80%

51%

Unexplained variance

60% 8%

40%

11%

20%

30%

Performance (TSR)

Industry

Size (Revenue)

0%

CEO Position

1

Total R2 = 49%. This means that 49% of the observed variation in CEO PAC is explained by the three-factor regression model.

3.00

S&P 500 Total Return Index

2.50 2.00 1.50

Nominal CEO PAC 1.00 0.50

Year Note: Data over rolling three-year periods ending in each year shown.

08 20

07 20

20

06

05 20

04 20

03 20

20

02

01 20

00 20

99 19

98 19

97 19

19

19

96

0.00 95

Indexed Growth (Base Year 1995 ⴝ 1.00)

Exhibit 4.4. CEO PAC Versus S&P 500 Index

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Exhibit 4.5. CEO PAC and Performance Alignment by Industry Sector 1 Health Care

$12.0

1

2 Energy

2

3 Information Technology 4 Financials

$10.0

3 4

Annualized PAC (2008 $MMs) $2B Revenue

5 Telecommunication

5

6 Broad Market

6

7 Consumer Discretionary

$8.0

7

8 9 10

$6.0 11

$4.0 8 Industrials 9 Consumer Staples

$2.0

10 Materials 11 Utilities

$0.0 –30%

–20%

–10%

0%

10%

20%

30%

40%

50%

Annualized Three-Year TSR

Exhibit 4.6. CEO PAC (2008 $000s) at Various Combinations of Revenue Growth and TSR for a $2 Billion Revenue Company Total Shareholder Return1 Revenue Growth 30% 25% 20% 15% 10% 5% 0%

0% 6,600 6,320 6,050 5,770 5,500 5,230

5% 7,050 6,750 6,460 6,160 5,870 5,580

10% 7,500 7,190 6,870 6,560 6,250 5,940

15% 7,960 7,630 7,300 6,960 6,630 6,300

20% 8,430 8,080 7,720 7,370 7,020 6,670

25% 8,910 8,530 8,160 7,790 7,420 7,050

4,950

5,290

5,630

5,980

6,330

6,680 7,040

Represents three-year compound annual growth rates.

1

30% 9,390 8,990 8,600 8,210 7,820 7,430

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Exhibit 4.7. CEO PAC for High-, Medium-, and Low-TSR Performers

Annualized PAC (2008 $MMs) $2B Revenue

$12.0 $10.0

ers

rm

gh

fo Per

Hi

$8.0

ers

orm

erf um P

i

Med

$6.0

ormers

Low Perf

$4.0 $2.0 $0.0 –30%

–20%

–10%

0%

10%

20%

30%

Annualized Three-Year TSR

40%

50%

5 THE ALIGNMENT REPORT We Don’t Need Perfection We can imagine an ideal world in which the correlation between performance and pay for executives in the market would be 100%. Wouldn’t this make things easy for compensation committees and executives alike? There would be no second-guessing, no contentious shareholder meetings, no news for the media to exploit, no need for a government “paymaster,” and, of course, no compensation consultants. As appealing as this scenario may be, it is not realistic. Each individual executive is unique and each company is unique. The very same executive may be worth more to one company than to another given his or her specific capabilities, role on the team, and the needs of the company. Not only is a standard pay system unrealistic, it isn’t desirable. Companies work hard to differentiate themselves by developing innovative business strategies that are tailored to their specific situation. A company’s strategy is designed to be the blueprint that pulls it ahead of the competition. If companies are striving to differentiate their business strategies, then shouldn’t they work hard to differentiate their pay programs as well? After all, best practice is for companies to gear their pay strategy and programs to their business and talent needs. In 2009, the Conference Board formed a Task Force on Executive Compensation. Farient Advisors was an advisor to the task force. Interestingly, the number one guiding principle that the Task Force developed was as follows [emphasis added]: Compensation programs should be designed to drive a company’s business strategy and objectives and create shareholder value, consistent with an acceptable risk profile and through legal and ethical means. To that

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end, a significant portion of pay should be incentive compensation, with payouts demonstrably tied to performance and paid only when performance can be reasonably assessed.

In my experience, most compensation committees would agree with this principle. They would tell you that a one-size-fitsall approach to pay just doesn’t work. Bob Denham took a look at this issue when he worked on The Conference Board Task Force. In this regard, Denham lent support for the point of view that a one-size-fits-all approach is not workable. “We appropriately emphasized the idea that companies in different industries have different needs and what is an appropriate prescription for one, for Chevron, for example, might not be a good prescription for another, like an Internet company, for example.” Some differences in pay certainly make sense, even for the same level of TSR. However, this also doesn’t give us carte blanche for a “random walk.” This tension between a 100% correlation and a random walk is why I’m defining the realm of reasonableness in the market to be a zone, rather than a line. The Alignment Zone gives us some semblance of rationality, without being overly prescriptive.

Using the Alignment Model In my view, companies should generally live within the Alignment Zone. Yes, there are exceptions, such as a new CEO whose equity is bought out from his or her prior company, or an executive who receives a special one-time bonus for pulling off a diving catch on a major transaction. These items can, and should, be reported separately and clearly from the standard fare in the proxy report to shareholders. But these items are the exception and not the rule. (And just to remind you, we pulled new CEOs out of our alignment database—that is, anyone who was not a CEO for the full-year period came out of the data—so that new-hire packages would not distort the picture.)

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Perhaps the most important application of the Alignment Model is to use it on a company-by-company basis, first looking both backward at actual historical practice and then looking forward, projecting the alignment patterns that could be generated by the compensation plans. The company can look at its alignment pattern and see whether it stays in the Alignment Zone over time or drifts away into the NOzone. It can diagnose issues, test new plan designs, and test the effect of potential pay actions. Investors also can use the model to determine what they think of the pay programs as they voice their “say on pay.” This is a far cry from today’s world in which investors are likely to get their cues only from shareholder advisory groups, whose criteria differ and aren’t always readily apparent, leaving the board and the company somewhat exposed. Farient’s Alignment Model provides an opportunity for the company and investors alike to “get on the same page.” The company can explain the historical pay outcomes of their pay programs and actions, as well as the effect of any anticipated changes, while investors can react to the story and let the company know whether they buy it or not.

Reading the Alignment Report At Farient, we call our application of the Alignment Model for an individual company an Alignment Report. When reading a company’s Alignment Report, we check for six things: • Is the market definition appropriate for this company? • Is the company’s level of PAC appropriate for its level of performance? In other words, are the historical data points within or outside of the Alignment Zone? • Is the pattern of data points upward sloping? In other words, does pay generally increase with performance and vice versa? • Is the intercept of the company’s historical pay line and prospective pay line relative to the relevant market generally at the median level of TSR?

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• Is the company’s current pay program designed to produce outcomes that make sense relative to the company’s business and the Alignment Zone? • How well has the company performed in comparison to its relevant market? To get us started, I pulled an Alignment Report for VF Corporation. Why VF Corporation? Because they’ve demonstrated a remarkable track record of alignment, and I wanted to start off with a positive example. VF Corporation is a $7-plus-billion-revenue company with 46,000 employees in 150 countries that designs, manufactures, and markets branded apparel and related products. If you have worn Wrangler, Lee, Nautica, or Vans apparel, to name only a few of their brands, you’ve worn VF Corporation’s clothes. The company’s CEO, Eric Wiseman, cares deeply about talent. As he told Workforce Magazine, “If you sit in my office, with a growth plan to raise revenues from $7 billion to $11 billion by 2012, you’ll see that I need three things. I need a strong financial lever, and that’s never been more important than it is now. I need brands that are winning against the competition. And I need talent. Money and brands don’t do me any good if I don’t have the talent. I spend very little time on tactical HR and an enormous amount of time on our leaders.” VF Corporation has maintained a consistent, performanceoriented executive compensation philosophy over the past decade. As reported in the company’s proxy statement, the goals of VF Corporation’s executive compensation program are to • Provide incentives for achieving and exceeding VF Corporation’s short-term and long-term financial goals. • Align the financial objectives of VF Corporation’s executives with those of its shareholders in both the short and the long term. • Attract and retain highly competent executives.

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The pay system features the following key traits: • Compensation includes salary, annual cash incentive, and long-term equity compensation, consisting of a balance of stock options and three-year performance shares, topped off with benefits and perquisites that meet competitive norms. • For the CEO, in excess of 80% of target compensation is at risk, that is, based on performance. • The annual cash incentive is designed to support the achievement of VF Corporation’s financial goals, primarily EPS and revenue growth. • Stock options are in the mix to focus executives on attainment of VF Corporation’s long-term growth goals. • Performance shares encourage long-term shareholder value growth, with either relative TSR or EPS growth objectives. • Restricted stock, earned through service-based vesting, is used only selectively as a retention incentive. • The committee has generally not made special awards outside of the established plans. Let’s take a closer look at VF Corporation’s Alignment Report, shown in Exhibit 5.1 (page 82). Each data point is the three-year average PAC for the TSR generated during the same three-year period. As you can see from the chart, VF Corporation has an outstanding alignment track record. In fact, it stacks up extremely well on five of the alignment criteria: Market definition—VF Corporation is in the Consumer Discretionary industry sector. We have compared VF Corporation to the sector Alignment Zone and have noted the pay line for the S&P 1500 for reference. This market definition makes sense.

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Upward-sloping pattern—VF Corporation’s PerformanceAdjusted Compensation has increased with TSR performance and vice versa. Just for the record, VF Corporation’s PAC line has an 83% correlation coefficient, which means that 83% of the variance in PAC can be explained by differences in VF Corporation’s TSR. This reflects a very consistent application of the company’s philosophy and plans. Market Intercept—VF Corporation’s PAC line, both historically and prospectively, intercepts near 15% TSR when compared to the Consumer Discretionary sector line. This is close to our 10% mark, and perhaps is even a bit ambitious given that the broad market has produced a 10% median TSR and the Consumer Discretionary sector has generated an 8% median TSR. Program design—VF Corporation’s pay program is expected to produce outcomes that are generally within the Alignment Zone, and that are consistent with how the programs have paid out in the past. This company has a plan and sticks with it! In fact, the company has operated similarly under three CEO regimes, with Larry Pugh as CEO from 1982 until 1995, Mackey McDonald as CEO from 1996 to 2007, and Eric Wiseman as CEO beginning in 2008.11 Notably, Eric Wiseman is being treated conservatively as a relatively new CEO, as VF Corporation’s current plan positions him slightly below the historical VF Corporation trend, but with a similar performance orientation. Most evident is that Wiseman’s reported 2008 salary is $950,000 (less than the $1 million benchmark that many companies acknowledge due to IRC 162(m)), which is 20% less than the former CEO McDonald earned in the last year before his retirement.

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Relative performance—Overall, the company’s performance has been commensurate with the performance of the Consumer Discretionary sector. The sector’s TSR has ranged from −6% at the 25th percentile to 8% at the median to 22% at the 75th percentile. VF Corporation’s performance has generally been in that range, varying from 0% at the 25th percentile to 15% at the 75th percentile, with a median TSR of 9% over this same time frame. This is truly an impressive Alignment Report. VF Corporation demonstrates a rational pay pattern over time relative to the market. Kudos to the compensation committee, Eric Wiseman (CEO), and Susan Williams (VP of Human Resources) for getting this right.

Merits of the Alignment Report According to Kathryn A. DCamp, former senior vice president, Human Resources, Cisco Systems, Inc.

“I think people are going to be in a position where they’re going to have to be able to explain to shareholders how they paid and why. And I think that the smart companies are going to affirmatively disclose differently before they’re required to do so. I think graphs like this should go into the disclosures. If I was a running a company where that lined up well, I’d want this in the disclosures.” According to Raj Gupta

“This visual is actually very good. It says how we line up. Having a standardized methodology for everyone is important. It’s a good indicator from a shareholder perspective.” (Continued )

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According to Vern Loucks

“I think that comp committees would definitely benefit from looking at these kinds of charts, particularly if you did some analytical work on them and raised key questions. The questions that these charts raise are really the kinds of questions that analysts should be asking.” According to Pat McGurn

“This is a very interesting way to look at it because you can see what happened at each point in time. It definitely tends to show whether there’s consistency. That’s the interesting thing about Say on Pay. Ultimately, I think it’s a referendum on the administration of pay by the board of directors and the comp committee in particular, rather than necessarily a scoring out of the CEO’s pay itself. And so, this sort of a view I think would be something that would be very interesting to shareholders.”

The Gestalt The Alignment Reports offer us a look at the gestalt of what companies are about—things like their performance, consistency, discipline, culture, wealth, and stability, to name a few—because they go back in time and give us a history. Any company’s Alignment Report can usually be explained by anyone who knows the business well, and can also be tremendously informative to anyone who is in less familiar territory. Moreover, the Alignment Report gives us a starting point, along with a range around this point, to allow for differences in compensation philosophy, pay design, pay practices, and performance factors other than TSR that a single algorithm just cannot capture. This is a balanced position that is designed to be in everyone’s best interests in the long run. Not too loose. Not too tight. But just about right.

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Definitions for the Alignment Report • Alignment Zone—A range of what is considered to be reasonable PAC outcomes for various TSR performance outcomes. The Alignment Zone encompasses the empirical pay line for the relevant market observed between 1993 and 2008, as well as the theoretical pay line for a typical leveraged market program, plus a range around both lines. • Data Point—The three-year average PAC for a CEO who has been in the CEO position for the entire three-year period. Each data point is “restated” and translated into current company size and inflated 2008 current dollars. This is so that all data points can be compared on the same chart across time horizons and across companies. • Market Intercept—The performance point at which the company’s pay line crosses the market pay line. • PAC (or Pay) Line—The regression line, or line of best fit for the broad market, sector, subsector, or peer group, or for the subject company’s historical pay practices. • PAC Outcome—Average Performance-Adjusted Compensation for the three-year period ending in the year shown. PAC is shown on the y-axis. • Slope—The slope of the PAC line, measuring how much incremental PAC is delivered for incremental TSR. • TSR Performance Outcome—Compound annual TSR for the three-year period ending in the year shown. TSR is shown on the x-axis. • Year—The three-year period ending in that year. For example, 2000 represents the three-year period covering 1998, 1999, and 2000.

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Exhibit 5.1. VF Corporation Alignment Report VF Corporation CEO PAC Over Three-Year Periods Ending in Years Shown

Annualized PAC (2008 $MMs) $7B Revenue

$25.0

Data Point = Three-Years Ending 2006 CEO McDonald Annualized Three-Year TSR = 27% Annualized PAC = $13.7MM

$20.0

$10.0

VF Corporation Pay Line

Market Intercept = 15% TSR

$15.0

2006 2004

Consumer Discretionary Sector Pay Line

2007 2003

2001 2000

$5.0

Alignment Zone

S&P 1500 Pay Line

2005

2002 1995 1999

$0.0 –30%

–20%

–10%

0%

10%

20%

30%

40%

50%

Annualized Three-Year TSR CEO for Three-Year periods ending 1999 to 2007: McDonald CEO for Three-Year periods ending 1995: Pugh

McDonald Pugh

6 FROM MALIGNED TO ALIGNED Good Comp, Bad Comp As I’ve shown in previous chapters, it’s not so much the level of pay on average that’s at issue, it’s the lack of alignment. Yes, there are some bad apples in the barrel that are paying egregiously at the outlier level. These outliers are definite problems. They attract tremendous attention and give all of corporate America a black eye. But the much more widespread problem is lack of alignment. By my estimation, approximately two-thirds of the data points in our database fall outside of the Alignment Zone. Because our database goes back such a long way, I checked to see whether the alignment track record among U.S. companies was improving. I divided our fourteen three-year rolling periods into three roughly equal branches to see if the quality of the relationship between performance and pay had improved. It did not. We are still battling the issues I confronted ten years ago in the consulting engagement I described in Chapter One. To be sure, there are plenty of examples of both good compensation and bad compensation—or good comp, bad comp, as I like to call it. Admittedly, it’s easier to get compensation right in some cases compared to others. For example, it is my experience that it’s easier to compensate executives, and for that matter, employees, when performance is good. High-performing companies have the firepower to deliver better economics to shareholders, management, and employees alike. Where the rubber meets the road is when the chips are down and performance is poor. These are the times when our values and fortitude are most vigorously tested.

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Changing Times According to Pat McGurn

“Warren Buffett said at the ‘Woodstock of Capitalism’—the Berkshire annual meeting—that he thought the best tool to use in fixing executive pay was embarrassment. I mean, this is Warren Buffett talking, not some starry-eyed activist. He was saying that between investors and the media and others, they should be using the embarrassment factor to go after overpaid CEOs and probably more importantly, the boards that have sculpted those packages. This shows how far some people believe the problem has actually gone. As a result, I’m actually a lot more optimistic than Buffett because I think at the gut level we have seen changes, especially on the pay-for-performance linkage. But there’s still ground to be made up. And it was my feeling, and still is, that the market downturn is the perfect opportunity for companies to again scuttle a lot of the non-performancebased garbage that still circles in orbit around executive compensation and to really start thinking more in terms of long-term compensation.”

Hitting the Reset Button Clearly, getting compensation right takes a lot of heavy lifting. Take Tyco, for example. Dennis Kozlowski, an accountant with a flamboyant personality, rose quickly through the ranks at Tyco to become chairman and CEO in 1992. Kozlowski rapidly grew the company, largely through acquisition. By the late 1990s, Tyco had become a darling of Wall Street, a legendary performer. Joann Lublin, an esteemed reporter at The Wall Street Journal, did a lead story on Kozlowski in 1997 in which she interviewed him. She commended Kozlowski for his shareholder

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value performance and credited his $1 million salary (which had been unchanged for four years), bonus leveraged to EPS growth, and restricted share grants, contingent upon EPS and cash flow growth, as powerful drivers of this performance. After all, as shown in Exhibit 6.1 (page 89), Tyco’s stock price had risen from single digits to approximately $40 by 1997. However, at the time that her story was written, Lublin didn’t have the benefit of Tyco’s Alignment Report for the three-year periods ending 1996 to 2002, shown in Exhibit 6.1. In 1996, the year before the interview, Kozlowski’s pay package was still aligned. But a little modeling of his pay program would have shown his package would spin out of control. Moreover, Kozlowski was being measured on growth objectives that fueled his insatiable appetite for acquisitions. By the end of 1997, Kozlowski’s performance remained stellar, but his compensation was hitting the roof at a three-year annualized PAC of over $250 million. That was only the warmup round for 1998 and 1999, in which he topped $700 million and $1 billion, respectively (as adjusted for Tyco’s current size). Had Lublin seen the Alignment Report showing 1996 numbers, she may have been satisfied initially. However, the forward-looking model would have shown egregious upside potential, which actually materialized before Tyco’s bubble burst. Had she, the compensation committee, and Kozlowski himself seen the forward view, all may have concluded that while performance was terrific, pay was going to go too far. With this risk-oriented format, Kozlowski’s pay simply had the opportunity to defy gravity. Not only was the target value of Kozlowski’s salary, bonus, and restricted stock approaching $12 million per year during the 1994–1999 time frame, but he was receiving on the order of three million stock options a year and had just cashed in a heap of options worth $240 million. Kozlowski’s pay had simply risen above any standard of reasonableness. Bob Monks was on the board of Tyco from 1985 to 1994 and saw the drama unfold. Monks said, “Sales of subsidiaries

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and purchases of subsidiaries all were separate bonus machines. It wasn’t just one. There must have been fifty. And there’s one rule of thumb in compensation I’ve come to understand, which is that the more incentive schemes, the greater the abuse. They just add up.” Monks reports that he got fired from the Tyco board for speaking up. By 2002, the company had fallen from grace. The stock price went from a high of nearly $100 per share in 2001 to a low of less than $20 per share a year-and-a-half later. Due to a flawed strategy, fraud, accounting irregularities, and misappropriation of corporate funds, Kozlowski ended up being convicted of securities fraud, grand larceny, and conspiracy, and was sentenced to twenty-five years in prison.

Restructuring the Company In 2002, Tyco recruited Ed Breen from Motorola to be its new CEO. Breen had an appetite for tough challenges and began tackling the challenges at Tyco by restructuring the company’s businesses and talent. One of Breen’s early hires was Laurie Siegel, a woman he brought in to be senior vice president of Human Resources and Internal Communications. Breen and Siegel, together, needed to have conversations with each executive about whether there was a future for them at Tyco. As Breen puts it, “When I got to Tyco, it was such a pay-driven, bonus-driven environment that it was actually scary. Executives reporting to me were making $7, $8, and $9 million bonuses a year. It seemed as though their values and view of the world were just out of kilter and not necessarily aligned with longterm shareholder value. So our number one job was to put the right people in place, which transcended pay.” Inevitably, one of the subjects of conversation during this sorting-out period was about pay. Siegel explains how this was done. “At the old Tyco, we had people who were good people.

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They just grew up in a company that incentivized them for so long to only think about the short term, and that’s how they learned to manage. And so, some of the people had to change out. It wasn’t because they were greedy, evil people. It was that they grew up with the wrong set of business priorities, largely as a function of the pay system. When you have a pay system which continuously focuses on the short term and ignores the long term, people become a product of their culture.” As a result of these discussions, some executives left the company and others stayed. In addition, Breen recruited a number of people from the outside. Once he was finished, they were all part of the “Breen team” and were operating under a new set of shared values. During those first couple of years, Breen, Siegel, and the compensation committee of the board all worked hard to institute a more reasonable pay system that would truly link to performance. What resulted from their efforts was a performance-based system, calibrated to competitive market-level norms, featuring a combination of an annual bonus with an emphasis on unit performance and long-term incentives composed of stock options and performance shares, leveraged by a relative TSR objective. But the work didn’t stop there. In 2007, Tyco broke up into three separate entities: Tyco International, Tyco Electronics, and Covidian. Tyco went from being a $40 billion company to a $20 billion company. Since Tyco was breaking up the company, and in effect, downsizing, it also needed to downsize pay. (Remember the effect of company revenue size on executive pay? As size goes up, market pay goes up and vice versa.) Pay norms (lower pay for smaller size) did not keep Breen from doing the right thing for shareholders. Raj Gupta, chairman of Tyco’s compensation committee, reported that this was all but easy. He shared his thoughts with me on the subject. “Our issue was to deal effectively with a change of great magnitude, as we

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took the company from about $40 to $20 billion in revenue, and brought the compensation to a reasonable level for a company half its original size in a reasonable period of time without losing the talent. We accomplished this by freezing salaries and letting pay levels gravitate toward a pay structure that was appropriate for a company of a smaller size. This was somewhat of a challenge for the compensation committee to get it right.” In addition to working on moderating pay levels to match their smaller size, Tyco also decided to modify the structure of the long-term incentive program to “better align it with returns our investors realize from their common shares.” To accomplish this objective, Tyco replaced its time-vested restricted stock units with a 50-50 combination of stock options and performance shares. Now look again at Tyco’s Alignment Report in Exhibit 6.1 with Breen at the helm. In my book (so to speak), Tyco gets an “A” for alignment. All of Breen’s data points are in the Alignment Zone. What’s even more remarkable, though, is that Breen, Siegel, and the compensation committee accomplished this during two massive restructurings.

A Story Told These Alignment Reports tell a whole story. Exhibit 6.1 speaks to the high-flying culture of the late 1990s that Kozlowski promulgated. Moreover, it shows that this lofty performance was not sustainable. Tyco’s fall from grace between 1999 and 2002, with TSR plummeting from 69% to −30%, proves it. The Alignment Report shows the work of a new and disciplined management team that rebuilt the company, restoring it to sustained performance but, equally as important, supporting it with a foundation of a healthy culture and values.

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Exhibit 6.1. Tyco Alignment Report Tyco International, Ltd. Stock Price: 1/1995–10/2009 $100 Tyco CEO and CFO indicted for securities laws violations

Tyco Stock Price

$80 $60 $40 $20 $0 1995

1997

1999

2001

2003

2005

2007

2009

Year Note: Stock price history adjusted for Tyco spin off, creating three independent companies and the reverse 1:4 stock split on 2nd July 2007 Source: Capital IQ, Inc., a division of Standard and Poor’s

Tyco International, Ltd. CEO PAC Over Three-Year Periods Ending in Years Shown 1999 = $1.3B

$1,000.0

1998 = $701MM

Annualized PAC (2008 $MMs) $20B Revenue

1997 = $256MM

$100.0

$40.0

2001 = $89MM

Alignment Zone

2002 = $39MM

$30.0 1996 = $22MM

$20.0 Industrials Sector Pay Line

2006

$10.0

2007 2008

$0.0 –40%

–20%

0%

20%

Annualized Three-Year TSR CEO for Three-Year periods ending 1996 to 2002: Kozlowski CEO for Three-Year periods ending 2006 to 2008: Breen

40%

60% Breen Kozlowski

7 PATTERNS OF MISALIGNMENT More Than One NOzone There are a number of companies that do a good job of staying in the Alignment Zone. However, for every Tyco and VF Corporation, which are two companies that demonstrate laudable alignment, there are, according to our database, about twice as many companies that demonstrate poor alignment. These companies could benefit from improvement in their pay practices and processes, if not an extreme makeover. Not only would they have more credibility and less exposure to shareholder and public ire, but they also would have more credibility inside the company with employees as well. I could fill this book with hundreds of examples of companies that show patterns of misalignment. However, I decided that presenting endless cases of misalignment would be boring for even the most ardent students of executive pay. Instead, I decided it would be more helpful to look at the patterns of misalignment that I frequently see. I have essentially defined misalignment to be when either (1) Performance-Adjusted Compensation is not sensitive to TSR performance; (2) the PAC level is not within an acceptable range compared to the relevant market; or (3) both conditions are met. This definition is important because a lot of people think that alignment is only when pay fluctuates in response to performance. But I am saying that pay sensitivity to performance is not enough. The level of compensation delivered after performance happens also needs to be appropriate for the size of the company, its industry, and its performance. With this definition in mind, I set out to look at the patterns of misalignment in our data. While every company’s Alignment Report is unique, there are five patterns of misalignment, shown

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in Exhibits 7.1 through 7.5 (pages 105–109), that seem to come up over and over again. I have given each of these prototypical patterns a “handle” just to make it easy for you to remember them, and for me to refer to them later: • • • • •

Compensation Flatliner Compensation Riskseeker Compensation Dogleg Compensation Highflier Compensation Lowlier

Each of these prototypical patterns is discussed in more detail in the following sections.

Compensation Flatliner Compensation Flatliners have performance-adjusted pay that does not fluctuate much, even with performance. In other words, these companies deliver Performance-Adjusted Compensation at a similar level year after year, regardless of TSR. Compensation Flatliners have a picture of pay that looks like either a flat line; a descending line (yes, we do see a few companies in which performance and pay are inversely related); or, in most cases, a random scatter plot of data points. With Flatliners, most or even all of the data points may fall in the Alignment Zone. Pay level, per se, is not the problem. It’s just that pay does not vary much with TSR performance, or pay varies regardless of TSR performance. A year or two of this pattern is understandable, but a pattern of this over the long term suggests a chronic case of misalignment. So why is this the case? Do these companies tend to be bad performers, and therefore deliver pay only in the form of salary and benefits? Or do they have a relatively fixed targetpay mix, delivering target pay primarily through salary and

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benefits, with little or no emphasis on incentives? Or is the pay just engineered by the compensation committee to be essentially the same year after year, regardless of TSR performance? While the reasons for misalignment will largely be the focus of Part Two of this book, suffice it to say that human intervention, or seemingly endless tinkering with the pay plans or the payouts, is largely the culprit. Exhibit 7.1 looks at a Compensation Flatliner, along with an unidentified example of a corporate offender (page 105). The company shown is a large $5-plus billion company in the Materials sector. The company’s stated compensation strategy is (naturally) to align executive and shareholder interests over the long term, foster a performance-based culture, recruit and retain top talent, and motivate executives to achieve strategic objectives. It delivers executive pay through a combination of salary, bonuses, performance shares, restricted stock, and stock options. It’s relatively easy for this company to pay similar bonuses every year because bonus payouts are tied to return on capital, with no growth requirement. This means that this company can click along each year, producing income at the same level relative to the assets on the books, and receive bonuses even if there are no new investments, no growth in income, and, ultimately, no growth in shareholder value. In other words, the executives at this company can produce flat returns for shareholders, much like interest paid to bondholders, not create shareholder value, and still receive bonuses year in and year out. In fact, bonuses for this company have been fairly consistent over the years, even as TSR performance has fluctuated. In addition, the company makes fairly liberal use of restricted stock in the long-term incentive mix, further muting the leverage usually inherent in long-term incentives. Finally, the company’s compensation committee makes liberal use of special discretionary bonuses, which, as I look at it, are being used to make up for compensation that is not being provided for through the plans. No wonder the pay pattern is a shotgun, with no apparent link between pay and TSR.

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The Flatliner pattern isn’t inherently wrong. Having highly stable compensation payouts may best fit with the company’s business model and culture. However, I would ask whether the company is in fact achieving superior shareholder returns with this strategy. If so, then the shareholders may have nothing to beef about. If not, then another approach may be more advisable. In either case, Flatliners will need to do some explaining as to why their pay system is in shareholders’ best interests.

No Downside According to Nell Minow

“One thing that I’m very concerned about is that when the stocks are at a low, we either reprice options or we give new options, so there’s no downside. Now, the biggest single complaint I have about pay plans is no downside. And now is not the time to cheer everybody up with more pay. In terms of the labor market right now, I’ve got to tell you, you could throw a dime and hit ten very qualified Wall Street types who would be happy to come to work for you for half of what they were working for last year.”

Compensation Riskseeker In contrast to Compensation Flatliners, Compensation Riskseekers have performance-adjusted pay that is highly sensitive to performance. In this case, PAC soars above and falls below the Alignment Zone with high and low performance, respectively. Compensation Riskseekers have a picture of pay either with their data points arrayed along a very steep pay line or with their data points occurring in two clusters, one at the very high end of the performance spectrum and the other at the very low end of the performance spectrum, with nothing in between.

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In other words, these companies have pay programs that are designed to deliver outsized total pay when performance is exemplary, and severely diminished total pay when performance is disappointing. The Compensation Riskseeker model is shown in Exhibit 7.2, along with a disguised example (page 106). The company shown is a large $5-plus billion company in the Consumer Staples sector. The company has stated that its executive compensation strategy is to reflect the values of the organization, be competitive, put executive pay at considerable risk, and, of course, align the interests of executives and shareholders. It delivers executive pay through a risk-oriented package, with over 85% of the CEO’s compensation delivered through variable pay opportunities, including a short-term incentive, stock options, and performance shares. Goals are set in a relative context, meaning that the company assesses competitive performance levels and then chooses goals that reflect aggressive industry performance standards in order to qualify for above-target awards and vice versa. In addition, the company uses a relative performance measure to drive share awards under the performance share plan. Upside leverage on all incentive plans is on the high side of competitive. As you can see from the company’s Alignment Report, the company pays in the Upper NOzone when performance is good, and pays at the lower boundary of the Alignment Zone when performance is poor. As with the Flatliner, a Riskseeker pay pattern isn’t inherently bad. After all, executives may be running a highly risky business that requires a healthy tolerance for pay-at-risk. But there are two primary issues to watch out for in the Riskseeker world. One is that there is a tendency for Riskseekers to deliver outsized pay, in other words, pay that is in the Upper Alignment NOzone, in the good years but then not let pay drift to below competitive levels in the down years. Hence, the company’s pay line either moves to the left, creating a situation in which pay goes to below competitive levels only if performance is

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downright abysmal, or becomes a Dogleg, creating a situation in which pay is bolstered at the low end of the performance spectrum with special awards. Riskseekers who are experiencing only the upside of performance won’t necessarily know how they’ll react to the downside until it actually happens. When the downside happens, they realize that they should have projected what the downside pay was likely to be with low performance, and that they should have agreed in advance what the appropriate pay outcome should be. Even with this forward planning, the danger is that companies may not have the determination to stick with the plan when performance hits the proverbial fan. The second issue is that Compensation Riskseekers, by their very nature, encourage executives to take risks. After all, there’s a lot of upside available in hitting triples, and home runs. Compensation committees of Riskseeking companies, in particular, should make sure that they know what business risks the compensation system is encouraging them to take on, and then take steps to mitigate such risks, as appropriate.

Compensation Dogleg Compensation Doglegs look like Riskseekers, or even aligned companies, when performance is good, but the problem is that they occupy the upper Alignment NOzone when performance is poor. How do they pull this off? They tend to have Riskseekerlike compensation programs but then override those programs when times get tough. They might do this by granting a lot of off-plan equity or “reverse engineering” bonuses to justify awards that are in the realm of normalcy, despite poor performance. Essentially, these types of actions put a kink in the alignment curve, propping up pay when performance is bad and allowing retention concerns to overwhelm everything else. The Compensation Dogleg prototype, as well as an unidentified corporate example, is shown in Exhibit 7.3 (page 107).

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The company shown is a $5-plus billion company in the Technology sector. The company’s stated compensation strategy is to align compensation with business objectives; align the interests of executives and shareholders; and attract, motivate, and retain top talent. It is clear to me from looking at the Alignment Report that our model company was a Compensation Riskseeker for a long time. During the early to mid-2000s, the company delivered executive pay through salaries, bonuses, and stock options. It targeted short-term compensation at the 50th percentile, while issuing stock options at the 75th percentile or higher, justified by high company growth, a very impressive TSR, and the need to retain a “highly talented executive team.” These programs conspired to put the annualized CEO PAC to above $150 million. But a funny thing happened as the stock price fell. The company raised salaries (and in doing so, raised dollar bonus targets too), and then doled out generous grants of restricted stock for retention of key executives. In addition, it changed from an all-options long-term incentive program to a combination of stock options, performance shares, and restricted stock. In looking at the Alignment Report for this model company, the effect of the change in pay programs, coupled with the special retention grants, is clear. The company paid up in the good times but protected management in the bad times. It didn’t have the intestinal fortitude to respond with below-market stock option grants. Instead, the company resorted to making large front-loaded restricted stock grants for retention purposes. As a result, the company went from being a Compensation Riskseeker on the high end of the performance curve to a poorly performing Highflier (because PAC is still above the Alignment Zone) on the low end of the performance curve, thus creating the Dogleg pattern that you see in the exhibit. Neither pay line is a model of good alignment. This kind of misalignment pattern is probably most difficult to sort through. Our model Dogleg company probably

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would have paid ample awards had it issued 50th-, maybe 60th-, percentile grants. Instead, it paid 75th- to 90th-percentile-plus grants that not only were overreaching but put the compensation into outlier territory. In addition, our model Dogleg company paid above-market compensation for below-market performance by granting special restricted stock awards on top of an already competitive pay program. This is tantamount to having your proverbial cake and eating it too. It’s worth mentioning that not all Doglegs are bad. In fact, Doglegs can be good if they signal a change in pay strategy in response to a change in the business strategy. For example, in the early 2000s, Microsoft navigated its transition from a highgrowth to a more mature-growth organization by moving from stock options to performance-based restricted stock in its pay program. This was a permanent change in program design in response to their maturing business. Moreover, this change was clearly communicated to shareholders. This shift could have created a Dogleg pattern, at least temporarily. But, more important, it represented a permanent, deliberate, and legitimate move to a different pay strategy.

Pay for Effort Versus Results According to Raj Gupta

“I think the hardest thing is how to compensate when times are tough because the reality is when external environment is poor, perhaps people are working harder. And then you say, ‘My God, I worked harder in a tough environment, and I have less to show for it and I don’t get a reward.’ And maybe sometimes people get confused that the reward is not for this hard work, it is for results. And, I’ve seen it where people miss the numbers, and they will say that this is due to the external world, and that this is an outstanding performance, and that everybody on the

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team worked so hard, harder than last year, and that to pay them less than what was paid last year is not fair. And this is the question that’s put in front of the board and the comp committee. It’s a tough call. That’s where I think the board and the compensation committee have a decision to make. We have to discern what we pay for performance. And we better also have something to pay when there’s nonperformance. And sometimes you face that kind of compromise. And I think for today there is more dialogue around, ‘We set these objectives at the beginning of the year, but the world has changed. So we need to scale down the performance goals.’ And I’ve been in situations where we said, ‘Absolutely not.’ At Rohm and Haas, we went from paying 150% of target to almost zero in a year. Once you go through this, people understand that in a tough year, you get less.”

Compensation Highflier Compensation Highfliers have Performance-Adjusted Compensation that is generally above the relevant Alignment Zone at virtually all levels of performance. These companies have a pay picture that puts most if not all of the compensation data points in the Upper NOzone, or the “nosebleed section” of compensation, as I like to call it. There are any number of reasons why these companies may have gotten themselves into the Upper NOzone. They may have established a policy to pay executives at significantly above-market levels, even for average performance. They may have gotten overzealous in using comparatively high equity grants or in making special awards. They may have inadvertently piled one program on top of another. A program here and a program there often provides a ladder to the Upper NOzone. A Compensation Highflier and a case example are shown in Exhibit 7.4 (page 108). ExxonMobil was raised as a case

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example by Bob Monks in his interview with me. In my discussion with Monks, he offered his perspective on ExxonMobil’s alignment. “At an annual meeting at Exxon a few years ago, I asked Lee Raymond, the then chairman and CEO, ‘What is it that you do that is worth ten times what Lawrence Rawl did?’ (Rawl was Raymond’s predecessor.) To me, the only explanation I could see is that Exxon put the pay up because it could put the pay up, and if there were any correlation between performance and pay, well, that would have been a coincidence.” To test Monks’s assertions, I ran the Alignment Report for ExxonMobil. This Alignment Report, along with a description of the prototypical Highflier, is shown in Exhibit 7.4. ExxonMobil is the largest exploration and production oil and gas company in the world. Its revenue has fluctuated between $350 and $450 billion over the past few years. ExxonMobil features alignment prominently in its proxy report to shareholders. I found a number of references to alignment in a recent report, three of which are cited below:

Providing energy to meet the world’s demands is a complex business. We meet this challenge by taking a long-term view rather than reacting to short-term business cycles. The compensation program of ExxonMobil aligns with and supports the longterm business fundamentals and core business strategies of our Company. Within the context of the compensation program structure and performance assessment processes, the Compensation Committee aligned the value of 2008 incentive awards and 2009 salary adjustments with the: • Performance of the Company; • Individual performance;

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• Long-term strategic plan of the business; and, • Annual compensation of comparator companies. To achieve alignment with the interests of shareholders, it is the objective that 50% to 70% of annual total remuneration be in the form of stock with long holding periods.

A defining moment in Exxon’s history, of course, was the merger between Exxon and Mobil in 1999. With this one transaction, the company went overnight from being a $135 billion to a $200 billion revenue company, give or take a few billion. Lee Raymond, Exxon’s CEO since premerger days, was credited with spearheading the merger. Raymond remained CEO of the combined entity until 2005, when he retired. On the pay side, this merger seems to have flipped a switch. In looking at ExxonMobil’s Alignment Report, it is clear that Performance-Adjusted Compensation catapulted from being in the Alignment Zone in 1998 to the Upper NOzone from 1999 through 2005. In fact, on a size-and-inflation-adjusted basis, the company added upwards of $20 million per year to its performance-adjusted CEO pay package. The increase in company size alone might have justified a $5 million PAC increase, but not an increase of $20-plus million. Some of the pay practices that contributed to this pay positioning included a special merger bonus of $12.5 million in 1999; a near doubling of salary from $2.1 million in 1999 to $4.0 million in 2005; and a $32 million restricted stock grant in 2005, Raymond’s year of retirement. The Alignment Report clearly shows that the company seems to have gotten carried away following the merger of these two behemoths. While ExxonMobil’s compensation pattern reflects a strong positive relationship between compensation and performance, and its emphasis on long-term pay and vesting fits with the company’s long-term investment horizon, CEO

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compensation at every level of TSR performance was in the Upper NOzone, making the company a Compensation Highflier during the Raymond years. Since the time of Raymond’s departure, another switch seems to have been flipped. Take another look at the Alignment Report. The new CEO, Rex Tillerson, is earning PerformanceAdjusted Compensation that is considerably below alignment norms. This could be because Tillerson is relatively new in his job and new CEOs start out at lower pay levels than more experienced CEOs. It also could be because a new compensation committee, composed largely of new members, is at work. Or it could be a sign of the times. Regardless of the reasons, this is a refreshing change, although the compensation committee may have gone too far the other way.

Compensation Lowlier Compensation Lowliers have Performance-Adjusted Compensation that is generally below the relevant Alignment Zone at all levels of performance. These companies have a pay picture that puts most if not all of the compensation data points in the Lower NOzone. There are a number of reasons why companies get themselves into the Lower NOzone, but most often, they offer their executives things of value (often intangible value) that don’t relate to compensation. It could be a founder-led culture, a unique location, a great career track, work-life balance, or other such factors. Exhibit 7.5 looks at a Compensation Lowlier prototype company as well as a disguised example of one such company (page 109). The company shown is a large $5 billion company in the Consumer Discretionary sector. The company’s stated compensation strategy is to put heavy emphasis on the risk components of compensation to drive corporate and team-based compensation. It delivers executive pay through salary, an annual incentive

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opportunity, and stock options. The company does not explicitly benchmark its long-term incentives every year, likely contributing to more conservative grant levels, and its options contain performance hurdles, making them more difficult to earn unless they produce a reasonable return for shareholders. In addition, the company emphasizes internal promotion, has a history of long tenure, and is located in a highly desirable area of the country. In looking at the company’s Alignment Report, it is clear that the company has a rather consistent pay pattern that is on the edge of the Lower NOzone. One could argue that this is positive. It creates a competitive advantage for the company. However, it’s important to note that the system could be a little too damped down, as the company has generally underperformed others in its sector by a considerable margin.

An Alignment Picture Can Lead to More Questions In my travels, I have shown a great many companies their Alignment Reports. To a person, board members, executives, and shareholder advisors alike have found these reports to be highly provocative. Most people with any familiarity with the company are able to look at the report and explain why the data points are positioned where they are relative to the market. Some are pleased and comforted by the results. Others are surprised. Still others are somewhat disturbed. No matter what the reaction, their instinct is to want to drill down and ask more questions, such as, “What would the chart look like for our peers?” “Why was our 2002–2004 number high (or low)?” “What drove us into the NOzone in 1996–1998?” “Why am I making less (or more) than the previous CEO?” “Why is our current Alignment Model so flat?” “What would our current plan look like if we modeled it going forward?” “How do the rest of our executives look on this chart?”

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Asking such questions and getting the answers is exactly the point. The Alignment Reports help us gain insight quickly about whether total pay outcomes have been geared reasonably to total performance outcomes for shareholders over time. It’s a great place to start.

Good Processes Set You Up for Fair Play In this part of the book, I’ve covered examples of companies, VF Corporation and Tyco, that did an exemplary job of achieving alignment. I’ve also covered the patterns of misalignment. Good data give you standards for fair pay. Good processes constitute fair play. The next part of this book, “Fair Play,” more specifically delves into the types of decisions and decision-making processes that can plant companies squarely in the Alignment Zone, or NOzone, as the case may be.

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Exhibit 7.1. Compensation Flatliner Prototype

Description

Alignment

• PAC is not sensitive to performance. This usually shows up as a random set of points in a shotgun pattern.

Upper Alignment NOzone

PAC

Alignment Zone

Lower Alignment NOzone

TSR

Example Materials Sector Company CEO PAC Alignment Report Over Three-Year Periods Ending in Years Shown

Annualized PAC (2008 $MMs)

$20.0

Alignment Zone

$15.0

$10.0

Materials Sector Pay Line

2004 2003 2006 2007

$5.0

2005 1999

1998 1996

1997

CEO Pay Trend Line

1995

$0.0 ⫺30% ⫺20% ⫺10%

0%

10%

20%

30%

Annualized Three-Year TSR

40%

50%

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Exhibit 7.2. Compensation Riskseeker Prototype

Description

Alignment

• PAC is highly sensitive to performance and quickly travels out of the Alignment Zone as performance moves away from the median.

Upper Alignment NOzone

PAC

Alignment Zone

• Can also show up as a bimodal distribution — the company is either above or below the zone, with nothing in between. Lower Alignment NOzone

TSR

Example Consumer Staples Sector Company CEO PAC Alignment Report Over Three-Year Periods Ending in Years Shown

$30.0

Annualized PAC (2008 $MMs)

CEO Pay Trend Line $25.0

2004 2003

Alignment Zone

$20.0 1997

$15.0

2002 1995

$10.0

1996 1998

$5.0

Consumer Staples Sector Pay Line

$0.0 ⫺30% ⫺20% ⫺10%

0%

10%

20%

30%

Annualized Three-Year TSR

40%

50%

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107

Exhibit 7.3. Compensation Dogleg Prototype

Description

Alignment

• PAC is highly sensitive to performance at the high end of the performance spectrum and not as sensitive to performance at the low end of the performance spectrum.

Upper Alignment NOzone

PAC

Alignment Zone

Lower Alignment NOzone

TSR

Example Technology Sector CEO PAC Alignment Report Over Three-Year Periods Ending in Years Shown

2004 2003

Annualized PAC (2008 $MMs)

$150.0 $125.0

CEO Pay Trend Line

$100.0 2005

$75.0 2002

$50.0 $25.0

Technology Sector Pay Line 2007

Alignme

2006

nt Zone

$0.0 –30% –20% –10%

0%

10%

20%

30%

40%

Annualized Three-Year TSR

50%

60%

70%

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Exhibit 7.4. Compensation Highflier Prototype

Description

Alignment

• PAC is above the relevant Alignment Zone at all levels of performance.

Upper Alignment NOzone

PAC

Alignment Zone

Lower Alignment NOzone

TSR

Example ExxonMobil Corp. CEO PAC Alignment Report Over Three-Year Periods Ending in Years Shown

Annualized PAC (2008 $MMs) $460B Revenue

$120.0 $100.0

ExxonMobil CEO Raymond Pay Trend Line (Post Merger)

Alignment Zone

2000 1999 2001

2005

$80.0 2004

1998

2003

$60.0

2002

1997

1996

$40.0 $20.0

2008 CEO Tillerson

Energy Sector Pay Line

$0.0 ⫺30% ⫺20% ⫺10%

0%

10%

20%

30%

Annualized Three-Year TSR

40%

50% Tillerson Raymond

PAT T ERNS OF MISALIGNMENT

109

Exhibit 7.5. Compensation Lowlier Prototype

Description

Alignment

• PAC is below the relevant Alignment Zone at all levels of performance.

Upper Alignment NOzone

PAC

Alignment Zone

Lower Alignment NOzone

TSR

Example Consumer Discretionary Sector Company CEO PAC Alignment Report Over Three-Year Periods Ending in Years Shown

Annualized PAC (2008 $MMs)

$20.0

Alignment Zone

$15.0 Consumer Discretionary Sector Pay Line $10.0

2006 2007 1995

$5.0

2001

1999 1996

1997 1998

CEO Pay Trend Line

2000 2002

$0.0 ⫺30% ⫺20% ⫺10%

0%

10%

20%

30%

Annualized Three-Year TSR

40%

50%

Part Two FAIR PLAY

8 THE ROOT CAUSES OF MISALIGNMENT Moving from Hindsight to Foresight Given what I’ve covered so far, you could be telling yourself, “I’ve read enough to know that I’m already doing the right things when it comes to paying our executives.” Or, “I might not have been doing it exactly right, but now I know what to do.” Or, “Out of curiosity, I’ll just order up an Alignment Report and take it from there.” However, I encourage you to read on. First of all, fair pay— my suggested standard for alignment—is only half of the equation. Fair play—understanding the process by which alignment occurs (or not)—is the other half. My experience is that in the case of determining executive pay, form is as important as function. How a decision gets made is critical to the quality of the decision itself. This is why having a database and an alignment standard is only half the battle. The other half is achieving alignment in the heat of the battle. Some of the ways in which companies can become misaligned have become all too apparent, as uncovered by the deep recession of 2008. Now, looking back, we know that we should have thought more about the timing of award payments—the ability for executives to take short-term gains while shareholders endure long-term pain. We know that we should have had clawbacks in place. We know that equity holdbacks and ownership guidelines might have helped. And we know that having programs that could have bridged through the storm when virtually all options were sitting underwater might have been a good idea. Some companies thought about

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these things in advance. Others didn’t. For those that didn’t, all of these things would have contributed to their long-term alignment. But I’m not going to rehash the obvious. This is hindsight. What we’re all trying to do at this point is figure out a way to have some foresight. According to one of the directors with whom I spoke, “I think everyone is getting religion in the boardroom and in the compensation committees. And it’s going to take a period of time to change. I mean, our culture is changing on compensation. In this country, we tend to push things to their limits, and then all of a sudden, we push it to a limit where society reacts and they push back on us. And they’re pushing back now. And that’s part of the greatness of our country as well, because some of the limits are good. This time, I think the pushback is going to be a little more permanent than it has been in the past, even when things get better.” There are many subtleties to creating and maintaining alignment. Some involve decisions or program design points that may not have been apparent. Others involve process points. But at the deepest level, it’s about creating a performance or alignment culture—a culture that values a fair deal. By the end of this part of the book, you should be able to answer questions such as, “How does our goal-setting methodology affect alignment?” “How do our equity grant practices affect alignment?” “How does our willingness to use the full upward or downward discretion in our plans affect alignment?” “What if we reprice stock options on a one-for-one basis?” “What if we do a stock option exchange on a value-for-value basis?” “What if we change the stock vehicles we use?” “What if we change certain aspects of our program design?” “How will these actions affect alignment?” “How can we create and nurture a culture of alignment?” These are just some of the questions that Part Two will help you answer. Part Two is really about how a company’s decisions, behaviors, and culture regarding executive pay will affect their alignment.

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Five Design Forces and Two Decision-Making Amplifiers In studying dozens of alignment charts, working with hundreds of companies over the years, talking with prominent leaders on the subject of alignment in the interviews conducted for this book, and participating in forums with other informed thinkers on the subject of executive compensation, I have come to the conclusion that there are five fundamental pay design forces that can destroy alignment, plus two decision-making forces that amplify their destructive effects. I call these forces the “root causes of misalignment.” They are depicted in Exhibit 8.1 and are defined in the chart that follows (page 122).

A Culture of Misalignment Many of the forces listed in Exhibit 8.1 are really a reflection of a deeper issue, which I call a “culture of misalignment.” A culture of misalignment gives little or no regard to a fair deal. A culture of misalignment actually creates a change in the standards that are operating inside of an organization. These organizations then come to believe that their own standards are right, not the standards to which everyone else is held accountable. We saw this in the case of Tyco. What’s interesting is that it is easy to look the other way when shareholders and management both are benefitting from lofty stock prices. What should be thought about, however, is “What will happen when the stock price comes down? How will the company behave then?” Executives who are managing for the long-term health and prosperity of the organization versus the long-term prosperity of only themselves will think in these terms. Generally, when a culture of misalignment permeates the pay system, it is hard to stop it. Often, it takes a disruptive force such as a major financial crisis, a stock price meltdown, or an unfriendly takeover attempt to halt misalignment. It also may take new board members, a new CEO, a shareholder activist, or anyone else

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who brings new thinking to the table. The best course of action, however, is for companies to make mid-course corrections and to develop a culture of alignment before disaster strikes, that is, to make changes voluntarily as insight takes hold. This is what the Alignment Model should help us do.

The True Measure of Pay According to Ron DeFeo

“The topic of pay is in the nexus of the way people measure social value, but I would encourage people to talk a little bit more about the philosophy, and the kind of society we want to be before they get down to the tactical aspect of what to pay and how to reward. From my perspective, I would look at how society generates wealth and how wealth is created and distributed. So if we’re to have an effective conversation on pay, it should be a broadly based conversation on pay, inclusive of basketball players, movie stars, and those who entertain us versus just those who employ us. “We should look at how wealth is created in a society and how we are rewarding those who are trying to create wealth in the broadest possible context. And personal wealth is more than just financial wealth, it’s the wealth that comes as a result of knowing that you have a job, knowing that you’re doing something of meaning, knowing that your family is secure, and knowing that your community is a place of comfort and consolation. So wealth is not just what’s in your bank account, but rather in a much broader context of the society that we want to be. “All too often, I feel that we look for the soundbites of who made what and how they compare to somebody else versus what the individual or the group is doing to

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improve the lives of people they touch. So how much does a basketball player improve the lives of the people he or she touches? Same thing could be asked about a movie star; same thing could be asked about a baseball player; same thing could be asked about a CEO; same thing could be asked about a philanthropic CEO. So I think we have to be careful that we don’t just characterize pay and the society based upon a single metric.”

Many companies have undergone cultural reform the hard way, that is, through a seismic event rather than through an emerging realization that change is necessary, coupled with the resolve to make it happen. AIG is one such case in point. It clearly illustrates the link between alignment and culture. AIG is a global player in the insurance and financial services industry. Hank Greenberg served as AIG’s CEO from 1968 until early 2005, when he resigned. He is credited with AIG’s aggressive growth over nearly four decades, when he encouraged an entrepreneurial culture focused on diversification into new service lines and geographic markets. Greenberg turned AIG into one of the world’s twenty largest public companies (measured by market capitalization). In the 1990s, AIG flourished, with its stock price rising from single digits in the early 1990s to nearly $2000 per share (on a pre-reverse split basis). During this period, AIG’s entrepreneurial culture was reflected in the reward system, which was characterized by generous cash bonuses and stock option grants. This was a system that drove high performance and high pay. As can be seen from AIG’s Alignment Report, shown in Exhibit 8.2 (page 124), the pay system looked generally aligned. Pay went up steeply, however, as performance went up. By the three-year period ending in 2000, Greenberg’s PAC had leapt to the upper end of the Alignment Zone.

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But in the early 2000s, a culture of misalignment started to permeate the system. In 2002, 2003, and 2004, Greenberg received the maximum cash bonuses allowable under its incentive plan, despite negative three-year TSR performance at the end of each of those years, and a striking $1.8 billion net aftertax charge to earnings in March 2003 for an increase in loan loss reserves. The board noted AIG’s strong earnings growth during this period as one factor in its decision, but no specific quantitative metrics or formulas were described in determining why maximum bonuses were appropriate. Even more unusual was that certain AIG executives, including Greenberg, received long-term incentive cash payouts from private entities affiliated with AIG that were governed and controlled by Greenberg and other AIG executives. Starr International Company (SICO) was a holding company that owned about 12% of AIG and provided long-term incentive plan payouts to an elite group of AIG managers. Greenberg and other AIG executives who served as directors on its board had large personal stakes in the company, and decided who should receive awards. Greenberg himself received in excess of $21 million in long-term incentive payouts under the SICO program between 2002 and 2004. Such “off the books” incentive plans created multitudinous possibilities for conflicts of interest. In fact, SEC investigators believed that SICO was a convenient tool for sheltering executive pay, wresting powers that rightly should have resided with AIG’s compensation committee. Of course, hindsight is 20-20. It’s easy to see here how a culture of misalignment had developed and had become part of the fabric of the organization. The company went from being aligned to being a Compensation Dogleg—a company that bolstered pay despite performance that was not only poor but also built on quicksand. Regulators accused Greenberg and several former officers of manipulating the company’s financial statements in order

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to deceive regulators and investors. What began in 2005 as an investigation into reinsurance transactions mushroomed into a growing scandal involving accounting irregularities, conflicts of interest, and lack of transparency. In addition, AIG’s dealings with affiliates raised regulator concerns about the obscure nature of related transactions that might have been a tool for managing earnings, which had apparently become suspiciously consistent in a notoriously volatile industry. In the end, AIG had to restate its earnings, making a $3.9 billion adjustment over a five-year period. In 2005, Greenberg left AIG, but under duress. The company’s swift downfall came in 2008 from an accumulation of misplaced bets on credit default swaps12 and the insurance contracts underwritten by AIG on mortgage-backed securities. As 2008 progressed, so did the losses on AIG’s books. In the end, AIG required government assistance. In late 2008 and in 2009, AIG received a total of $173 million in federal bailout funds provided in a series of installments, including loans, credit lines, and preferred stock purchases, resulting in the government receiving almost an 80% ownership stake in AIG through its holdings of convertible preferred stock and warrants. The events of 2009 ushered in five new board directors; a new CEO, Robert Benmosche; and compensation oversight by the federal government’s special master of compensation, Kenneth Feinberg. Benmosche’s compensation package, which was approved by the federal “pay czar,” provided for • A $3 million base salary • A $4 million stock “salary,” immediately vesting, but not transferable for five years • A long-term incentive award of up to $3.5 million in the form of stock, based on a discretionary assessment of performance, and then cliff vesting two years after the date of grant • No severance, golden parachute, or tax gross-ups • Incentive payments subject to a clawback

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The Alignment Report shows Greenberg’s PerformanceAdjusted Compensation in contrast to Benmosche’s prospective Performance-Adjusted Compensation under a number of TSR performance scenarios. To model Benmosche’s pay package prospectively, I assumed that the full $4 million of stock “salary,” as well as the full $3.5 million long-term stock incentive award, will vary in actual value on the basis of the performance of AIG’s stock over the next three years. The Alignment Report shows the drastic repositioning of compensation at AIG. In contrast to Greenberg’s Compensation Dogleg, Benmosche’s new compensation package will essentially be that of a Lowlier and a Flatliner, two other forms of misalignment. The move toward moderation may have gone too far in response to political concerns. At this point, investors should be concerned about (1) retention of top talent; (2) insufficient performance-orientation in the pay system; and (3) the boomerang effect, catapulting compensation to where it was in the old days once the TARP monies are paid back and the government lightens up. AIG seems to have made the misalignment rounds, from a Highflying Dogleg to a Lowlying Flatliner. Doesn’t this organization, like every other, deserve an aligned compensation program?

Something Else to Consider While AIG provides us a blatant case of misaligned behaviors, my experience is that more often than not, the causes of misalignment, like culture, are much more subtle. Unlike at AIG, misalignment can result from seemingly innocent actions that don’t show up now but may create problems down the road, or may show up under certain performance scenarios but not others. It can result from bad data, or bad assumptions, or not having thought about the assumptions at all. It can result from a series of actions in which one move just piles up on top of another. It can result from blindly following the trends. “If most companies do it, then we’ll do it too.” And finally, misalignment practices can

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become downright habit-forming, with various companies or even industries having their compensation “drug of choice.” These things are subtle, but real. While I don’t believe that these subtle actions create a culture of misalignment, per se, they can just as easily lead into the NOzone on the Alignment Report.

Macro to Micro So there you have it. A culture of misalignment can lead to pay abuses. But small inadvertent actions, taken together, also can add up to misalignment. Either way, the Alignment Report is the manifestation of a culture of misalignment or an amalgam of inadvertent actions. It can tell whether a company has problems, and if so, point to the nature and magnitude of those problems. It can help break down the issues into their parts so they can really be tackled. To do this, companies need to have a better understanding of what actions got them out of alignment in the first place. They also need to know what decisions are likely to bring them back into alignment in the future. Knowing what these choices are is a big head start. In the following chapters, we’ll take a look at each root cause of misalignment one at a time.

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Exhibit 8.1. The Root Causes of Misalignment Compensation Design 1. Aggressive target pay • Companies become Compensation Highfliers with above-market pay positioning13 regardless of their performance. 2. Turbo-charged upside • Companies become Compensation Riskseekers or Doglegs with highly leveraged incentive upside, and in the case of Doglegs, cushioned downside. 3. Conventional goal-setting • Companies become Compensation Flatliners with goals that drive consistent target payouts, or • Companies become Compensation Highfliers with goals that drive consistent above-target payouts, or • Companies become Compensation Lowliers with goals that drive consistent below-target payouts. 4. Short-term gain; Long-term pain • Companies become Compensation Highfliers with high bonuses or option gains that are harvested just prior to their financial and stock price collapse. 5. Flattening the curve • Companies become Compensation Flatliners by taking one or more actions that dampen the sensitivity of pay to performance.

Decision-Making Processes (Amplifiers) 1. Ad hoc decisions • Companies fall into any of the misalignment patterns by regularly making decisions outside of their plans or by changing their plans from one year to the next. 2. Decision-making influences • Companies fall into any of the misalignment patterns due to human decision-making biases; relying on false assumptions for making decisions; and other behavioral, personality, and process-driven influences.

THE ROOT CAUSES OF MISALIGNMENT

Exhibit 8.1. Continued

Compensation Design Decision-Making Processes Ad hoc decisions

Decisionmaking influences

123

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FAIR PAY, FAIR PLAY

Exhibit 8.2. AIG Alignment Report American International Group, Inc. Stock Price: 1/1995 –10/2009 Federal Reserve announces bailout of AIG

AIG Stock Price

$2,000

$1,500

$1,000

$500

$0 1995

1997

1999

2001

2003

2005

2009

2007

Year Note: Stock price reflects 1 for 20 stock split on 7/1/2009 Source: Capital IQ, Inc., a division of Standard and Poor’s

American International Group (AIG) CEO PAC Alignment Report Over Three-Year Periods Ending in Years Shown

Annualized PAC (2008 $MMs) $100B Revenue

$70.0 Alignment Zone

$60.0 2000

AIG CEO Greenberg: Compensation Dogleg

$50.0

1998

$40.0

2004

2002

$30.0

AIG CEO Greenberg: Compensation Riskseeker

1996

2003

ector

ials S

$20.0

1999

2001

c Finan

ne ay Li

P

1995

AIG CEO Benmosche: Compensation Lowlier and Flatliner

$10.0 $0.0 –20%

–10%

0%

10%

20%

Annualized Three-Year TSR CEO for Three-Year periods 1995 to 2004: Hank Greenberg CEO for 2009: Robert Benmosche

30%

40%

50% Greenberg

9 AGGRESSIVE TARGET PAY On Being Average By reading the newspapers or listening to members of Congress, you’d think that the primary compensation objective of all U.S. companies is to be a Compensation Highflier, in other words, to pay executives above market for mediocre performance. While it’s true that most executives would like to be paid highly, it is my experience that they would like to be paid highly in return for high performance. High performance is a win-win. It satisfies shareholders and executives alike. As I’ve always said, high performance is the best retention tool around. The “problem” is that over the long run, the stock market is efficient and stock price performance tends to revert to the mean for the level of risk that the investor is taking on. This means that it is unrealistic to expect companies to produce superior total shareholder returns into perpetuity. It is more realistic to expect median returns that are appropriate for the risk level of the investment over time. To look at how this “reversion to the mean” phenomenon shows up in our database, I looked at how our S&P 1500 companies performed in each of the three-year rolling periods over the fourteen-year time horizon, after stripping out those companies that didn’t have fourteen years of history. I figured that if top performers consistently stayed on top, then onethird of the companies in our database would stay in the top one-third of performers for all fourteen years. What did our data show? None of the S&P 1500 companies stayed in the top one-third of performers all fourteen years, and only about 6% of the S&P 1500 companies stayed in the top one-third

125

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FAIR PAY, FAIR PLAY

of performers for ten years. Only about 33% of the companies stayed in the top one-third of performers for five years. Further, maintaining high performance for consecutive periods was even rarer. These data prove the case that while investors would be delighted to realize outsized returns, maintaining abovecompetitive returns over the long haul is no easy feat and certainly not a realistic expectation. While I don’t mean to be discouraging, I do want to make the observation that companies are better off planning their compensation systems around a competitive result, as opposed to around an abovecompetitive outcome. This does not mean that companies should not strive for and be incented for the above-competitive win. It just means that companies cannot count on this as they design their pay systems. This, of course, is the logic embedded in our Alignment Model. The basic premise of the model is that target compensation for executives should be set competitively, that is, within an established range around target, and that actual pay should be driven up or down by actual performance, within a reasonable range over time. In contrast, setting target pay at aggressive (above 50th-percentile) levels bears an implicit assumption that performance will be at above-competitive levels, and will stay there over time.

The Case for 50th-Percentile Pay Positioning Interestingly, I have not met a single capitalist over the years who doesn’t think that alignment, at least conceptually, is a good idea. As I mentioned earlier in this book, most proxy reports to shareholders state that a key objective of the company’s executive pay program is to “align the interests of our executives with those of our shareholders by emphasizing equity incentives in the total pay package and by varying pay levels

AGGRESSIVE TARGET PAY

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with company performance,” or something to that effect. As Ursie Fairbairn says, “Talented people buy the concept of pay for performance.” To their credit, most companies today have set their pay positioning strategy at the 50th percentile of the market. This is a good thing. I believe that shareholders and executives alike get the fairest deal if target pay positioning is at market, and actual pay positioning is merely a function of performance. One reason why I generally am not in favor of an above-market pay strategy is because this is what leads to “leapfrogging.” If all companies in the marketplace set target pay at above market, then all companies would be raising their pay to catch up. This creates an arms race of sorts—one that we never really win. The pay keeps ratcheting up, with one company leapfrogging another, and with no end in sight. I would probably think differently about this if I saw some companies with a stated strategy of above-market pay and others with a stated strategy of below-market pay. But in thirty years of consulting, I can’t recall a company with a below-market total compensation strategy. Yes, a component or two of the compensation package might be “deemphasized,” but not total compensation. So in the marketplace in general, above-market pay positioning paves the way to pay escalation. Now, this isn’t just my opinion. Shareholder advisory groups and expert panels are on to this too. They have advised that middle-of-the-road pay positioning at target is generally good practice. According to a report issued in 2009 by The Conference Board Task Force on Executive Compensation: It is axiomatic that no more than 25 percent of peer companies can perform at or above the 75th percentile. Companies should target above-median pay only with appropriate justification, such as large differences in scale or unusual recruiting or retention challenges. Of course, incentive plan design will commonly

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provide for above-median payouts for exceeding plan performance objectives.

Even with these admonitions, there are still compensation committees and executives who feel as though an above-market executive compensation strategy is in the best interests of shareholders. There are still more than a handful of companies, for example, that target the 60th to 75th percentiles, at least for some components of pay, such as equity. High-tech companies are particularly prone to this practice given the high growth rates of emerging market companies. The logic goes like this. Highgrowth companies need to “punch above their weight” from a recruiting and retention standpoint. In other words, they need to aggressively add people with the skills required to run a larger business. These are companies that are expecting to “grow into their pay,” so to speak. I buy this logic and have used it myself in consulting with clients when the need is clear, but too often, these same companies stick with above-average pay positioning even when their growth slows and the need for this strategy diminishes. In extreme cases, I have seen companies stick with their above-market pay strategies even as they are downsizing their businesses. Do these companies really need to pay above market, particularly among the executive ranks, as people are losing their jobs? Probably not. Many companies that might have once had a valid above-market pay positioning strategy would do well to rethink this strategy as business conditions change. While it makes sense to develop a “killer” business strategy to try to achieve above-market returns, companies cannot bank on this level of performance given strong market forces and reversion to mean performance over time. This is why companies are usually better off planning around competitive pay for competitive performance before performance happens, and actually paying above-market pay for above-market performance after performance happens (and vice versa).

AGGRESSIVE TARGET PAY

129

Setting Aggressive Pay Targets According to Jill Kanin-Lovers

“I don’t think that the absolutely outrageous pay packages that have captured so many people’s attention were based on competitive market data. For some of these packages, the ones that take your breath away, I just don’t believe that they went out and did a comp survey to decide that that should be his target. It seems like some of these numbers that you’re hearing about, the ones that caused the lightning rod on compensation, weren’t based on any kind of analysis.”

Above-Target Pay for Average Performance Then why is it that companies target aggressive compensation? Sometimes they intend to have above-target pay positioning, but other times, it’s inadvertent. It seems like it just happens. As far as I can tell, aggressive target compensation occurs due to four basic reasons: • Stated pay positioning—companies deliberately put shareholders on notice that they intend to pay above market for target (aka average) performance. Reasons for this pay strategy could include planned growth, retention of key talent, or “hazard pay” for working in a toxic corporate culture (although this third reason is never really stated). • Peer group abuse—companies choose an inappropriate peer set, which in turn can distort the competitive pay benchmark, generally upward. • Bad analytics—companies employ analytic methodologies that create inconsistencies between external benchmarks

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and internal pay comparisons. This is mixing apples and oranges. • Implicit pay positioning—companies take actions that are outside of the pay structure that ratchet up pay to abovetarget levels. Let’s take each of these one at a time. Stated Pay Positioning While some companies embrace a 50th-percentile pay positioning strategy to achieve better alignment, others regard above-market pay positioning as a permanent fixture of their talent strategy. These above-market players tend to show up as Highfliers on the Alignment Report. Take Oracle, for example, which is a Riskseeking Highflier. Oracle is a $23 billion enterprise software company that provides the “system of record” for corporations to keep track of their financial, human resources, sales, customer, and other types of information.14 Larry Ellison has been the CEO of Oracle since he cofounded the company in 1977. He still owns approximately 22% of the company’s stock. Oracle lets shareholders know right up front in its proxy report that its intention is to provide above-average compensation, contingent on performance. The question here, of course, is, “How much compensation for how much performance?” but let’s go on. The company’s proxy states, Our philosophy with respect to our results-oriented executive compensation program, both in fiscal 2009 and historically, continues to be to reward the individuals with the greatest responsibilities and our top performers (i.e., those with the potential to contribute the most to the success of our business) with very attractive pay packages, but only if they and Oracle achieve a high level of performance. Therefore, we set overall target

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compensation significantly above the average compensation level of selected companies to which we annually compare our executive compensation.

The proxy goes on to say, The objectives of the compensation program are to: attract and retain highly talented and productive executives; provide incentives for superior performance; and align the interests of our executive officers with those of our stockholders.

Oracle has been bringing this pay strategy program objective to shareholders for years. In an August 28, 2009, Bloomberg article, the reporter wrote, “Oracle Corporation founder Larry Ellison, the fourth-richest man in America, is drawing criticism from some shareholders for a $72 million pay package that’s 12 times bigger than the median pay of CEOs in the technology industry.” The pay determination process at Oracle has been unusual. In 2008, Ellison submitted his own pay proposal recommendation directly to the board. As stated in the 2008 proxy, For fiscal 2008, our CEO, Mr. Ellison, submitted to the Compensation Committee his proposal for his own base salary, target performance cash bonus award opportunities and the size of his stock option grant. The Compensation Committee reviewed and considered his proposal and ultimately determined and approved Mr. Ellison’s compensation based on the collective judgment of its members. The Compensation Committee approved Mr. Ellison’s compensation in the amounts disclosed in this proxy statement, which were greater than those of our other named executive officers, because he is not only our CEO with overall responsibility for our business strategy, operations, and corporate vision, he is also our founder who has guided Oracle for the last 30 years and who the

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Compensation Committee believes is vital to our success as a company going forward.

Oracle’s Alignment Report, shown in Exhibit 9.1 (page 143), certainly makes the point that Ellison isn’t shy. In looking at this report, you cannot miss how Oracle’s aggressive target compensation strategy shows up. In fact, we needed to create a logarithmic scale on the y-axis just to get all of Ellison’s data points on the page. For the most part, Oracle’s CEO compensation is that of a Highflier, with a modicum of Riskseeking added in. In nine of the past thirteen three-year periods, Ellison’s PAC was in the Upper NOzone; in two of the past thirteen three-year periods, his PAC was in the Alignment Zone; and in the remaining two periods, his PAC was in the Lower NOzone, driven by three years in which Ellison took no compensation. To Ellison’s credit, Oracle has performed at very impressive levels. The three-year rolling TSR for Oracle for most years in our database is positive, with a median of 19%. This compares to a median TSR of 8% for all companies in the Software & Services Industry sector (which is a subset of the Technology sector) and a 75th-percentile TSR of 25%. But even if Oracle had pursued a competitive target pay strategy, Ellison’s actual pay would have been considerably above market in the good years, driven purely by performance. Wouldn’t this have been a better result for shareholders? And why should any company need to pay more than the upper boundary of the Alignment Zone for the performance delivered? Despite Oracle’s good performance, its shareholders have been speaking up. They have repeatedly submitted proposals to adopt “say on pay” to give shareholders a nonbinding vote on Oracle’s pay programs. Oracle continues to be opposed to the adoption of “say on pay,” citing the following reasons: A retrospective “yes” or “no” advisory vote is a relatively blunt and ineffective mechanism for registering stockholder concerns

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and would not provide any meaningful insight into specific stockholder views. We believe that direct communication between stockholders and the Board of Directors is a more effective method of expressing support or criticism of our executive compensation practices, as it allows stockholders to voice specific observations and provide meaningful input.

To date, “say on pay” proposals have been defeated by Oracle’s shareholders, although let’s not forget that Ellison has a 22% voice in that vote. One can argue that Oracle is a straight shooter about its executive pay intentions, and investors go into the stock with their eyes wide open. However, the Alignment Report shows that shareholders are overpaying Ellison for the performance they are receiving. If the board were to cut Ellison back from $72 to $22 million and save $50 million a year in compensation expense, then at a ten times pre-tax valuation multiple, this savings would translate into a $500 million value increase, of which 22%, or $110 million would accrete to Ellison. While I admit that this is only a one-time value enhancement, there’s a strong argument that aligned pay would not be all bad for Ellison. In this case, moderation doesn’t have to be all about valor. Peer Group Abuse Peer group abuse is when companies use peer groups that are inappropriate for pay comparison purposes. To give you an example, I conducted a consulting assignment for a financial services company in the sub-prime lending business in its heyday. The CEO of this company made no bones about the fact that he thought that one of the companies in his peer group should be Citigroup. Citigroup was not only about a hundred times larger than my client company, but also much broader in its business and geographic scope and, of course, known for its high levels of

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compensation. This one was so obvious that the compensation committee didn’t have to think twice about whether Citigroup should be in the peer set (they said “no”). But I brought it up to illustrate an extreme case of attempted “peer group abuse.” To be fair, much of the peer group abuses of the past have been forced out of the system. The SEC and shareholder advisory groups have been instrumental in this process. The issue of peer groups is a hot button for Nell Minow of The Corporate Library. She reports that The Corporate Library constructs its own peer groups, so that they do not have to rely on a company’s judgment in this regard. The Alignment Report gives us a good barometer for testing Performance-Adjusted Compensation against any number of peer groups. We can test a company’s pay outcomes against just about any group of companies, all the way from the broad market to an industry sector, an industry group, an industry subsector, a specific peer group, or even down to an individual peer company. To illustrate how the Alignment Report can help tease out peer group abuse, we ran the report for one of the distribution companies in our database. Distribution companies are interesting to look at because they have distinct economics. Because they are buying finished or nearly finished goods and then reselling them, they have a very high cost of goods sold relative to most other types of companies. This makes their value-added structure small, and their margins razor thin. In other words, their revenues are outsized relative to their profits. In fact, companies in the broad market have EBITDA margins that are three to five times those of distribution companies.15 Armed with this information, I tested three peer approaches for the model distribution company in our database: • Peer Group 1: Companies in the broad market using revenue size, unadjusted for the economics of a distribution company

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• Peer Group 2: Companies in the broad market using revenue size approximately one-fifth of the size of companies in the broad market to reflect the economics of a distribution company • Peer Group 3: Companies in the distribution subsector using revenue size, unadjusted for the economics of a distribution company (since the companies in this group are distribution companies) The Alignment Report for our disguised case company is shown in Exhibit 9.2 (page 144). Interestingly, the Alignment Report clearly shows the impact of peer group selection. Size matters. Peer Groups 2 and 3 show virtually the same pay line. In other words, the distribution company line and the broad market line, adjusted for the economics of a distribution business, are practically on top of one another. This suggests that the market pays according to the economics of the business, which makes perfect sense. However, the pay line for Peer Group 1, the broad market unadjusted for distribution company economics, is nearly twice the level of the pay line for Peer Groups 2 and 3. It’s easy to see from this Alignment Report that our case company compares pay to companies in the broad market, unadjusted for distribution company economics, for determining executive compensation. To investigate the matter further, I looked at this company’s proxy report to check out its peers. The company defines its peers on the basis of the end markets it serves, not on distribution peers. In addition, the company is vague about how it positions pay relative to its peers. I would argue that this is a clear case of peer group abuse. The more relevant market lines are Peer Groups 2 and 3, not Peer Group 1. While peer group abuse can be subtle, a good alignment analysis can usually tease it out.

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Peer Groups According to Nell Minow

“We often have contempt for peer manipulation on the part of companies, which is why we created our own peer groupings. That’s because if you’re Timberland, which is relatively small, and you’re going to say you’re in the same peer group as Nike, which is large, you’re going to do it because you both make shoes. But in reality, the scale of the two companies is very different. How companies make their peer group assignments tells you a lot about the board and about the company. A lot of companies wanted to say they were in the same peer group as Disney, during the Michael Eisner period, because he was paid so much. If a company was in the hotel business, or the restaurant business, they put themselves in the same peer group as Disney. That’s because everyone’s going to look modestly paid next to Disney. In my view, peer group selection is subject to a lot of abuse. We have even seen companies that say, ‘We’re in this peer group in terms of market cap, and that peer group in terms of industry, and another peer group in terms of something else.’ So I would be very cautious about how peer groups are selected, and I would make certain that it is explained very clearly.”

A Word About Performance Peers Because the whole point of this book is to develop new ways of thinking about performance-pay alignment, a discussion on peers wouldn’t be complete without some commentary on performance peers. I don’t see the same peer group abuse with performance peers as I do with pay peers. But this doesn’t mean we’re off the hook. The problem is that I tend not to see performance peers discussed at all. Kate DCamp shared some of her

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observations with me. “There’s very little emphasis internally on the performance side of the equation. Compensation committees, consultants, and HR professionals tend to put a tremendous amount of time and effort into the competitive pay side of equation and then all but ignore the competitive performance side. In fact, I would say that too much attention gets paid to competitive pay and not enough attention gets paid to competitive performance.” So the problem tends not to be peer group abuse in the performance realm. The problem is not having any peer group at all. To this point, I rarely see “performance peers” listed in proxy reports to shareholders. This may be because companies want to keep competitive peer information confidential. Or it may be because goals are being internally set, without regard to peer performance. My experience is that the more common reason is the latter, and not the former—that companies are generally not doing a sufficient job of taking the competitive performance context into account when they are linking pay to performance. (I will talk more about this in Chapter Eleven.) One HR executive told me that he was discussing a new incentive plan design with the compensation committee’s consultant. When it came to discussing the performance parameters in the plan, the consultant said that “he didn’t care what measures were selected, as long as the goals were tough.” But my question is, “If he doesn’t care about the measures, then how can he possibly know whether the goals are tough?” This is the sort of “ hands off ” approach to performance that weakens the relationship between performance and pay. My colleagues at Farient Advisors and I always put performance on the agenda. The question we get most often about performance peer groups (besides being asked to construct them) is, “Does it matter that the performance and pay peers aren’t the same?” My answer to this is that it generally does not matter. Why? Because performance peers are competitors for products, services, and capital, and pay peers are competitors for talent.

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The two peer sets are usually not the same. My view is that the performance and pay peers should overlap (and the greater the overlap the better), but they don’t need to be the same. The Alignment Report gives equal weight to performance and pay. Moreover, it allows a company to assess its alignment against both its performance peers and its pay peers. Now that’s a beautiful thing. Bad Analytics So far, I’ve covered two causes of aggressive target pay, one that is deliberate—an above-market pay positioning strategy—and the other, peer abuse, which may or may not be deliberate. I’ve also discussed how these two types of pay decisions can create aggressive target compensation and how they can show up in the Alignment Report. The third category of actions leading to aggressive target pay is bad analytics. Bad analytics can start out innocently enough. But among those who are savvy in the compensation arena, they can be employed to “reverse engineer” an answer about executive pay. Regardless of whether confused analytics are innocent or deliberate, the compensation committee and internal staff alike need to be on the lookout for these issues. Since this book is not intended to be a tutorial on the technical aspects of compensation, I’ll just list the most common analytic pitfalls, which can result in above-market target compensation without your even knowing it. They are related to either inflating competitive pay values or deflating internal ones. Inflating Competitive Pay Values • Using rank-order proxy data to match positions for all but the CEO and CFO positions (two jobs that must be reported in the proxy), rather than using survey data to match

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positions (Using proxy-ranked data for the non-CEO, nonCFO positions generally distorts pay information because it automatically draws in data for people who make it into the top five, regardless of job responsibilities, which creates an upward bias in the data.) • Including special deals (such as promotional increases, newhire packages, special retention grants) in the competitive pay data, which inflates the competitive data • Using a different Black-Scholes methodology to value competitive grants compared to internal grants, thus mixing apples and oranges • Reporting on the 50th- and 75th-percentile pay, but not the 25th-percentile pay, setting up a psychological bias toward the higher end of a competitive range Deflating Internal Pay Values • Not counting special awards that add to the value of the pay package (although it makes sense to take out promotional and new-hire grants, which truly are one-time deals) • Not counting add-ons that can be triggered voluntarily— add-ons such as stock-matching programs • Not understanding scope adjustments to position matches (Pay professionals sometimes apply premiums or discounts to competitive jobs to reflect differences in responsibility for their client company jobs.) • Not counting the value of gross-ups for benefits and perks, such as personal use of company aircraft The moral of the story here is that it’s important to understand the analytic methodologies being employed. Seemingly small differences can add up to big differences that can send target pay upward.

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Good Examples of Separating Out Pay for New CEOs HP

When HP hired Mark Hurd as CEO from NCR, HP’s board clearly described the purpose of each pay element in his new contract, with continuing elements such as base salary, annual incentive, and long-term performance cash and stock options. They differentiated these elements from the one-time make-up grants of HP restricted stock and options to replace forfeited awards in NCR stock, and signing bonus and relocation to encourage his joining HP and provide transition assistance. International Rectifier

Another example demonstrating clarity occurred when International Rectifier hired a new CEO in 2008 and clearly identified in the employment contract that the CEO’s sizeable up-front equity grant was “intended to satisfy the Company’s obligation to grant equity incentive awards to Mr. Khaykin for the initial four years of his employment,” and that “the parties do not anticipate that additional equity incentive awards will be granted during such period.”

Implicit Pay Positioning By implicit pay positioning, I’m referring to pay that is not counted as part of the company’s normal pay positioning policy but rather pay that is added on and counted separately—these are often special awards, such as grants of equity given out for retention purposes. Whether or not these types of awards show up in the target-pay analysis, they do show up in the proxy statements to shareholders and also in the Alignment Reports.

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The reasons for this are complicated, and I will deal with them in more detail in the chapter on decision-making influences. But some of the reasons deserve mention here. First, boards and compensation committees want to retain their top executives. To help sprinkle a little insurance on the matter, they use compensation as a lever to help them lock in the talent. Second, given our competitive nature, peer comparisons are part of the human condition. CEOs, and board members for that matter, are born competitors. They want to win. They always want to be a bit better than their peers. Third, by and large, companies think that their own executives are the best, and so they pay them a little higher than market, reflecting this belief. All of this adds up to the Lake Wobegon effect on steroids.16 Interestingly, most (but admittedly not all) executives tell us that what they really want is to be treated fairly for the services they render and for the performance they deliver. They don’t really need to be locked in with above-market pay. Maybe this is a sign of the times, or maybe it’s been this way all along. Nevertheless, I think this provides an opening for boards and compensation committees. They can show executives “the love” without bestowing rich target awards before performance happens. While each of these implicit pay positioning moves can be rationalized, they do result in changes in pay positioning over time and contribute to a ratcheting up of market pay. This, however, is the dilemma. Directors need to act on behalf of their own organizations, so they pay the “retention insurance” and show “the love.” However, if a number of companies behave this way, pay for the entire market tends to increase. As a result, I generally urge compensation committees to assess whether these pay actions are really needed, and to consider what consequences such actions might have on the broader market for executive talent as well as on the company.

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Aggressive Target Pay: What to Do About It There’s nothing like the Alignment Reports to bring aggressive target pay practices out of the closet. There are a number of things that companies can do to combat aggressive target pay and achieve better alignment. These include the following: • Unless there is an unusual circumstance, like hyper-growth, set pay strategy at the 50th percentile, on average, for the executive team. This does not mean that companies need to apply a median pay level to every individual on the executive team. Rather, it means that a 50th-percentile pay positioning strategy should be applied to the executive team overall, allowing for differences for individual experience and performance. • Scrutinize the peer group to ensure that industry economics and other relevant factors are being taken into account. Test various peer groups using the Alignment Report to better understand the implications of peer group selection. • Choose performance peers, not just pay peers, and use these two peer sets to test alignment and calibrate performance and pay linkage. • Understand all of the methodologies used in analyzing pay. Declare war on bad analytics. • Use Alignment Reports to check actual, not just stated, pay positioning relative to performance.

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Exhibit 9.1. Oracle Alignment Report Oracle Corp. Stock Price: 1/1995 –10/2009

$50 $45

Oracle Stock Price

$40 $35 $30 $25 $20 $15 $10 $5 $0 1995

1997

1999

2001

2003

2005

2007

2009

Year Oracle Corp. CEO PAC $1,000

Alignment Report Over Three-Year Periods Ending in Years Shown1 2000

Annualized PAC (2008 $MMs) $23B Revenue Logarithmic Scale

2001

$100

2002 2006

2007

– 40%

1996

Alignm

ent Zo

ne

2005

Software & Services Industry Pay Line

2004

$1

1997

1999

1998

$10

2008

20032

–20%

0%

20%

40%

60%

Annualized Three-Year TSR 1

Fiscal Years as reported by Oracle

2

Ellison received no salary, bonus, or options during the three-year period ending in 2003

80% Ellison

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Exhibit 9.2. Distribution Company Alignment Report Distribution Company CEO PAC Alignment Report Over Three-Year Periods Ending in Years Shown

Broad Market Pay Line $50B Revenues

Annualized PAC (2008 $MMs)

$30.0 2006

CEO Pay Trend Line

2005 2004 2007

$20.0

Alignment Zone

2003 2008

$10.0

Distribution Subsector Pay Line

Broad Market Pay Line $10B Revenues $0.0 –20%

–10%

0%

10%

20%

30%

Annualized Three-Year TSR

40%

50%

10 TURBO-CHARGED UPSIDE Big Opportunities Good executives by their very nature are optimistic, and they like to plan. These planning efforts can result in big changes— investing in new products, services, markets, or geographies, and doing this through organic or acquisitive growth. To pull off these transformative moves, executives need to inspire the troops. Lead people into the unknown. Focus them on the right priorities. And help them accomplish what once may have seemed all but impossible. That’s what good executives do. If you combine an aggressive CEO with a big market opportunity and a healthy economy, there’s the promise of a lot of upside for shareholders. That’s why executive teams come up with transformative plans in the first place—for the benefit of shareholders. I had a client in the transportation business that traveled down this very road (no pun intended). The executive team took the company private through a leveraged buyout, restructured the business to create an efficient operating platform, and then went public again. Once they raised public equity, it was time for Act II. They had to figure out how to grow the business through whatever means made economic sense—new service offerings, expansion into adjacent geographies, better pricing strategies—you name it. The company went through a painstaking process to determine its priorities and develop a solid plan. As the revenue-enhancement ideas were unfolding and the plan was being developed, it was not lost on management that the company also was increasing its risk profile. They had a plan to create more value for shareholders, but at a higher level of risk.

145

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The compensation committee and CEO of this company decided that their old compensation plans were not going to sufficiently drive the new strategy. Nor was merely embedding new measures or goals into their current plans going to do the trick. Instead, they decided that they needed a “turbo-charged” incentive plan to drive Act II—a plan that would “make the view worth the climb,” while also recognizing the greater risks that they were taking on. Their logic was that investors would be willing to share the spoils disproportionately with the executives if they were successful. Given this logic, I helped them design and implement a “turbo-charged” incentive plan that provided above-market upside Performance-Adjusted Compensation for an exceptional performance outcome. The plan worked by layering on a long-term incentive plan on top of their normal incentive plan, but kicked in only if performance was 75th percentile or greater.

Turbo-Charged Upside “Turbo-charged upside,” as I like to refer to it, is either an incentive plan or a pay mix that provides above-market Performance-Adjusted Compensation for above-market performance. It focuses the mind on the high end of the performance curve. Companies turn to the “turbo” model because they feel as though a more typical model won’t be powerful enough to encourage the heavy lifting involved in transformative efforts. Turbo-charged compensation arrangements tilt the PAC line so that it is steeper than before. They, in essence, turn the company into a Compensation Riskseeker. There are a number of pay schemes that convey the turbo effect. These include • Extreme risk mix • Highly leveraged incentives • Uncapped upside

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• Stock options as payout currency • “Big hit” incentives This isn’t necessarily bad, but there are dangers to watch out for. These pay schemes and the alignment issues associated with them are discussed in greater detail in the following sections.

Extreme Risk Mix An extreme risk-oriented pay mix is one in which executives give up less leveraged pay in return for more leveraged pay. The most common form of this action is to give up short-term cash pay (salary and/or short-term incentives) in return for equity, usually stock options. Executives generally do this when the company is in trouble, or when the executive perceives that there is much more upside than downside in the company’s equity value. The likes of John Chambers, chairman and CEO of Cisco Systems; Steve Jobs, cofounder and CEO of Apple; Rick Wagoner, former chairman and CEO of General Motors; Roger Enrico, former chairman and CEO of Pepsico; and others all adopted this approach at one point or another over the years. Usually, this pay format sticks for two to five years to accomplish a specific purpose. Higher-risk pay for executives is generally considered to be a good thing. After all, a risk-oriented pay mix suggests higher sensitivity of pay to performance and alignment with shareholder interests. But there is a catch. The problem is that executives, being smart, want to be compensated for the higher risk that they are taking on. In fact, they generally want to be over compensated for this risk. Our data show that a CEO receives, on average, more than $1 of target equity value (measured in present value terms) for every $1 of target short-term compensation surrendered.

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Take Copart as a case in point. Copart, founded in 1982, is a $750 million dealer in vehicles that have been deemed to be a total loss. They process and sell these vehicles for their salvage value and parts, using a technology-driven platform that links buyers and sellers around the world. In 2009, Copart asked its shareholders to vote on a proposal to approve an up-front grant of two million stock options each (a total of 4.8% of Copart’s outstanding common stock) to the company’s CEO, Willis Johnson, and its president, Jay Adair. Both executives would give up salary, bonus, and other equity compensation for a five-year period in return for the options. The options would vest ratably over five years. As stated by Dan Englander, the company’s compensation committee chairman: The Board believes this proposal demonstrates an extraordinary commitment on the part of senior management to Copart and its shareholders and offers strong evidence of management’s conviction concerning Copart’s strategy and prospects. In addition, this proposal will align Mr. Johnson and Mr. Adair’s incentives as closely as possible with our shareholder partners. We believe shareholders will be comforted by the fact that Mr. Johnson and Mr. Adair will earn no compensation over the next five years unless they deliver where it is most visible, in the share price. In an unprecedented market environment, this sharing of risk is a strong and unique statement by Mr. Johnson and Mr. Adair, and we stand behind them fully in this effort. Having said that, we feel it is only right to put the matter before shareholders. The Board believes this proposal is in the best interests of all Copart shareholders, and the individual members of the Board have committed their significant shares to vote in favor of it.

Following this announcement, the proposal passed with 77% of shareholders voting to adopt this pay plan. But what exactly did they adopt? The Alignment Report can help us sort through

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whether this is in fact a good deal for executives and shareholders alike. Let’s take a look at Copart’s Alignment Report, shown in Exhibit 10.1 (page 155). The Alignment Report shows that these two executives can earn up to three times their prior potential compensation at a median performance level of 10% TSR over the next three years, and five times their prior potential compensation at 30% TSR. This represents an aggressive pay positioning at median performance, but with complete downside if performance doesn’t materialize. So essentially what this company has done is tilted the pay curve upward very significantly. Is this a good deal for shareholders? Well, let’s see. The executives took advantage of the downturn in the secular stock market, getting their shares when the stock price was relatively low. If shareholders receive a competitive three-year TSR of 10%, which is likely if stock valuations are depressed and there is reversion to mean performance, then they will overpay executives by a factor of approximately three times. At higher levels of TSR, the multiples go up. Will these executives really be any less focused or work any less hard with a more conventional pay plan? I don’t think so, particularly since Mr. Johnson is also the founder and already owns in excess of 10% of Copart’s stock outright. My own view is that shareholders would have done better over time with a more conventional pay plan. I wonder how the votes would have turned out had investors seen the Alignment Report. One last point: Copart’s shareholders should definitely stay away from approving any additional forms of pay for these two executives for the five-year option vesting period. Highly Leveraged Incentives A highly leveraged incentive plan is an incentive plan that delivers very high incremental pay for a relatively small level of incremental performance, usually once a certain performance

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hurdle is met. This performance hurdle adds risk to the incentive vehicle. A good example of a highly leveraged incentive plan is a performance-based stock option plan. Stock options are already fairly leveraged equity vehicles. They become more leveraged if companies give additional stock options in return for the increased performance risk. A version of this type of incentive is indexed stock options, which was popular in the 1990s. The most common type of indexed option is when the strike price on the option increases each year with some index, such as inflation or the company’s cost of capital. This increasing option price makes the value of the option lower. My predecessor firm, SCA Consulting, did a study on indexed stock options and found that companies need to grant over three times the number of indexed options to equal the value of normal options. This “three times” factor, coupled with difficult performance hurdles, makes indexed options a highly leveraged incentive plan. Indexed options aren’t used much today, because people realize how binary these awards tend to be. You’re either wildly in or wildly out of the money. In addition, because of the three-to-one grant ratio, these plans eat up shares like crazy, another difficulty in the post-Sarbanes-Oxley environment. Uncapped Upside In my view, the best form of uncapped upside potential is outright equity ownership on behalf of executives. This makes the upside opportunity of the executive the same as that of the investor. Short of this, uncapped or very high upside potential can create misalignment issues, including the outlier effect and issues of providing the opportunity for large awards in the short term when performance is not sustainable in the long term, as was evidenced by high payouts from virtually uncapped

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incentives in the financial services industry right before the financial meltdown of 2008. Just plain vanilla stock options, by their very nature, are uncapped. That is why recipients like them so much. But their uncapped nature also leaves the possibility of the company going into outlier mode, particularly with stock market runups. One idea to counteract the potential outlier effect of stock options is to cap their upside. Companies could issue options that are automatically “exercised” when they reach some multiple (such as three times) of the strike price. This feature would provide plenty of upside without the risk of becoming an outlier. It also would help to limit a company’s “overhang,” which is the shares authorized by shareholders as a percentage of shares outstanding that can be issued as incentive compensation. Stock Options as Payout Currency Using stock options as a “leveraged incentive payout currency” is just a fancy way of saying that the company will determine the value of the stock options it gives out on the basis of corporate performance. If corporate performance is good, then it will give out an above-market grant of stock options in aggregate. If corporate performance is poor, then it will give out a below-market grant of stock options in aggregate. This is different from using individual grant ranges with the midpoint of the grant range set around the 50th percentile. Instead, this type of “leveraged incentive payout currency”— using stock options as the currency—is moving the midpoint of the grant range to above-market (or below-market) levels. If the range midpoint is set at a high level, the value of the grant for individuals could be at the 90th percentile, for example, if an individual were to receive a grant at the high end of his or her range. This all adds up to what I call “double leverage.” The first source of leverage is in establishing the value

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of the grant itself at above-market (or below-market) levels, and the second source of leverage is in the performance of the option itself. This is what the Dogleg model company, shown in Exhibit 7.3, was up to. The company had a system of granting options at high relative target values when the most recent year’s performance was good, and then granting options at low relative target values when performance was poor. The problem was that this system resulted in runaway outlier Performance-Adjusted Compensation when performance was good and resulted in Dogleg status, scrapping the plan in favor of a safety net of restricted stock, when performance was poor. “Big Hit” Incentives A “big hit” incentive plan, as I like to call it, is a plan that is layered on top of the normal compensation plan but is invoked only when performance hits a relatively high hurdle, such as 75thpercentile performance. A “kicker” or multiplier on awards for performance above a certain level is a variation on this theme. The transportation company I mentioned earlier put a plan like this in place, with my assistance on the design. The way the plan worked was to pay out after five years, but only if certain financial performance hurdles that linked to 75th-percentile TSR were met. In this case, the plan was effective. But these plans don’t always work. I had other clients whom I helped implement plans of this nature just before the 2008 financial meltdown. One company ended up scrapping the plan and another has just let the plan go dormant. The issue with “big hit” plans is that the downside looks like business as usual. However, I would argue that given what the executives are trying to pull off in many of these situations, the downside is riskier from a performance perspective than it was prior to any strategic change, thereby making the normal pay system riskier too.

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The Importance of Modeling Incentive Plans According to Kate DCamp

“I think there’s not enough modeling that goes on with how a program will perform. You have to look at how a standard package will pay if it’s the worst case and if it’s the best case. Would the pay be ridiculous? Could somebody make a billion dollars? And how would we feel about that? The other thing that happens is you put these plans in, and then they don’t do what you wanted them to do with respect to Joe or Jane—that’s where you get this outside-theplan kind of exception. Had they modeled the plan, they might have understood this and might have changed the plan design in the first place.” According to Charles Elson

“With respect to Lee Raymond, former CEO of Exxon, the board probably never anticipated that the price of oil would reach about $100 a barrel. When the compensation committee designed his plan, the price of oil was effectively between $16 a barrel and $25 or $26. And I’m sure they awarded the options on the basis of oil prices moving in that range. And when oil moved to $100, it blew them up because no one on the compensation committee looked at the ‘what if.’ It’s like the housing problem. No one said, ‘What if prices go down 10% or 15%?’

Alignment Issues with Turbo-Charged Leverage Turbo-charged incentive plans come in many flavors, and they are not necessarily misaligned. They only have great potential to become misaligned for the reasons I have discussed. These plans tend to creep up when markets heat up. But one

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thing that might moderate their use, in addition to our being smarter about their impact on alignment, is their impact on risk-taking behaviors. These types of plans are, by their very nature, designed to encourage people to assume more business risk. Following the financial meltdown of 2008, there has been a heightened sensitivity to how pay plans may be encouraging people to take undue risks. Going forward, this alone may make compensation committees think twice before they approve turbo-charged upside plans.

Turbo-Charged Upside: What to Do About It? • Make sure you are familiar with the risks associated with turbo-charged upside arrangements (encouraging undue risk-taking, potentially moving into outlier status, becoming a Compensation Dogleg, or moving the payout curve to the left, making it easier for executives to earn above-average compensation for median performance). Make sure the measurements and time horizon features built into the program counteract issues of encouraging participants to take undue risks. • Get philosophical agreement up front on what will happen on the downside, not just the upside, if performance does not materialize. Will the tendency be for the company to provide downside protection, in effect turning the alignment pattern into a Dogleg? • Use the Alignment Report to model potential plan designs. Make sure you know what you’re signing up for.

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Exhibit 10.1. Copart Inc. Alignment Report: Prior CEO Program Versus New Equity-for-Cash Compensation Plan Copart Inc. CEO PAC Alignment Report Over Three-Year Periods Ending in Years Shown

Annualized PAC (2008 $MMs) $750MM Revenue

$50.0

Prior CEO program assumes Salary = $750,000 Target Bonus = 200% of salary Annual Options = 150,000

$40.0

CEO New Plan: 2MM Front-loaded Options for 5 years in lieu of other compensation

$30.0

$20.0 Prior CEO Program

$10.0

Industrials Sector Alignment Zone

$0.0 –30%

–20%

–10%

0%

10%

20%

30%

Annualized Three-Year TSR

40%

50%

11 CONVENTIONAL GOAL-SETTING Goal-Setting Is Frustrating Goal-setting is one of the most frustrating areas in compensation. I regularly see boards, compensation committees, and management frustrated over goals. I have seen companies design entire long-term incentive plans and then scrap them because they couldn’t reach agreement on the goals, or didn’t have confidence that they could even set the goals. Often, these folks mutter that they are agreeing to a goal because “that’s as good a guess as any.” I have seen compensation committees throw up their hands and say, “Let’s just see what Finance can come up with.” The job of goal-setting seems to take on that of a seer of sorts. Who has the best crystal ball? It used to be that goals were set at the 11th hour. Then when IRC Section 162(m) was enacted in the 1990s, it was required that goals be set by the end of the first quarter of the fiscal year as a condition of deducting compensation paid over $1 million to any of the five most highly compensated officers. Now, most goals are set by the end of the first quarter in order to ensure tax deductibility of payouts under the plan. The requirement to set goals earlier in the year was at least one positive outcome from Section 162(m). What I rarely hear boards or management say is, “Gee, we really got that goal right” or “We really knew what we were doing when we set those goals.” Instead, I hear, “The goal was too hard.” “The goal was too easy.” “The goal didn’t take into account this or that.” “The goal wasn’t really fair.” In general, people have a really hard time setting goals, and after performance happens, they don’t like the goals they set. While some companies have a philosophy that “the numbers

157

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are the numbers,” others are tempted to override the goals one way or the other, with a view that the calculated results didn’t produce the right answer—they just didn’t capture the intent of the plan. Companies might override the plan, or just “reverse engineer” the performance results to yield the “right answer.” But no one thinks that fudging the goals makes sense either. Goals need to be set with integrity because of Section 162(m) requirements, proxy disclosure requirements, heightened sensitivity to using discretion, and the need to uphold the credibility and motivational value of the plan.

Not Much Guidance There is not as much guidance or new thought on goal-setting as there is on measuring performance. Performance measures are the criteria by which performance is evaluated. Goalsetting is the level of performance to which a company aspires. For example, income growth may be the measure; 10% may be the goal. In the report issued in 2009 by The Conference Board Task Force on Executive Compensation, their first principle of compensation focused on linking incentives to company strategy: There are a number of factors in motivating executives to contribute extraordinary efforts in support of the company’s business strategy. Among those factors are the culture and values of the organization, the scope of the individual’s roles and responsibilities with associated opportunities for professional challenge and growth, and of course, compensation programs. While clearly not the only factor, there is no question that compensation programs can contribute to—or undermine—the culture and success of a company by directly influencing executive priorities and actions. Consequently, it is critical that executive compensation programs link pay directly to results

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that help achieve the company’s business strategy, are consistent with the company’s values, and [are] reflective of a risk profile that is appropriate in light of the company’s strategy and systemic considerations.

As a case in point, this statement gives some guidance in thinking about measures, but the report is silent on the issue of goals. However, of all the design features of compensation, goal-setting has one of the most dramatic affects on alignment.

Deconstructing the Compensation System Before we get too far down the path of why unconventional rather than conventional goal-setting concepts might be better aligned with shareholder interests, let’s deconstruct the compensation system to see what part of an executive’s compensation is really contingent on goal-setting. As shown in Exhibit 11.1 (page 179), I’ve taken a typical compensation package for a CEO and divided it up by pay component. For the CEO, I’ve assumed that 25% of target total compensation is delivered in the form of salary and benefits, 20% in target bonus opportunity, 20% in the target annualized value of stock options, 20% in performance shares, and the remaining 15% in restricted stock. Not surprisingly, nearly half (45%) of the CEO’s compensation is driven by equity value; approximately 30% is driven by financial and strategic goals; and the remaining 25% comprises salary and benefits, which are not linked to goals at all. So, in total, achievement against goals for a typical executive tends to drive 30% or less of an executive’s Performance-Adjusted Compensation. Don’t get me wrong. This is still an extremely important percentage of the whole. It attracts a lot of attention. But how we determine how much equity to grant is equally, if not more, important.

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Differentiating Performance Measures by Business Unit According to Ed Breen

“We instituted a few years ago some very specific metrics by business for 25% of the bonus. In one of our companies, we decided that revenue growth was going to be the most important metric over the next couple of years, so we instituted that. In another one of our companies, we decided we had a working capital focus, so we decided to tie the bonus to that. I love those programs because the overall drivers tie into the specific metrics of this business, and this has a huge impact. I see it when I’m with the management team. They’re talking about it all the time. And so you can actually see the benefit of this. Our compensation committee has been very good about differentiating measures and goals depending upon which company we’re dealing with. When you’re in a conglomerate, not every company is the same, so this is very effective for us. “One of the things I keep in mind is whether our companies are gaining market position. At the end of the day, we’re the world leader in three major industries, but are we advancing ourselves? Are we gaining position in those businesses? This is indicated by market share. This year, business is down, but we could gain nice market share in our industry, which for the long term would be extremely valuable for our investors. And are we gaining ground with a good return on invested capital? Are we getting the right return out of what we’re doing? And if I can gain market share and get a good return doing it, somehow that’s going to translate into a better stock price over time. That’s what you get rewarded for. So I think you’ve always got to sit back and take a breath and look at it that way.”

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The Goal-Setting Inherent in Equity The conventional wisdom is that stock options and restricted stock don’t require any goal-setting. You just grant the equity and go. But another way to think about it is that there is a goal embedded in the equity grant itself. If a company makes a 50th-percentile grant to the executive team overall, then it is requiring the team to generate a competitive return to earn a competitive award. But if the company makes an above-market grant to the executive team, then it is requiring the team to generate a below-competitive return to earn a competitive award. All other things being equal, special above-market equity grants are tantamount to setting below-competitive TSR goals. To illustrate the point, I calculated the TSR that a company would need to generate in order to provide a competitive Performance-Adjusted Compensation level if it made 75thpercentile instead of 50th-percentile up-front equity grants. The answer, shown in Exhibit 11.2 (page 180), is that competitive awards are generated at a 3.5% instead of a 10% TSR. See what I mean? The point is that the way in which companies position their equity grants implicitly embeds goal-setting into the equation. Above-market equity grants imply below-market performance goals, and below-market equity grants imply above-market performance goals. No One Size Fits All According to Bob Denham

“The first question is to understand the strategy of the business, and if you don’t have a coherent strategy, you’re not going to achieve very much. But starting with a coherent business strategy and aligning the compensation program with the strategy is important, so that when (Continued )

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you’re thinking about performance, you’re not just thinking about more money. “I think that compensation really starts with business strategy. You can’t think about performance without thinking about ‘performance against what?’ And that’s against strategy. Companies in the same industry generally have similar strategies. But then, they differ in some respects. And to the extent that they differ, the performance objectives should differ. “We’re measuring performance and determining pay against a backdrop of some risk of greater government intervention. This, in turn, will reduce the ability of boards to make different judgments in different situations. One size does not fit all. We need to appropriately emphasize that companies are different. They are in different industries. What’s an appropriate prescription for one might not be good for another.” According to Steve Sanger

“Each company uses its own particular approach. But each approach is logical in its own right relative to what drives value for that company. There are a lot of factors that go into the approach a company uses, one of which is, ‘Do the employees understand it and does it motivate them to do the right things?’ That’s why I like ’simple.’ I tend to like simple plans and plans that are consistent—that you don’t change all the time. And I think in the case of the boards I sit on, they meet those descriptions. I think the other thing you look for is director discretion in case things happen that you could never have anticipated. And so, the approaches are different; the things they measure are different; in some cases, the time periods are different. But they all have their logic. They represent what the company is trying to do.”

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Goal-Driven Compensation With the point made about goal-setting being implicit in the equity grants, let’s go back to the issue of goal-driven compensation, the other 25% to 30% or so of an executive’s total compensation. These goals, whether short or long term in nature, tend to be composed primarily of financial goals and secondarily of strategic goals. (Companies also might set share price or TSR goals, but for purposes of this discussion, I’m looking at these as stock price goals.) Of course, the financial goals can be revenue, income, or return-based measures. The strategic goals can be about customers (number, type, satisfaction), relative market positioning (market share, relative growth, new products), employees (engagement), operational excellence (cost management, operating ratios), or anything else that the company feels is indicative of its strategy to create and sustain value over the long term. The conventional thinking about goal-setting is that financial and strategic goals should be motivational. This means that companies want to make goals “stretch, but be achievable.” They want to make them fair from the perspective of the executive. In trying to make goals motivational, companies are trying to find the sweet spot—the target—the place where the probability is the highest that the goals will be hit. Exhibit 11.3 shows an example of a typical motivational goal-setting system (page 181). I call this goal-setting system a “mark-to-budget” system. It starts with the motivational sweet spot and then fans out from there. Reframing the Goal of Goal-Setting The motivational sweet spot views the pay system from the perspective of management. Management drives strategic and financial performance, which in turn drives outcomes for shareholders.

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But what if boards and management look at the whole issue of goal-setting more from the perspective of shareholders? This shareholder perspective requires companies to forget about what performance they think they can deliver, and instead focus on the performance that they need to deliver in order to provide shareholders a competitive return. In turn, this perspective requires that companies understand the various combinations of longer-term cash flow growth and returns that will produce the competitive return. And backing up from there, it requires that they break down the cash flow growth and returns into strategic objectives that will produce the needed financial results. Since company valuations are, at least in part, a function of competitive position, it also requires that companies assess their achievements relative to competitors. Investors won’t have a lot of confidence in a company if, for example, it grows revenue and profit at 10% per year when others in the industry are growing at 20%. I call this goal-setting system a “mark-toshareholder” system. This approach starts with trying to deliver competitive returns to shareholders and then works backward from there. In its extreme, the problem with a mark-to-budget approach is that it makes no attempt to determine the extent to which the company will create value for shareholders. On the other hand, the problem with a mark-to-shareholder approach is that it makes no attempt to determine the extent to which the goals will be motivational. The Right Metrics According to Bob Eckert

“We start by asking, ‘What are the right things to measure?’ We tend to focus on things that look a lot like cash flow because that’s a key to our company’s success. We tend to focus on capital—that is, how much money we make and what assets or capital we have to deploy to make that

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money. And we tend to focus on two types of assets around here. One is inventory and the other is accounts receivable. This is not a capital intensive business, but the trick is that it’s a working capital intensive business. You make inventory all year, then you ship that inventory to retail customers in the fall. The inventory then becomes the receivable. And if all goes well, customers pay you, and that’s when the cash comes in. And if you screw up in the toy business, it tends to be that you either made too many items or you shipped them to people you shouldn’t have shipped them to and didn’t get paid. So that’s the capital we concentrate on. “And then there’s how much money we make off of our capital. How do we set standards? Right now we look backwards at TSR and ask, ‘What did it take to be in the top 50th percentile or in the top third in performance?’ And, ‘What do we need to do to get from here to there?’ On the internal measures, like cash flow, we look at our own historical performance and we benchmark our performance against well-run consumer goods companies. We arguably are not just ‘fashion for four-year-olds,’ which is the inherent nature of the toy business, but we are a consumer goods company, and we generate cash flow off of our brands. So we benchmark ourselves against Proctor & Gamble, Coca-Cola, Lever, Nestlé, and we compare our performance relative to that peer group. We have eighteen peer companies listed in the proxy, and we benchmark everything against them—financial performance, pay, everything.”

Mark-to-Budget to Mark-to-Shareholder The following is an example of a company in an extremely volatile sector of the technology industry that made the transition from a mark-to-budget to a mark-to-shareholder goal-setting approach. The company’s leaders, not surprisingly, were having a very difficult time setting goals. Given the strength of the industry

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cycles, they either outperformed their goals by June or fell so short of them that there was no hope of recovery by the end of the year. The company decided to reset its expectations by reframing the goal-setting process. The new process entailed applying a long-term industry growth rate to the prior three-year average financial results. The high end of the goal range was set at 75thpercentile industry growth, and the low end of the goal range was set at a number that was motivational—something that linked to the internal budget. In addition, they also carved out 25% of the award pool to reward for the achievement of strategic objectives, subject to a profit “circuit-breaker.” In other words, unless some minimum level of profit was achieved, no bonuses would be paid. This system smoothed financial goals, required industry-competitive growth for competitive payouts geared to the long-term prosperity of the business rather than the business cycle, and provided some motivational value to management. This new system entailed a significant reframing of what the goal-setting process was all about. What the executives (and the compensation committee for that matter) had to get over was the desire to set target financial performance at a level that was perceived at the beginning of the year to have some reasonable probability of being achieved. Instead, they had to embrace a system that wasn’t about the achievement of the goal, per se, it was about the achievement of long-term shareholder value creation. While this new system, as with any other, certainly wasn’t perfect, it was much better than the budget-based system they were used to, primarily because they had a new perspective on what the goal-setting system was supposed to do. Compensation Starts with Strategy According to Jill Kanin-Lovers

“I’ve been on five corporate boards, and every company has their own way of going about it, and some are not as good as others in terms of strategic planning. Probably

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the strongest strategic plan that I’ve seen comes from a privately held company on which I’m on the board. It’s a company called Dot Foods. They take it so seriously that their executive team meets three times a year to talk about strategic planning. The planning is quite detailed and in some ways very operational, but they always have that long view built in that they try to consistently map into their compensation program. Now, it happens it’s not always as perfect as one would like. There’s a little bit of a time lag. But I think other organizations are not always as disciplined as they need to be on strategic planning, which then makes it more difficult to design the compensation program that’s supposed to be supporting the business strategy.”

The Effect of Conventional Versus Unconventional Goal-Setting on Alignment Now, let’s think about the effect on alignment of the two goalsetting processes. A mark-to-budget goal-setting process, as I have defined it, would produce the same incentive payouts as a percentage of target award each year. Assuming that the target award opportunity does not change, this system produces a flat relationship between TSR and incentive payouts. In other words, it is not aligned to shareholder value. On the other hand, a strict mark-to-shareholder goal-setting process would theoretically produce a nicely sloped relationship between TSR and incentive payouts. I wondered how this theory would play out in practice using the Alignment Report. To test this, I modeled how total Performance-Adjusted Compensation would behave for a CEO with the pay mix we discussed earlier. I assumed that the mark-to-budget bonus and performance share goal-setting system always yielded 100% payouts, and I assumed that the

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mark-to-shareholder bonus and performance share system had goals that geared to absolute levels of TSR. As you can see in Exhibit 11.4 (page 181), the mark-to-shareholder system provides a total compensation outcome that is more leveraged and aligned compared to a mark-to-budget system. In fact, the mark-to-shareholder system tracks the upper boundary of the Alignment Zone, and the mark-to-budget system falls toward the lower boundary of the Alignment Zone. Mark-toshareholder systems promote alignment and mark-to-budget systems damp it down. Bob Eckert agrees that the goal-setting process needs to tie back to shareholder value. In fact, he uses his own version of the mark-to-shareholder system at Mattel. “We do some pretty good work on what drives our TSR, and then we set goals on what it’s going to take to generate a competitive TSR. When we go to internal measures, we focus on the things that drive TSR. We also look at relative performance. We benchmark well-run consumer goods companies.” Eckert went on to talk about how, if companies were setting their goals more from a shareholder perspective, they’d get better alignment of pay to performance. He talked about why there’s a performance and pay alignment issue in corporate America. “Let me tell you why there’s a problem. My pay last year was down 38% from the prior year, largely driven by the fact that I received zero annual bonus. None of Mattel senior executives received an annual bonus last year because we didn’t hit the numbers. And in the 2008 environment, it’s hard for me to believe that a lot of companies hit their numbers. Relatively speaking, I think we finished the year in the 64th percentile of the S&P 500, so we did better than 64% of other big cap companies. Of the eighteen peers listed in the proxy, only three of them did not pay an annual bonus. And of the ones who did, the average CEO bonus was $2 million. So I put those facts together and I say, ‘Something’s not right here.’”

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Open-Minded About Goals According to Nell Minow

“I’m very open-minded about goals because my view is that that’s the way the company tells you a lot about itself. And if they want to tell me that their goals are in terms of cash flow or in terms of market share or in terms of some other sort of less conventional measures, I’m perfectly happy as long as they stick with it on the way up and on the way down. That way, investors can decide if it is something they want to bet on or not. And that way you’re not trying to impose some sort of cookie-cutter approach. “Some companies are cyclical, some are not; some are emerging, some are failing; some are conglomerates, some are not, so you know, my view is that the board should decide what the number is and/or what their goals are, and they should be as specific about it as possible and then let the market pick and choose.”

Absolute Up-Front Versus Relative After-the-Fact Goal-Setting Benchmarks Because the nomenclature can be confusing, I have put together my definitions of goal-setting, shown in Exhibit 11.5 (page 182). Essentially, absolute up-front goals are set at the beginning of the performance period and are calibrated either against shareholder expectations (as determined by what levels of performance are needed to support various stock prices), against competitor performance (based on competitors’ or industry historical trends as well as projections), or against plan. If a company refers to either one or both of the first two factors, shareholder expectations and competitive or industry performance, to set its goals, then it is “externally contextualizing” its goal setting. If the company is only referencing its internal plans to set its goals, then

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it is simply setting internal goals. Bob Eckert feels as though, in general, goal-setting by companies is too internally focused, leaving it exposed to “honest people inadvertently gaming the system.” Relative after-the-fact goals, on the other hand, are goals that are expressed in relationship to an external benchmark, like performance against a peer set or an index. These goals also are what I call “externally contextualized” because they are referenced against something in the external environment. I call these “after-the-fact” goals because performance against these goals can’t be determined until after performance happens for both the company and its benchmark. Emerson Electric, for example, uses a relative after-the-fact goal in its long-term incentive plan. Under the long-term compensation plan, the company’s compound annual growth rate in earnings per share must exceed the compound annual growth rate of the U.S. gross national product (GNP) by three percentage points over the four-year performance period in order for target awards to be earned. Emerson Electric measures EPS growth relative to the U.S. gross national product because its ability to grow is so dependent upon the U.S. economy and because outperforming this goal likely will deliver superior returns to shareholders. Externally contextualized goals, particularly those that link to shareholder expectations, have a higher probability of aligning performance and pay than internal goals. In addition to the alignment benefit, there are other benefits to externally contextualized goals as well, as shown in Exhibit 11.6 (page 183). Kate DCamp is a proponent of testing the competitive waters in setting goals and notes the imbalance in how companies tend to treat performance versus pay: “On the one hand, the pay side of the equation is completely competitively contextualized. And on the other hand, the performance side of the equation is too rarely competitively contextualized.” As discussed in Chapter Two, Pat McGurn also brought up the merits of a more relative approach.

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I think the virtues of externally contextualized goals have been overlooked for too long and the virtues of internal ones have been somewhat overrated. At the end of the day, I subscribe to a mix of measures and goals, with a heavier weighting on externally contextualized benchmarks.

The Competitive Context for Setting Goals According to Steve Sanger

“At General Mills, annual goal-setting was based partly on what we thought we needed to do to be a superior company, but also on the realities of the business when the goals were being set. However, performance metrics for compensation purposes were based entirely on peer group performance, and as such, were independent of the annual goals. The system was designed to pay at median total comp for median performance and at 75th percentile total comp for 75th-percentile peer group performance. So there was a real strong attempt to align overall executive pay with relative performance.” According to Laurie Siegel

“The long-term metric for our performance share plan is relative TSR, relative to the S&P industrials. And in the short-term plan, we set goals in a competitive context. We have views on what the competitive range of performance will be, and we want to position ourselves at the upper end of our peer group.”

No Perfect System Neither the mark-to-shareholder nor the mark-to-budget goalsetting system is perfect. A mark-to-shareholder system gives the nod to alignment, but less so to motivation. A mark-to-budget

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system gives the nod to executive motivation, but less so to alignment. So what is the best way to resolve this dilemma? First of all, my view is that all goals for long-term incentives (like those used for performance shares or long-term cash plans) should be mark-to-shareholder, externally contextualized goals. In this way, the goal-setting process will be more closely aligned with shareholder interests. Second, goals for short-term incentives can be a combination of mark-to-shareholder (externally contextualized) and mark-to-budget (internally driven), using the goal ranges to get a bit of both.

A Range of Possibilities So let’s talk about the goal range. It’s not only about the target, the centerpoint, of the goal system. It’s also about what’s around the edges, the thresholds and maximums that also define an incentive plan. Most conventional goal-setting systems start with a target and then draw a range around the target to derive the plan leverage. I think that this method underutilizes the incentive range. Instead of just working from the center out, I am a proponent of thinking about the high and the threshold of an incentive range, and then working inward toward the target. The reason I say this is that to justify earning a maximum award, the upper end of the goal range should be geared to producing superior returns for shareholders, leaving the lower end of the goal range available to trigger smaller awards for legitimate but doable achievements that will lead to sustainable value over time. Exhibit 11.7 illustrates what I mean by this (page 184). This exhibit shows a mark-to-shareholder goal-setting framework that I think is both practical and aligned. For example, to justify above-competitive awards, companies need to generate financial and market results that will lead to outperforming shareholder expectations, and they need to gain competitive ground. To justify competitive awards, companies need to generate financial and market results that will lead to meeting shareholder

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expectations and at least maintain competitive ground. Performance benchmarks can be set either by referencing the external factors or by paying directly against relative benchmarks. To justify earning some award, if not target, the company should at least perform well on factors that drive sustainable value. These could include strategic goals or relative competitive measures that indicate good management, sustainability, or preservation of value, even in difficult times. What if relative performance is terrific, but absolute performance is not good because the entire industry is down? My experience is that while relative performance counts, absolute performance trumps relative performance. It’s nearly impossible to justify target awards just because a company is “the best of a bad lot.” To help execute on this, I feel as though companies should invoke a circuit-breaker of sorts, a point below which no bonuses, at least for executives, will be paid. I recommended invoking this circuit-breaker concept quite a bit during the financial crisis of 2008 and 2009. For most clients, they decided it would be best not to pay an incentive in 2009 unless earnings at least met or exceeded 2008 levels. There was concern that shareholder value would remain in the dumps unless earnings showed signs of recovery, and without some movement upward, bonuses should not be paid.

The Alignment Report and Goal-Setting An alignment report can be tremendously helpful in smoking out goal-setting issues. This is because alignment reports don’t lie. They tell us what one company is willing to pay its executives for a given level of TSR performance, relative to the relevant marketplace. If we set goals that aim too low relative to the market, we will overpay for the performance delivered. Conversely, if we set goals that aim too high, we will underpay relative to the market for the performance delivered. If we engineer our goals or reverse-engineer our results to ensure competitive payouts, then we flatten the alignment curve and reduce the sensitivity of pay to performance.

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A number of companies bifurcate their assessment of performance and pay. But to ensure alignment, companies need to look at both, together. Not long ago, I received an inquiry for work from an S&P 500 company. They wanted us to advise them about competitive pay levels, but did not request information about performance. We pointed out that their alignment could be random unless we analyzed both performance and pay together. They acknowledged the point and agreed to look at both. This made a big difference to the quality of the work and their alignment prospects for the future. A Picture Is Worth a Thousand Words To illustrate how the Alignment Report can help sort out goalsetting issues, I decided to run an Alignment Report for one of my esteemed clients, The Cheesecake Factory. If you’ve ever been to a Cheesecake Factory restaurant, you’ll know that the food is delicious and there is always enough left over for lunch or dinner the next day. The company began in 1972 when Oscar and Evelyn Overton opened a small bakery in Los Angeles. In 1978, their son, David, opened the first restaurant in Beverly Hills. The company went public in 1992 and now operates about 175 restaurants across the United States. The company is especially known for its creativity and operational excellence. I was particularly struck by the company’s creativity when I learned that its ticker symbol is CAKE. Since going public, the company’s executive compensation program has been relatively straightforward. It has consisted of salary; a bonus opportunity, contingent largely upon meeting corporate profit objectives; and stock option grants, with a few restricted stock grants strategically placed along the way. Like other companies we looked at, The Cheesecake Factory states in its proxy report to shareholders that one of its compensation objectives is to “align the interests of [its] executives with the interests of [its] shareholders.”

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I ran The Cheesecake Factory’s Alignment Report for the CEO, as shown in Exhibit 11.8 (page 185). The Alignment Report told me that there was a very respectable level of sensitivity between pay and performance and that the company had applied its pay policies consistently over the years. However, the placement of the alignment data showed that The Cheesecake Factory was approaching the realm of Compensation Lowliers—paying relatively low for the level of TSR performance produced. This picture, of course, led to one overarching question, “What was causing the systematic shortfall in PAC outcomes relative to TSR performance?” and many subsidiary questions: “Was it the peer group used for comparative purposes?” “Was it below-market salaries, bonus targets, or long-term incentive grants?” “Was it pay mix differences?” “Was it performance measures or goal-setting?” “Was it use of downward discretion in award determination, or pay positioning strategy?” “Was it that The Cheesecake Factory was a great place to work with an exceptional track record due largely to inspirational leadership, so it didn’t have to pay up?” Any one of these factors, as well as others, could have been the cause. In pursuing these questions, we found that the company had a philosophy to pay competitively, but that the shortfall had been caused by two factors. First, target bonus levels and upside opportunity, particularly for the CEO, had fallen behind market norms. Second, and more important, the bonus goals had been set aggressively relative to peer performance, causing The Cheesecake Factory to pay lower bonuses for better performance. As a result of our analysis, The Cheesecake Factory instituted a new bonus design to respond to these issues. The Effect of Stock Option Exchanges on Alignment I have maintained for a long time that repricing options or doing an option exchange is equivalent to a goal reset. Goal resets are not considered to be “fair play.” It’s like heads—I win; tails—you

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lose. Moreover, repricings are looked upon very negatively by the shareholder advisory groups and by shareholders themselves. But I wanted to be open-minded about this issue, and so I decided to test the effect of repricings and stock option exchanges using our alignment research. To model this issue, we assumed that a hypothetical company experienced a decline of 75% in the value of its stock in the first year after making options grants (isolating the impact of the option grant exclusively by excluding other elements of compensation). I then tested three courses of action that the company could pursue: • No stock option exchange—Executives hold outstanding options. • One-for-one option exchange—Executives exchange all of their outstanding underwater options for new options at the new fair market value (FMV) exercise price. • Value-for-value (or economic) exchange—Executives exchange all of their outstanding underwater options on a Black-Scholes value-for-value basis. In our hypothetical company, the 75% decline translates into an exchange ratio of three underwater options for every new FMV option granted. Our results are shown in Exhibit 11.9 (page 186). The share-for-share exchange result is not surprising. A repricing on a share-for-share basis clearly destroys alignment, and only serves to move the pay curve upward. This makes sense because in a one-for-one share exchange, companies are taking several years of grants and just establishing a lower “goal line” for those grants, even though shareholders “take it on the chin.” As the stock price rises again, so do the repriced shares, pushing the entire pay curve upward. Not surprisingly, a value-for-value option exchange flattens the performance alignment curve, due to the new lower number of options granted at a stock price that already reflects a negative

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TSR starting point when compared to the original option grant. However, what is a bit more surprising is that the people who are taking the economic exchange are not necessarily better off. At relatively modest stock price gains, the employees are better off not taking the exchange offer. So option exchanges really are a way to recycle the options outstanding into “new” options. In other words, these companies can take the surrendered shares back (or have room for a new authorization) so that the company can make new grants. If the stock price has any chance of bouncing back in some reasonable period of time (for example, five years), those who take the exchange are not necessarily better off. The real beneficiaries are those who receive new grants going forward. Are the shareholders better off with a value-for-value exchange? I don’t think they’re really any better or worse off, except that the “perception value” of the outstanding options are likely to increase among optionees. This is all a long way to say that I have changed my mind on value-for-value exchanges. While value-for-value exchanges should certainly not be overused, they generally are neutral from a shareholder perspective and may be positive from a perception perspective among participants. Stock option exchanges are one way to help control overhang. But other ways include using shorter option terms. Another way, which some of our clients are considering, is to put a feature into the stock option whereby it automatically expires if its underwater for a continuous, extended period of time (for example, three years). This feature would help give companies an opportunity to refresh their option pool and make new grants without carrying the very heavy drag of underwater options in the system until they expire.

Finally, Better Guidance Goal-setting is difficult. And because of this, it seems to be an area in which scant guidance is given. Sure, there are the “how to” manuals on how to think about goals from a theoretical

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point of view. But where are the tools that can really help us get to a better goal-setting process? My view is that compensation committees, managements, and investors all need unconventional, not conventional, ways of thinking about goal-setting. A reframing of sorts is needed, particularly with the benefit of all of the information on goals that is now starting to flow in through proxy reports. I have no illusions that people will read this chapter of the book and all of a sudden enjoy goal-setting. But I have tried to clarify the issues, and make the answers easier to come by, by putting the whole subject through the lens of alignment. The alignment objective is a good way to separate the practical from the theoretical. It shows how goal-setting is implicit in equity grants. It shows how a less conventional mark-to-shareholder framework trumps the traditional mark-to-budget process. It shows how the mark-to-shareholder process only is actionable if it is informed by objective external benchmarks around shareholder expectations and competitive or industry performance. It shows how using an entire goal range to link to value, rather than working from the target outward, is a way to achieve shareholder sensitivity as well as management motivation. In short, it helps us reframe what the goal-setting process ultimately is all about—the shareholder.

Conventional Goal-Setting: What to Do About It • In making equity grants, recognize that TSR goals are implicit in the grant. • Externally contextualize goals—take an “outside-in” approach starting with shareholder expectations and competitive or industry performance. Establish a mark-toshareholder goal-setting framework. • Use the entire goal range to infuse both shareholder sensitivity and motivational value into the process. • Use the Alignment Report and the new information provided in proxy reports to test goal-setting processes and “nail” the issues.

179

Total

Salary and benefits Short-term incentive Long-term incentives (LTI) Stock options Performance shares Restricted stock 100% 50% 100%

20% 20% 15%

100%

0% 0%

25% 20%

0% 50% 0%

0% 75%

0% 0% 0%

0% 25%

0% 0% 0%

100%

45%

20% 10% 15%

0% 0%

% of Total Stock Stock Compensation Price Financial Strategic Individual Price

Weighting of Measures in Typical Plan

Weighting of Measures in Total Compensation

25%

0% 10% 0%

0% 15%

5%

0% 0% 0%

0% 5%

25%

0% 0% 0%

25% 0%

Financial Strategic Individual

CEO Compensation

Exhibit 11.1. Weighting of Performance Measures in Total Compensation

180 $10.00

$10.00 $10.00

$3.331

Value Per Share at Grant

2

1

佢

$13.31

$13.31

$1,200,000

$600,000

$600,000

Assumed 75th Percentile Equity Value

$10.00

$10.00

Stock Price Per Share at Grant

$10.00

$3.331

Value Per Share at Grant

$13.31

$4.502

Value per Share of Equity in Three Years

佢

$11.09

$11.09

$11.094

$3.753

Implied goal with 75th-percentile grant

60,000

180,000

75th Percentile Grant #

Stock Price in Three Years @ 3.5% TSR5

Value per Share of Equity in Three Years

Implied goal with 50th-percentile grant

50,000

150,000

Competitive Grant #

Stock Price in Three Years @ 10% TSR

75th-Percentile Grant—Performance Required to Generate Median Award Value

$1,000,000

$500,000

$500,000

Stock Price Per Share at Grant

Assumes Black-Scholes value at grant as a percentage of the strike price ⫽ 33.3%. Assumes Black-Scholes value at the end of three years as a percentage of the strike price = 45.0%.w 3 675,000/180,000 ⫽ $3.75. 4 665,000/60,000 ⫽ $11.09. 5 $10 stock growing to $16.09 after three years = CAGR of 3.5% per year.

100%

50%

Restricted Stock

Total

50%

Stock Options

Value Mix

100%

50%

Restricted Stock

Total

50%

Stock Options

Value Mix

Competitive Equity Value

Competitive Grant—Value at Median Performance (Three-Year TSR = 10%)

Exhibit 11.2. Performance Required to Generate Median Award Value with 75th-Percentile Equity Grants

$1,340,500

$665,500

$675,000

50th Percentile Value of Award in Three Years

$1,340,500

$665,500

$675,000

50th Percentile Value of Award in Three Years

CON V ENTIONAL GOAL-SETTING

181

Exhibit 11.3. A Typical Mark-to-Budget Goal-Setting System Award As a Percentage of Target Goal

Probability That This Level of Award Will Be Earned

⬎200%

10%

125 % to 200%

20%

75% to 125%

50%

0% to 75%

15%

0%

5%

Motivational sweet spot— highest probability of achievement

Exhibit 11.4. Effect of Mark-to-Budget Versus Mark-to-Shareholder Goal-Setting Processes

Annualized PAC (2008 $MMs) $2B Revenue

$15.0

$10.0

Design assumes: 20% Salary 5% Benefits 20% Bonus 20% Stock options 20% Performance shares 15% Restricted stock

Alignment Zone

Mark-to-Shareholder

et

udg

-B -to

rk

Ma

$5.0 Observed Market Pay Line

$0.0 ⫺30% ⫺20% ⫺10%

0%

10%

20%

30%

Annualized Three-Year TSR

40%

50%

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FAIR PAY, FAIR PLAY

Exhibit 11.5. Goal-Setting Definitions and Examples Internal Goals Derived From:

Internal Plans Relative, afterthe-fact goals

N/A

Externally Contextualized Goals Derived From: Peer, Industry, or other External Performance Indicators

Shareholder Expectations

Performance measured relative to external peer benchmarks or indices

Performance measured against relative TSR or stock price indices

Examples: Examples: • 50th percentile • 50th percentile income growth TSR relative relative to to peers peers • 50th percentile • 33% market TSR relative to the S&P 500 share Goals based on internal plans

Absolute, upfront goals

Absolute goals set by taking historical and prospective competitive performance into account

Goals set by taking shareholder expectations into account

Examples: Examples: Examples: • 20% revenue • 50th percentile • ROTC plus growth based earnings 2% over the on plan growth based cost of capital on historical • 30% of • 10% earnings industry revenue comes growth based growth from products on industry introduced • Labor costs relationship in past three greater than or of earnings years equal to 25% of growth to TSR revenue based on industry standards

CON V ENTIONAL GOAL-SETTING

Exhibit 11.6. Advantages of Goal-Setting Processes: Two Approaches Mark-to-Shareholder Externally Contextualized Goal • Achieves better pay for performance alignment over time • Forces competitive awareness • Does not force public disclosure of internal information, such as budgets

Mark-to-Budget Internally Contextualized Goal • Serves as a good focusing and communication tool • Can be tailored to the unique requirements of the business • Is motivational and highly relevant to management

183

Below threshold

Threshold

N/A

Maintains or improves competitive position

External Factors Achieving Alignment

Losing competitive ground

At least meets expectations

Competitive

Line of sight improving

No awards

Below competitive

Competitive

Above competitive

Exceeds expectations

Above competitive

Strength of alignment improving

Internal Factors Leading to Alignment

Poor performance on factors that drive sustainable value

Good performance on factors that drive sustainable value

PerformanceAdjusted Pay Positioning

Returns to Shareholders

Level of Achievement Required for Pay Positioning Performance Positioning Among Peers

Exhibit 11.7. Mark-to-Shareholder Goal-Setting Framework

Strategic Drivers

FAIR PAY, FAIR PLAY

Target

Maximum

Level of Achievement

184

CON V ENTIONAL GOAL-SETTING

185

Exhibit 11.8. The Cheesecake Factory Alignment Report The Cheesecake Factory CEO PAC Alignment Report Over Three-Year Periods Ending in Years Shown

Annualized PAC (2008 $MMs) $1.6B Revenue

$15.0

$12.5

Alignment Zone

$10.0

2000

Consumer Discretionary Sector Pay Line

$7.5

$5.0

2001 2005 2004

1996

$2.5

2002 1998

1999

1997

2006

CEO Pay Trend Line

2007

$0.0

2003

2008

– 40% –30%

–20%

–10%

0%

10%

20%

Annualized Three-Year TSR

30%

40%

50%

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FAIR PAY, FAIR PLAY

Exhibit 11.9. Effect of Stock Option Exchanges on Alignment

Annualized PAC (2008 $MMs) $3MM Grant

$15.0

Reprice with Same # of Options

Alignment Zone

$10.0 Hold Original Options (no exchange)

$5.0 Economic Exchange at 3:1 Ratio $0.0 ⫺30% ⫺20% ⫺10% $7

$10

$15

0%

10%

20%

30%

40%

50%

$20

$27

$35

$44

$55

$68

Annualized Three-Year TSR (Stock Price) Design assumes $3MM option grant Year 1 price decline from $20 to $5 New option price ⫽ $5

12 SHORT-TERM GAIN; LONG-TERM PAIN Adversity Is a Teacher We all learn a lot in times of adversity, about the world around us down to our inner core. The question in my mind is, “Do we carry these lessons with us through the good times, or do we forget these hard-learned lessons when things turn around?” In times of economic adversity, the equity markets “correct,” or even worse, crash, depending on how overvalued they may have become. We learned this lesson the hard way in 2008. The world of executive compensation is significantly affected by the condition of the equity markets, given that executive compensation is weighted so heavily toward equity in the total pay mix. The issue, of course, is when executives are rewarded for short-term gains but the shareholders holding onto the stock well after performance wanes suffer long-term pain. This is just one more form of misalignment. However, investors also have come under criticism for their short-term outlook. In 2009, the Aspen Institute issued a report called Overcoming Short-Termism: A Call for a More Responsible Approach to Investment and Business Management. The report, written by twenty-eight prominent business, investment, government, academic, and labor leaders, starts out as follows: We believe a healthy society requires healthy and responsible companies that effectively pursue long-term goals. Yet in recent years, boards, managers, shareholders with varying agendas, and regulators, all, to one degree or another, have allowed short-term considerations to overwhelm the desirable long-term growth and sustainable profit objectives of the corporation. We believe that

187

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FAIR PAY, FAIR PLAY

short-term objectives have eroded faith in corporations continuing to be the foundation of the American free enterprise system which has been, in turn, the foundation of our economy. Restoring that faith critically requires restoring a long-term focus for boards, managers, and most particularly, shareholders—if not voluntarily, then by appropriate regulation.

What those who authored the Aspen Institute report are saying is that investors themselves bear some responsibility for the relentless focus on short-term gains.

The Psychological Effect of Equity Compensation Committee Chair Perspective: G. Chris Andersen, founder and partner, G. C. Andersen Partners and lead director, Terex Corporation

“You have to look at equity compensation and at total equity exposure that a manager has and then see what happens from year to year because that exposure has a huge amount to do with their psychology. And they will do things differently in different years based upon that psychology. So psychology is one of the things you have to appeal to. There are lots of little ways that this happens in the context of a compensation structure. It’s not about the cash, it’s about the equity. You want equity more than the cash to get you aligned. If you don’t get it, that’s where it gets screwed up.” CEO Perspective: Ron DeFeo

“I had a conversation with my compensation committee, and we said, ‘Hey—we’re struggling.’ I’ve made a ton of money running Terex. I’ve run Terex for seventeen years, and I’ve seen it through good times and bad times, and my pay package now is contextually different than it was

SHORT-T ERM GAIN; LONG -TERM PAIN

189

ten years ago. Terex is another company now, but I’m also a product of all those years, so to me, the only thing that really matters is whether I can get the stock price up, because I’ve got a million shares that are sitting out there that have the ability to appreciate. So everything else is less meaningful.”

Bad Timing Despite some short-term profit-taking by investors, the job of executives, in my view, is to manage for the long-term prosperity and sustainable value of the business. Certain investors come and others go, but unless executives own 100% of the business themselves, then there are always other investors’ interests to watch out for. Our executive pay system is seemingly long term in nature, but can still miss on the long-term alignment dimension. In the financial services industry, for example, the short-term bonus opportunity was so big that multimillion-dollar bonuses were being paid out even as the financial crisis of 2008 spun out of control. This wasn’t only an issue of paying bonuses just as the sky was falling. It also was an issue of not seeing the financial risks soon enough—not until after the money was paid out. The issue of risks is a big one. Risks don’t only show up in bad times. There are plenty of risks in the boom times, not the least of which is the inability to sustain high growth due to the hidden organizational stresses and strains of hyper-growth. In addition to taking hefty bonuses off the table for performance that isn’t sustainable, a second timing issue is when stock option gains are accumulated and then cashed out just before equity values are about to collapse. While options are a two-way street—they’re leveraged up and down—so executives can win or lose big, the big win attracts the most attention. This happens when option gains are harvested right before the economic storm. This isn’t an issue of whether executives know more about the

190

FAIR PAY, FAIR PLAY

company than investors do. They do. But insider trading rules are designed to take care of this. The issue is that stock options, by their very nature, allow these timing differences to happen. If executives can benefit from short-term profit-taking (that is, high bonuses and accumulated option gains), then that might also suggest that they are incentivized to run up the short-term financial profits of the organization, regardless of the sustainability of these profits, which brings us right back to the issue of whether incentives cause excessive risk-taking. The Securities and Exchange Commission (SEC) is onto this issue as they are considering new disclosure rules around discussing in the CD&A in the proxy report the extent to which compensation programs encourage excessive risk-taking (however vague that may be). The reason for the SEC wanting such a disclosure is that compensation policies “have become disconnected from long-term company performance because the interests of management and some employees, in the form of incentive compensation arrangements, and the long-term wellbeing of the company are not sufficiently aligned.”

Short-Termism in Executive Pay Drill down a level, and we can see this circular system at work. Bonuses and stock options provide for short-term profit-taking either because the performance cycles, vesting schedules, or cashout periods17 are relatively short, or because the time window on option exercise is relatively long. By option time window, I am referring to the difference between the expiration of the option and the vesting of the option. For example, if an option has a three-year ratable vesting (that is, an average two-year vesting) and a tenyear term, then the option time window is eight years (ten years to exercise minus two years average vesting). This is a long time, and is a core reason why stock options are so attractive to the recipients. This window allows executives several years to accumulate the options and then cash most of them out during a runup.

SHORT-T ERM GAIN; LONG -TERM PAIN

191

Short-Termism Among Investors According to Jay Lorsch

“What’s the time horizon that the shareholder is thinking about? If you’re a shareholder and you’re only going to be in a company for a year, you don’t give a damn about newproduct development; you don’t give a damn about morale; you don’t give a hoot about all those kinds of things. But if you’re a shareholder—and we’ve talked with them—and you plan to stay with the company for a long period of time, then you are concerned about these other things—new products, the morale of the organization, union relations—you pick it. They understand that if they’re going to be investors for five or ten years they’d better be concerned about how well management is dealing with some of these other issues that are going to have a longer-term impact. And then the problem is if you just reward on short-term financial performance, there’s a disconnect, a lack of alignment to use your term, between what the shareholder wants and what the management is being rewarded to do. “I think the notion is that we’re really trying to build a society in which there are some stable long-term companies. This is really an important notion for the long-term health and well-being of the economy.” According to Pat McGurn

“I think we have seen problems that can arise in some instances where all those proverbial eggs are put in that single basket. If people use options, for example, I think it’s focused in on TSR, but all it’s really focused on is getting the value up in the short run and then seeking the profit from that. There weren’t a lot of safeguards in place to ensure that there wasn’t undue enrichment going (Continued)

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FAIR PAY, FAIR PLAY

on, or in many cases, outright fraud, or other practices like backdating where people were seeking to game the system. So I think investors are hopeful that the shock to the system that just occurred will have a silver lining, which will be that boards really kick their compensation structures back down to the ground and rebuild them on a much stronger foundation, and again focus them on long-term, sustainable value creation, having TSR as a substantial element but not the only element in the overall pay structure, and deemphasizing short-term pay and short-term performance, making sure that they are much less important and much less central to the compensation structure than they are today.”

Deconstructing the Compensation System, Again Just as we deconstructed the pay system to better understand goal-setting, it helps to deconstruct the pay system to better understand the time horizon of compensation. As before, I took a typical compensation package for a CEO and divided it up by pay component. From this part of the math, we can determine the pay mix. But then, I assigned a time value on each component of pay to calculate the weighted value of the compensation system, shown in Exhibit 12.1 (page 198). I gave salary and benefits a weighting of zero, annual incentives a weighting of 1 (to reflect the typical one-year performance measurement period), and long-term incentives a generous weighting of 5 (to reflect the typical performance measurement and vesting periods associated with long-term incentives), assuming we count in the effects of rolling performance cycles, holdbacks18 on equity gains, ownership guidelines,19 and typical option exercise periods. In thinking about a conventional pay mix, we usually think in terms of a mix of pay that is heavily weighted to longterm incentives. Long-term incentives for our prototypical CEO constitute about 55% of the total pay package. But the

SHORT-T ERM GAIN; LONG -TERM PAIN

193

time-weighted analysis tells a different story. It tells us that, overall, the average CEO pay package measures performance over approximately three years, and this period would be shorter for other executives. The three-year time horizon is shorter than the time horizon that most people would conjure up by just looking at the pay mix. This seems particularly short when you figure that longer time horizons can help retain executives and more readily link to business time horizons. Vern Loucks always wants to make sure that the time horizon is sufficiently long. He says, “Put some gold at the end of a rainbow and make sure the rainbow is long enough.”

Option Window A number of my clients have said over the years that they need a long (for example, ten-year) term on stock options to encourage a long-term focus, but need a short-term vesting period to attract talent. While I don’t disagree with the arguments on the parts, I don’t think that short vesting and a long-term business time horizon really go together. This combination creates the long option window, allowing for a significant accumulation of options that then can be cashed out in heady times. It also is what creates a big overhang. Kate DCamp thinks that “using options more judiciously and maybe with longer vesting would be better than what most companies do now.” She says, “The concern I’ve always had is you vest in two, three, four, or five years, at most. And generally, the term runs ten years. If an executive has made decisions that tank the company after they exercise, there’s no recovery absent his getting fired.” My own view is that companies should think about narrowing the time window for stock options to take care of both the overhang and the timing issues associated with long window periods. I personally like three- or four-year windows (for example, three-year vesting with a six-year term, or five-year vesting with

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FAIR PAY, FAIR PLAY

an eight-year term). For businesses in which the investment period is short, consider shortening the term. For businesses in which the investment period is long, consider stretching out the vesting.

Setting Long-Term Goals According to Vern Loucks

“One of the big complaints people have when they don’t want to use the performance share plan is, ‘Well, it’s really hard to set a three-, four-, or five-year goal,’ and I don’t have a lot sympathy for that. I think it’s a total copout. I think you can set five-year goals, or at least three-year goals. But you need to set some kind of an objective over a longer period of time. “For example, the Emerson guys are probably performing better this year than they have in past years. They’re going in and making the kinds of changes in the corporation that are extremely difficult to make, and they’re getting the cash flow. The executives are doing a superb job of positioning the company for the future, which will be felt when the market turns. When that happens, Emerson will be going up while the rest of the industry will still be going downhill. So that’s not something that you can do every year. You have to have a period of time to make those kinds of adjustments. That won’t pay off soon in the plan, but eventually it will, and they recognize this.”

Grant Frequency and Performance Cycles Over the years, I’ve seen a number of companies make episodic, or large up-front equity grants instead of annual grants. These episodic grants have their place in situations such as startups

SHORT-T ERM GAIN; LONG -TERM PAIN

195

and turnarounds. They provide a way to jumpstart the system. In other situations, such as with private equity, up-front grants are made at the time of purchase, and cash-outs of equity are allowed upon a liquidity event for the private equity investor. But these situations are more the exception than the rule. Most companies need to look after shareholders on a continual basis, without regard to ownership changes. As a result, incentive systems that gear to continual time periods tend to work better for alignment. These systems include annual equity grants, instead of up-front grants, and include overlapping long-term incentive cycles, rather than back-to-back cycles or one-time programs.

Time Horizon and the Alignment Report I would like to be able to tell you that the timing issues I’ve discussed show up readily in the Alignment Reports, but the fact of the matter is that they don’t. The best way to see a timing difference in the Alignment Report is to look for high-TSR years that are followed by low-TSR years. This is a signal to look for undue profit-taking prior to a decline in performance. Our Dogleg company in Exhibit 7.3 is a good example of this. In this case, PAC is particularly high in years just preceding a precipitous drop in TSR. The question is, “What did the executive actually receive in those heady years when the stock price was high?” A look at the SEC Form 4 is needed to see whether the executive cashed out of his or her options and how much money he or she actually earned. Even though we can ferret out timing differences on the alignment charts, the best way to look at alignment issues created by timing problems is by assessing the timing characteristics of the pay programs themselves, much like I did in the deconstruction analysis, and by understanding all features of the plans, such as clawbacks, holdbacks, vesting restrictions, and other fine print. This type of analysis will tell you what timing risks exist and what design fixes might be required.

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Ways to Mitigate Short-Termism According to Raj Gupta

“I think holding requirements are an important thing for shareholders.” According to Jay Lorsch

“I think clawbacks are important. Clawbacks are trying to cause people to take responsibility for things that happen after they leave. So I think you can make a strong argument that clawbacks are a good idea, a healthy idea for the economy because the economy is better off to the extent you have a higher proportion of companies that are striving to stick around for the long term, meaning many years. That’s what makes stronger economies in Europe and in Japan. That’s what’s going to make strong economies in the emerging markets, and that’s what is going to make a strong economy in the United States.” According to Laurie Siegel

“We have ownership guidelines for all of our officers and we think that they relate to the discussion about risk and short term versus long term. Ownership guidelines go a long way in making sure people are in it for the long term.”

Short-Term Gain; Long-Term Pain: What to Do About It • Analyze weighted average performance measurement and vesting periods, and the window period for stock options. • Run an alignment report, looking for data points in which there is a high-TSR year followed by a low-TSR year. • Check the Form 4s to see whether significant option gains were realized prior to an unsustainable share price result.

SHORT-T ERM GAIN; LONG -TERM PAIN

197

• Know the fine print in all of the pay plans. Understand the following features and their effect on alignment: • Performance measurement periods • Clawbacks • Holdbacks • Ownership guidelines • Window periods • Pay mix • Continuous versus point-to-point grants and measurement cycles

198

20%

Short-term incentives

15%

Restricted stock

100%

100%

100%

100%

100%

0%

0%

Unweighted Short term Long term

45%

0%

0%

0%

20%

25%

55%

15%

20%

20%

0%

0%

Weighted Short term Long term

1

Number of LTI grants can vary around a competitive range on the basis of individual performance.

100%

20%

Performance shares

Total

20%

Stock options

Long-term incentives (LTI)1

25%

Salary and benefits

% of Total Compensation

CEO Compensation

5

5

5

1

0

Time Weight Factors (Years)

2.95 years

0.75

1.00

1.00

0.20

0.00

Time Weighting

Exhibit 12.1. Weighted Average Time Horizon of Executive Pay System

13 FLATTENING THE CURVE Don’t Assume Alignment I’ve worked with a number of companies over the years that thought the issue of alignment was simple. All you had to do was offer a high-risk pay mix or load up on equity, and voila, the company’s pay programs would be aligned with shareholder interests. I think investors fall into this trap too. It’s easy to confuse alignment and pay risk. In my view, the slope of the pay line can be either steep or gradual, depending upon the needs of the business, and the level of the pay line should be within a generally acceptable range of reasonableness for the size, sector, and performance of the business. That leaves a lot of latitude for design choices. Through these design choices, companies can do extreme makeovers on their alignment. We saw this in the case of Tyco and AIG, for example. Overall, I think it’s important for investors and management alike to not confuse slope with alignment and to not underestimate the importance of pay level in evaluating alignment.

Design Choices We’ve already talked about some of the design choices that can enhance or detract from alignment, things such as aggressive pay positioning and inartful goal-setting. But for the most part, alignment is achieved through a series of choices that, when taken together, create alignment. Design aspects to manage include • Level of the pay line (high, medium, low) • Performance level at which the pay line for the company and pay line for the market intercept (high TSR, median TSR, low TSR) 199

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FAIR PAY, FAIR PLAY

• Shape of the pay line (shotgun, clusters, Dogleg, or curvilinear) • Slope of the pay line (gradual, steep) The slope of the pay line is one of the most important design choices. Seemingly small decisions can make big differences. I had one client who, at my suggestion, decided to switch from a value-based20 to a fixed-share21 equity grant methodology. This single change made a material difference to the company’s alignment slope. Exhibit 13.1 shows how the pay line can change with this one decision (page 203). By changing from valuebased to fixed-share grants, this company went from being in the middle of the road to being at the upper end of the Alignment Zone. This change was desired and intentional, but illustrates the power of just one decision. In Exhibit 13.2 (page 204), I recapped the various pay program design choices that could increase or decrease the slope of the curve. The primary levers companies can use to change the slope of the pay line are pay mix, mix of long-term incentive vehicles, goal-setting methodology, and equity grant methodology. While these choices are intuitively obvious, the trick is to test their effect on alignment before you make each choice.

Compensation Flatliners This book is not a tutorial on how to design pay programs. It’s about how to align pay with performance. The only slope that is not aligned is one that is so gradual that performance hardly matters—it’s when a company essentially becomes a Compensation Flatliner. With today’s norms in executive compensation, it’s difficult to become a Flatliner. A company could be a Flatliner if it had an all-salary-and-benefits program, for example. But very few executives of the companies in our database fit this no-risk profile—only the likes of such people as

FLATTENING THE CURVE

201

Warren Buffett, chairman and CEO of Berkshire Hathaway, and Jeff Bezos, founder, chairman, CEO, and president of Amazon. And their risk comes from outright ownership in their respective companies, not from compensation. Alternatively, a company could be a Flatliner by making a series of low-risk design choices. To test this theory of how difficult it might be to have a compensation design that is insensitive to performance (we’re talking about design here, not out-of-spec grants or reverseengineered outcomes), I actually compared two pay programs for our prototypical CEO. I left the pay mix constant between the two scenarios. One pay program had a 100% restricted-stock long-term incentive coupled with a mark-to-budget goal-setting process—two line-flattening design choices. The other had a 100% options program, coupled with a mark-to-shareholder goal-setting process—two line-steepening design choices. The answer was surprising. Both companies showed up in the Alignment Zone. Both strategies are workable from an alignment perspective. So how does a company become a Compensation Flatliner? The answer may surprise you. It’s from ad hoc decision making. All of the special awards, special adjustments, plan changes, and other tinkering we do with the pay system year after year leads to misalignment. Don’t get me wrong, it’s not that the pay system can be left on autopilot, but there is something to be said for designing the system and largely letting it run, that is leaving it alone, at least for the most part. Because the effect of ad hoc decisions is so pervasive—and so damaging to alignment—I’ve devoted the entire next chapter to this root cause of misalignment.

Flattening the Curve: What to Do About It • Run an alignment report. Analyze the extent to which PAC is sensitive to performance and fits the company’s business model—on the basis of both historical and projected outcomes.

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FAIR PAY, FAIR PLAY

• If the alignment report shows either a shotgun pattern or an insufficient level of pay for performance sensitivity, diagnose how the program design, ad hoc decisions, or both are flattening the curve. Determine aspects of the pay program or decisions that have the greatest impact on flattening the curve. • Determine what changes should be made in order to strengthen the performance-pay relationship.

FLATTENING THE CURVE

203

Exhibit 13.1. The Effect of Fixed-Share Versus Value-Based Grants on Alignment

Annualized PAC (2008 $MMs) $2B Revenue

$15.0

$10.0

Design assumes: 20% Salary 5% Benefits 20% Bonus 20% Stock options 20% Performance shares 15% Restricted stock

Alignment Zone

Value-Based Grants Fixed-Shared Grants

$5.0 Observed Market Pay Line $0.0 –30%

–20%

–10%

0%

10%

20%

30%

Annualized Three-Year TSR

40%

50%

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Exhibit 13.2. Alignment Design Choices Type of Company

Highly Sensitive Steep Slope

Business profile (culture, • Risk-seeking stage of development, • High growth industry growth • Early stage of prospects) development • Heavy management influence on TSR

Moderately Sensitive Gradual Slope • Risk-averse • Low growth • Mature • Moderate management influence on TSR

Pay risk mix

• Heavy incentive mix • Moderate incentive mix • Heavy ownership by management • Little or no ownership by management

Equity

• Stock options • Performance shares • Leveraged measurements

Goal-setting

• Mark-to-shareholder • Mark-to-budget

• Restricted stock

14 AD HOC DECISIONS Amplifiers Ad hoc decisions and decision-making influences tend to cause and amplify the alignment design mistakes discussed in previous chapters. These decisions are not necessarily random. There are usually good reasons for them. But they are “off plan” nevertheless. They are decisions that are made in special cases. Ad hoc decisions are pervasive in causing misaligned performance and pay, so much so that the topic of ad hoc decisions has crept into my discussion regarding all of the other forces of misalignment. Ad hoc decisions basically come in two flavors. The first is making discretionary decisions outside of the established pay plans. Discretionary decisions outside of the plans create the difference between what the plan says should be paid and what actually is paid. And the second type of ad hoc decision is changing the plans due to external or internal economic conditions, as opposed to a fundamental change in compensation strategy driven by a change in business strategy. What I am not talking about here is planned and bounded discretion. Planned, bounded discretion is discretion that is

A Landmine According to Ed Breen

“Ad hoc compensation awards are a landmine. We use special awards only very judiciously. We’ve only done it once. And in fact, a couple of people on our board said, ‘Let’s be clear. This is the exception, not the rule.’ So I think that gets into a danger area when you do that.”

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premeditated and limited. It is discretion that is designed right into the pay plans. Because I am a proponent of planned, bounded discretion, and feel that this type of discretion can be a useful and valid feature of an aligned incentive plan, I will discuss planned discretion first, just to make sure you know what I am talking about.

Planned, Bounded Discretion Is Not an Ad Hoc Decision As discussed in Chapter Three, the chain of events around executive compensation is a virtuous circle. Once the alignment model and pay programs are in place, performance happens, and then incentives yield actual pay. In determining actual awards, the compensation committee generally needs to do two things: (1) determine if any adjustments need to be made to the financial results (these are things such as adjustments for changes in accounting rules, or adjustments for big, unforeseen events such as a major transaction) and (2) determine how much, if any, discretion should be used in establishing corporate, division, or individual awards. This seems relatively straightforward, until you try it. But as long as compensation committees have guidelines for how discretion should be used, I think planned, bounded discretion is a legitimate way to ensure that pay outcomes make sense.22 As far as adjustments to the financial results are concerned, I am a proponent of adjusting for nonoperating items such as changes in accounting rules in all plans. In addition, I am generally a proponent of adjusting for material events, such as mergers, acquisitions, and divestitures, at least in shortterm plans, because not making these adjustments can distort results, incentivize the wrong behaviors, and result in a compensation system that doesn’t make sense to participants. To keep these adjustments out of the ad hoc category, compensation committees should decide up front how they are going to treat all adjustments, including the impact

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of mergers, acquisitions, divestitures, recapitalizations, tax rate changes, write-offs, changes in foreign exchange rates, litigation gains or losses, natural disasters, restructuring charges, transaction charges, and other similar items. Agreeing on the treatment of adjustments up front will have more credibility with executives and also will help strengthen alignment. While the objective aspects of the plan can provide a “center of gravity”23 for award determination, the more subjective discretionary aspects can provide room for judgment around this center of gravity. Raj Gupta calls this “bounded discretion,” which is a term I like and have used in this book. He says, “I’m beginning to think that there should be some discretion. Maybe awards should be based 75% on objective targets, relative or absolute, and then 25% subject to discretion. You cannot really quantify everything, especially if you’re making strategic plans for the company. There has to be some measure of discretion. But it has to be based on something, like a scorecard. Not on, ‘Well, I like that person. He did a good job. He worked hard.’ It can’t be based on that kind of thing. So I think some amount of discretion is advisable.” My view is that in short-term incentive plans, a good amount of discretion is generally about 25% of the target award pool. However, in certain cases I have recommended discretion up to 50% of the target pool. In one such situation, my client was in a highly cyclical business. The compensation committee agreed up front on how it would use the discretionary portion of the award. The starting point was to assess how the company performed in comparison to the industry. If the company’s growth was good relative to the industry, then upward discretion could be warranted; if the company’s growth was not as good, downward discretion could be warranted. The committee also agreed to consider other factors in relation to whether it would apply upward or downward discretion to group or individual awards (such as pulling off a major transaction under favorable terms), but growth relative to the

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industry was the primary factor used. Given the degree of volatility and uncertainty in the business, as well as the forethought and quantification about how discretion would be used, I felt comfortable recommending a 50% discretion level. This kind of premeditated, bounded discretion adds credibility to the plan and the award determination process. It also is good for alignment. It requires that discretionary adjustments be based on reasonable criteria that are set in advance. The purpose should be to adjust the compensation awards in a way that encompasses factors that people agree to up front, not to overturn the compensation plan. Some organizations feel threatened by using nonquantitative judgments as part of the incentive plan. This sometimes can be an issue of trust or control. In my view, defaulting to 100% quantifiable measures is okay too, as long as discretion is not then overused, or abused, outside of the plans. To recap, planned, bounded discretion is different from ad hoc decisions. Planned, bounded discretion is part of the plan; ad hoc decisions overturn the plan. It is important to note that the concept of bounded discretion actually shows up in our Alignment Model—that is why I suggest that it is appropriate to think about an “Alignment Zone” instead of an “Alignment Line.”

The Use of Discretion According to Laurie Siegel

“Discretion may have to be applied in many different places, but routinely the discretion is in the bonus calculation itself. And even then, you have rules of the road. Every year you encounter certain things that are anomalous. And our CFO makes a recommendation, and then we present it to the comp

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committee for their final decision. So there’s a use of discretion there in how we treat certain events during the year. So the incentive pool itself has some discretion, and then the allocation of the pool to individuals has some discretion. We encourage discretion within plus or minus 25% of the calculated awards because calculated awards represent a team effort, but we believe that within any team there are people who did more to achieve that result. So we want differentiation within the team, but it’s bounded by plus or minus 25%. “All of our plans allow for discretion, but I think there’s a very heavy burden to explain any change from what was originally set.” According to Ron Defeo

“So now you’re back to the question of, ‘How the heck do I pay these guys for this both hard and soft job?’ And I think you pay them against hard and soft metrics. Hard metrics that are irrefutable: TSR, EPS, ROIC, whatever is appropriate for that business. And then the soft metrics that require judgment: ‘Is this a guy people trust?’ ‘Has he created value in terms of the organization’s image?’ ‘Is his strategic thinking and planning what we need for the long term?’ That’s why you don’t run a pay package solely off of the basis of reported financial statements. “Then there is always the point where the hard metrics override the soft metrics. If you’re losing money and the industry is in recession, then you probably should not pay a bonus.”

Discretionary Decisions Outside of the Pay Plans It seems relatively straightforward to “turn the crank” on the pay plans and let them generate an answer on what to pay, but there often is consternation and sometimes drama during the process.

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“Which of our stars are likely to stay or go?” “Is morale good or not so good?” “Should we be more sympathetic to paying a bonus because there is no embedded value in the outstanding options?” These are just a few sample questions that compensation committees and executives face. This is when ad hoc decisions get made. With all of these questions swirling about, it sometimes is difficult for compensation committees and executives to stay the course, or as I call it, “stay on pay.” What I try to do is encourage committees to stick with the philosophies and programs that they worked so hard to establish in the first place, that is, stay within the “four corners of the plans.” Why? Because going outside of the plans is not only a bad habit, it also undermines the credibility of the plans and is generally a shortcut to killing alignment. Ad hoc discretion, as distinct from planned, bounded discretion, is generally not as analytically based and not limited in advance. With planned, bounded discretion, there are limits imposed on subjective considerations and data with which to advocate for a position. There are parameters set in advance to prevent unintended changes in policy. With ad hoc discretion, policy shifts can occur, inadvertently, without knowledge of their consequences. Let me give you some examples of discretionary decisions outside of the pay plans. A company I have some knowledge of had a CEO who had run the company for almost twenty years and was paid in alignment with the value he helped create. In fact, this company presented itself almost as a poster child for linking pay to performance. The executive’s tenure at the company produced substantial results for shareholders for which—I might add—he was handsomely rewarded. But when he announced he was retiring, the compensation committee seemed to lose its way. Rather than honoring him at a dinner and giving out a gold watch or a watercolor painting, the committee awarded the executive an extraordinary grant of stock for his service to the firm. What had

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been a nicely aligned company fell into the Alignment NOzone. This special payment was like one of those “lifetime achievement” awards they give out at the Academy Awards. But in this case, the CEO had already been rewarded throughout his career for the value created. This special payment was akin to paying the executive twice. In another instance, I saw a company giving outsized salary increases to a CEO who was planning to retire. In my view, this was done only to increase the payout stream from the executive’s retirement plan, since the size of the stream was contingent on average salary and bonus five years prior to retirement. A third example involves a special grant of stock options to make up for a lower bonus payment in a given year. And of course, I can cite numerous other examples that hark back to retention. (Just like ad hoc decisions, the issue of retention grants seems to come up in every chapter.) I understand the pressure to work outside of the plans, particularly when retention risk is perceived to be high. I understand how emotionally depleting it can be to lose a valuable player on the executive team. I understand how this pressure is particularly acute when corporate performance is down. This is when cries for special awards and stock option exchanges are the loudest. The problem is that this also is the time when alignment has the highest probability of being compromised. Too often we assume that the valuation of a company is inextricably linked to a particular executive. In my experience, this is rarely the case. It is also the job of the board to avoid this situation by developing a good succession plan. According to the people with whom we spoke, and in accordance with my own observations, retention risk for top executives is not as high as most people think it is. This is because top executives generally like their jobs. It also is because compensation often is not the core issue. As one executive I spoke with said, “I’ve held the line [on pay] and have never had anyone quit. People want more money to make them feel better.

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But when I don’t give them the money, they tend to have a fair, reasonable, and honest conversation with me. And frankly, people would rather have the honest conversation than the money. Boards sometimes want to pay a CEO a ‘concession’ prize for an acquisition they didn’t get. It’s a way to say, ‘We still love you.’” Most of the people with whom we spoke said that they wouldn’t really want to employ a top executive who stays with the company just for the money. Most also acknowledge that retention risk is greater with lower-level executives, because they may find more upward mobility outside of, compared to inside of, the company. Ad hoc decisions lead to misalignment problems. They may create Highfliers or Doglegs, for example, or may just flatten the alignment curve. But an additional problem is that they often lead to misalignment patterns and policies that remain in place. Ad hoc decisions do this because through these decisions, the standards actually change. A new precedent is set. Once the compensation committee makes a special retirement award for one executive, for example, it’s easier to apply this logic to others in the broader executive group or to his or her successors.

Changing the Pay Plans with Economic Conditions Following the great financial crisis of 2008, I was confronted by a number of companies who had been using a defined mix of restricted shares and performance shares in their long-term incentive plans now suddenly wanting to use options. They wanted to change equity vehicles because they thought their stock was undervalued and they wanted to take advantage of this “one-time” event. I had a feeling that this action would affect alignment, so I tested its effect using our Alignment Report. Essentially, granting stock options when the stock price is low and granting restricted stock when the stock price is high creates a cushion for executives if the stock price declines and

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creates more upside if the stock price increases. Moreover, these plan changes are simply driven by the vicissitudes in the secular stock market. Changing the Copart pay mix to all options in April 2009 was, for example, a variation on this theme. The change in their pay mix from salary, bonus, and stock options to all stock options seemed to have been driven by economic conditions rather than a strategic change. These kinds of actions not only compromise alignment but create confusion among plan participants as well. As Ursie Fairbairn says, “I have a problem with changing pay vehicles situationally.” I agree with her in general. In another situation, I showed an executive the Alignment Report for his company. This report showed that the company was a well-performing Compensation Riskseeker, paying in the upper NOzone. I asked the executive whether he thought the company would stick with this high-wire act if its performance were to drop—would the company want to live with such a leveraged plan? The executive admitted that he would be a proponent of changing to a lower leveraged type of plan if performance were to flag. I wonder whether the compensation committee was philosophically in agreement with this idea. This example isn’t about changing the plan due to external economic conditions, it’s about changing the plan due to internal economic conditions. Unless the company is undergoing a fundamental change (for example, making the transition from a growth to a mature company or changing strategies), changing plans in response to company performance also should be avoided. It kills alignment.

Ad Hoc Decisions: What to Do About It For compensation committee members, the challenges of developing a plan and staying with it are neverending. There are human pressures, economic pressures, negotiations, and the constant fear of losing good executives over pay.

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But we need to get back to the concept that if performance happens, pay happens, and the two should be tightly linked. Rather than making ad hoc decisions that undermine alignment, why not just stick to the plan unless there are strong foundational reasons for changing the plan? There are actions that companies can take to minimize the misalignment effects of ad hoc decisions. These include the following: • Build planned, bounded discretion into the short-term incentive plan by delineating what adjustments will be made to the financial results and defining the way in which subjective performance assessments will be used. • To the extent possible, “stay on pay.” Shore up philosophical grounding on when and how ad hoc decisions might be made. Perhaps take a retrospective look at when these types of decisions were made in the past and determine whether they comport with the company’s pay philosophy. Perhaps require that ad hoc decisions of a certain magnitude be approved by the full board. Determine to what extent and when the compensation objective to retain good executives will trump the objective to achieve alignment, if at all. • Put other mechanisms in place (such as good succession plans or recognition for good performance in difficult times) so that the company can use compensation less as a retention device and more as a way to deliver fair pay. • Keep track of how discretion both inside and outside of the plans is being used. • Using the Alignment Report, model the effect that ad hoc decisions might have on alignment.

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The Committee Has to Have Backbone According to Jay Lorsch

“The compensation committee’s got to have backbone. And I think many comp committees have developed that. They can’t just knuckle under to the CEO who says, ‘The CEO of our competitor is getting so many million dollars more than me. You guys aren’t paying me enough. I want more.’ Or the CEO who says, ‘Look, I know we didn’t hit target, but we worked like crazy and actually we’ve been working harder in the last year in this economic downturn than we ever thought we would just to keep the company at the level it’s at, and we really need to reset the bonus terms.’ The comp committee’s got to be able to take an independent and tough stance on that stuff. The comp committee, it seems to me, has to have a perspective which says, ‘We’ve got to do what’s right by the shareholders, and one of the things that’s right by the shareholders is we’ve made a set of arrangements, and we’ve said this is how we’re going to pay if you perform at this level or at that level, and we’re not going to change the game retroactively. We just can’t.’ “And you have to have an understanding of this with the CEO in advance, and you have to have an understanding that the comp committee’s decisions are final. Basically you’re creating an agreement that the comp committee is going to work according to this plan, and this is the plan we’re going to follow for the next few years. If we want to think about a plan for the future, we can think about that any time, but we’re not going to change the current plan because of a retroactive change in events.”

15 DECISION-MAKING INFLUENCES Awareness The first decision-making amplifier is ad hoc decision making (see Chapter Fourteen). The second is decision-making influences. In using the term decision-making influences, I am referring to the things that both inform our judgment and cloud our judgment—things such as decision-making biases, making assumptions that don’t hold true, and the strong dynamics certain personality types can bring to the table. All decisions are affected to some extent by these influencers, and decisions about compensation are no exception. In fact, I see decisions about compensation affected more by these things, probably because compensation, by its very nature, can be a highly personal and emotional subject. It is clearly both art and science. Because of these influences, alignment can be thrown off track. They can push and pull at us in ways that we may not even be aware of. That’s why it’s so important for us to understand them. Boards and committees are charged with making decisions that are objective and responsive to the long-term interests of shareholders. Objective information, insightful analysis, the right team, and good processes all help to correct for these decision influencers. Awareness of these influencers is the last, but also essential, ingredient to help guard against their impact. Let me share with you some of the leading research on this subject, as well as my own observations.

Asymmetric Performance Attribution Bias Asymmetric performance attribution bias is the psychological name for something most of us do from time to time. It’s when we attribute good performance to our own hard work—or the hard 217

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work of those we care about—and attribute poor performance to the work of others or to external circumstances. “It is one of the most basic observations of social psychology,” says Dan Ariely. “This bias is that ‘the good things that happen to me are because of me and the bad things that happen to me are because of circumstances.’ The way it plays out is that ‘if I slipped on the banana peel, I didn’t do it because I was clumsy; I did it because it was impossible to see the peel.’ But when other people slip on a banana peel, ‘they didn’t do it because they couldn’t see it, they did it because they were clumsy.’ We think in these terms because it’s actually very important for us to build a confident view of the world in which we think that we have control. We don’t like thinking that what happens to us is not because of us. So we strive to have a positive view of ourselves.” In compensation circles, I have seen this bias most often play out when compensation committees are trying to determine how to apply discretion or what performance rating to assign. This is why I sometimes see more upward discretion than downward discretion applied. Compensation committees look at the executive and they tell themselves that he or she really worked hard and tried hard, and that the reasons for the individual’s poor performance were circumstantial. They tell themselves that no one could have foreseen the circumstances that their management teams encountered. To some extent, committees have caught on to this over the past several years, and it’s much harder to apply uward discretion within the constraints of Section 162(m), which limits the tax deductibility of certain discretionary awards. But it still plays out from time to time, particularly with special awards that are given outside of the incentive plans. By way of example, I was close to one company in the entertainment business in which this bias was playing a strong role. In one year, the compensation committee decided to use the upward discretion in the bonus plan, even though corporate performance was lackluster. In another year, it made adjustments

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to the income measure for incentive purposes by backing out new product-development expenses to justify a higher award. In yet another year, it made special equity grants in lieu of bonuses. The committee always assessed performance in favor of management because it truly believed that management was doing an excellent job. It assigned credit to management when performance was good and blamed the economy when performance was bad, never mind the fact that this company’s relative performance was nothing to write home about. I brought this to their attention using the Alignment Report. Once the Alignment Report was presented to the committee, it acknowledged that it was applying discretion as a one-way street. The committee decided to run the Alignment Report annually and track the use of discretion over time, including adjustments to bonus awards, adjustments to the performance results, and special awards over time. These actions are helping to keep the committee’s asymmetric attribution bias in check.

Peer Comparison Bias Peer bias is the way we shortcut decision making. We do this by comparing one thing to another. According to Ariely, people often make decisions through the use of comparisons. “For the most part, they determine if a carton of milk or a bottle of wine is expensive, not through any deep analysis, but through comparison. They pick up the milk carton and compare its price to other milk cartons and they look at a bottle of wine on the menu and compare its price to those of other bottles on the menu.” Ariely says this method is built into human beings because it is quick and often effective for decision making. When we are figuring out compensation for an executive, we are in effect pricing their services and doing the same thing. Incentives implicitly say that we want to motivate executives to do well. They also say that we’re willing to pay a higher price for a high-performing executive than for one who is not performing

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as well. The alignment concept takes it a step further by saying we’re willing to pay a higher price for an executive who produces higher performance outcomes than for one who does not. Of course, no two executives are alike, and pricing executive services and performance is difficult to do. While making comparisons are helpful in compensation decision making, they are biased because we all want to feel like we’re above average. One of my associates mentioned a study that had been conducted in which students at the Harvard Business School were asked whether they would rather receive a $125,000 salary upon graduation if they knew that their peers were earning $150,000, or if they’d rather receive a $100,000 salary if they knew that their peers were earning $75,000. The majority of the students said that they would rather earn $100,000 because this meant that they were doing better than their peers, never mind the fact that they would make more money if they took the $125,000. These types of special awards that implicitly bolster the pay positioning help us feel like we are doing a little bit better than our peers. This study is a good indicator regarding the way people think of themselves and the way they measure themselves to determine if they are successful. “In life, there are some things about which we don’t care how much we have, we just care that we have more than someone else,” Ariely told me. He calls these “positional goods.” “We don’t necessarily need a bigger house, we just want a house that’s slightly bigger and slightly better than other people’s houses. People look at compensation as a positional good. When you say, ‘How big are you? Think about the peacock as a metaphor. How big is your tail? How virile are you as a man? How successful are you?’ You’re measuring it by your performance compared to other people. And if you’re not at the top, it doesn’t feel good.” This is why pay comparisons are so tricky. Executives want to be winners, and compensation is an indicator of how well they’re doing. Many executives have told me over the years that they

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don’t care about compensation, per se; they care about compensation as a way to keep score. It’s not enough to be at parity with a rarified group of America’s leaders, they want to be slightly better, among the best of this group. This is human nature. As hard as it is to do, the best way to combat peer bias is to approach the compensation issue from an alignment perspective—fair pay for fair play. In practice this usually means positioning target pay for an executive team at median, and then letting performance determine actual pay.

Asymmetric Information Bias Another bias that compensation committees must deal with is asymmetric information bias. This is a situation that I see frequently. People say, “We like and respect the people we work with. We think they are the best. So we want to pay them as if they’re the best.” But the reality is that we don’t have the same level of information about people in other organizations as we do about the people working in our own firms. We know our colleagues and peers better and more intimately; we understand their roles far more deeply than we understand those in rival firms. The most objective way to handle this problem from a compensation perspective is to let executives prove their value. They should get paid more if performance materializes in such a way that performance, rather than perception, is the reason for their pay. The best way to overcome the asymmetric information bias is to employ objective information that is a proxy for what is not known. Alignment Reports help serve this purpose by showing the linkages between pay and performance.

False Assumptions Making false assumptions is another kind of decision influencer. When we think we are making decisions on the basis of our keen observational powers, high IQs, and years of experience, many

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of the decisions we make are, in fact, based on “self-evident” truths that, when put to the test, do not hold up. And while this category of bias probably has entries too numerous to count, some of the most notable examples include • “We will lose our best executives if we don’t pay them more.” • “Our compensation system will automatically be aligned with shareholder interests if we heavily emphasize equity in the pay plan.” • “This type of compensation system worked well in my company, so it should work well here too” or, a variation on the theme, “This type of compensation system worked well in private equity, so it should work well in our public company.” Let’s take these three often-cited examples of false assumptions one at a time. Nowhere do I see unfounded assumptions more often at play than with the issue of executive retention. Often, compensation committees assume that if an executive is effective, then he or she is vulnerable to departure. Moreover, they sense that the risk of a CEO departure is much greater than shareholder malcontent. The tendency is to pay the executives a little bit more to mitigate the retention risk. But of course, retention risk can also be mitigated through vesting and other restrictions that make the value of pay realized by the executive contingent upon staying with the company. And paying a little bit more has the effect of an arms race—you’re always ratcheting up the pay to keep up with the competition. Interestingly, the people we interviewed for this book (including CEOs themselves) overwhelmingly felt as though the retention card was overplayed, particularly with respect to the CEO position. They point out that CEOs, by and large, like their jobs. They do not stay because of the pay—pay needs

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to be fair, but not overblown—nor do they leave because of it. Bob Eckert speaks from experience. “I think the challenge is always whether you need to do something for retention. This issue is grossly overstated in most companies because people aren’t leaving. My initial reaction is if somebody says, ‘Well, we have to do this for retention,’ then let’s look at the track record. How many of their top people have left in the last three years? Why do they think they’re all going to leave next year? So, I think the retention argument is a weak one and one that is frequently abused. We try to be pretty disciplined about it. If we’re going to make a retention award, it’s for a specific individual as opposed to a blanket retention program.” Among the academics I talked to, all of them agreed that pay was one of many factors that had to do with whether an individual felt fulfilled in a job and would remain in it. Eckert supported this assertion. “The number one reason anybody works is for their boss as opposed to their paycheck; every survey I’ve ever seen says that’s a fact.” Relying on pay for retention also leaves the company on weak competitive footing. After all, people should be working for the company because they believe in its mission and respect the people they work with, not for the money. Finally, if people go to work for another company, it is often for career progression and recognition, not solely for the pay. To a person, the people we interviewed believe that good development and succession plans are better ways to mitigate flight risk than pay. Another false assumption has to do with the use of equity. Many people believe that if the company’s executive compensation system is heavily geared toward equity, then alignment will automatically happen since equity value increases along with shareholder value. However, as I mentioned in Chapter Ten, the tendency is to overcompensate when there is an over-emphasis on equity in the mix, in turn throwing the pay system out of alignment. This is because companies tend to overcompensate for the incremental risk.

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A third false assumption is that because a compensation program works well in one venue, it also will work well in another. To some extent, this may be true, but it often is not true and by no means is a certainty. This logic was particularly popular from the early 1990s to the mid 2000s, when some compensation committees began exploring paying public company executives like executives of portfolio companies held by private equity firms. Executives in private equity situations are paid differently from their public company cohorts. They generally receive an up-front percentage of the equity when the company is acquired, with no ability to cash out until there is a value-realizing event for investors. In contrast, executives in public companies tend to accumulate their equity over time through annual equity (stock option, restricted stock, or performance share) grants. These differences make sense. In private-equity-backed companies, the equity is generally purchased all at once up front by the investors, and then some years later, the company is supposed to have a value-realizing event, which also is when the executives can cash out. This is what I call a “point-to-point” system. In a public company, on the other hand, the equity is priced on the open market every day. Executives are tasked with taking care of all shareholders over the long term, regardless of when those shareholders acquired the stock. This is more of what I call a “continuous system.” As a result, we have to be careful about making the assumption that a point-to-point compensation system will work in a continuous equity-pricing environment. We also have to be careful about taking a system that works in one situation and applying it to another.

The Retention Argument According to Vern Loucks

“You have to be willing to take the retention risk. We have great confidence that the people who operate under our

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plans believe that they’re being treated fairly, and believe that the reasons why things are being done are good ones. They may feel that they didn’t have a lot to do with that outcome, but they realize also that they’re part of a team, and companies are teams. It’s just like any athletic team, you know, if one fails the whole team goes down, and that’s a fact of life. So, yes, I feel that retention is way overplayed, this notion that I’m going to lose everybody if I don’t do something stupid. It just doesn’t make sense. “The bigger problem is at the lower ranks. The secondary ranks of executives that you’re building for a succession play, for example. Those guys are the ones that are the greatest amount of risk for a corporation. Those are the people that make things happen in the trenches, and somebody coming along and ticking one of them off because you’re not being fair to them is much more likely.” According to Kate DCamp

“I think when there’s a sense that the market is stagnant or going down, management isn’t seeking advice on what to pay. They make the retention argument and they don’t bring consultants in, because the consultant might argue that real pay has gone down and/or the industry is compressing and there are lots more jobs than people and that you don’t really have retention problems.”

Individual Personality Biases and Group Dynamics Finally, a word about how individual personalities and group dynamics can bias decision making and create misalignment. There are as many personalities as there are people. There are those who avoid conflict, and those who like and readily engage in it; there are those who are quiet, and those who dominate; there are those who seek power, and those who eschew it. The list goes on.

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Whoever is “in the room,” whether they are the decision makers or not, can affect the dynamics. Contrarian views are helpful for testing the assumptions and exposing the risks. Some people look at a good debate as a failure of the process; others take the opposite view. I look at good debate as an avenue toward getting better answers, identifying issues, and having a more defensible governance process. I consider a good debate to be a success, not a failure. One of my friends who is the chair of a compensation committee came to me recently and suggested that there was a “conspiracy” at work in her company, particularly between the consultant and members of the management team. I told my friend that I thought that the consultant should play a completely objective role and develop his own thinking around the issues. That is my own view and the way I run Farient. Having a consultant “side with management” or “side with the committee” does set up a conspiracy of sorts, and does not work in the long run. Moreover, it lets the consultant get away without adding any real value. The best way to not have a conspiracy is to work with advisors who come to the table with their own thinking, and with the understanding that they are accountable to the committee, while working with all parties to get the work done with the highest level of objectivity and integrity. Thankfully, my friend started a request-for-proposal (RFP) process to find just such a consultant. This is where a good compensation committee chair comes in. A good chair plays a critical role in the entire decision-making process. He or she can help manage the decision-making biases, the personalities involved, and the group dynamics. He or she can make the difference between alignment and misalignment.

Decision-Making Influences: What to Do About It According to Bob Eckert, “The spotlight has moved from the audit committee to the compensation committee.” Decisionmaking influences, amplifiers to the causes of misalignment, are

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complex. The ways to correct for them are complex too. Not only do compensation committees need to think about how to correct for decision-making influences, they also need to think about how not to overcorrect for them. It’s tricky business. Some of the fixes are to ask the right questions, get the facts, test your assumptions, work with strong personalities “off line,” as well as “in the room,” and insist on good process. But you already know these things. The best advice I can give on this topic is to build awareness of these decision-making influences, call them out when you see them, and design good processes to help mitigate their effect.

The Role of Compensation Committees According to Ron Defeo

“Well, I think we’ve gone through an interesting and healthy process, in general, for business and for boards. The role of boards and the role of compensation committees have been elevated, and that’s a good thing. I think the independence of the compensation committee is crucial. You mentioned the word process earlier. That’s a good word because process improvement was needed. There was a lot of control that management tried to have in the process of determining compensation, and there was a lot of control in choosing the consultants and in choosing the projects that they worked on. I think that shining a light on this has been good, to bring it to the same level of purity that we’ve had to do with the audit committee. So we now have pretty good models of how compensation committees should act. They should hire and fire the consultants. They should focus on the CEO and top officers. They should focus on incentive compensation packages in general to ensure that (Continued)

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they support management as a fiduciary in leading the organization. The compensation committees needed to take charge of the outside resources. “We’re not entirely there yet, but we’ve made real progress, really good progress. I don’t think you ever get there, because we all try to find our sea legs, so to speak, because management does have an important say in how people get paid. The compensation committee is never going to be close to the attitudes, the aspirations, and the difficulties of the reward system in a global business. So the compensation committee by itself is not the right place to have all of those tactical decisions made. But on the other hand, if the compensation committee focuses on principle, it can make a huge difference in the tone of how an organization rewards performance.” According to Kate DCamp

“We basically made the compensation and management committee responsible for succession and performance management, including the CEO’s assessment and goals. They were really responsible for talent. So that led to some activities, like having the committee be exposed to the top talent and having them go through a pretty extensive succession plan. The one thing they were not ready for, but I thought should be added, was to have succession management cover both internal and external candidates because otherwise you could get insular. They would only know about the people we had. Maybe there was someone at a competitor who was fantastic and we should have been looking at, as a backup in case we lost one of our own. “So it’s not a hard thing for a compensation committee to get their heads around that they should be looking deeper into the company and understanding where the bench is, including technical talent. It’s not just about having

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the right leadership. It’s also deeper in the organization and for specialized skills. If the competition has all the good people in a specialized area and you have a real shortage, that’s a business issue. The committee should understand and provide real direction on the risks of this. It’s really risk management.” According to Raj Gupta

“I think some of it goes back to the independence of the compensation committee and the board and how they define their role in these kinds of issues. And I think this is really a big change. My view is over the last six or seven years of the ten years I was CEO at Rohm and Haas, I encouraged my board to take on risk management—it was part of their responsibility. The board had heavy involvement in strategy and risk management. All the routine compliance things could be handled by the committees.”

The Role of the Board in Compensation According to Steve Sanger

“Compensation committees are specifically tasked with pay, and in most cases, with reviewing development and succession plans. But some of the things that are important in a company, like the organizational climate and how people feel, how engaged they are, are really discussed at the full board level, rather than just at the comp committee level, because the full board cares about the people development, retention, succession, climate, and diversity, and all of those things. The comp committee spends time on those things but not to the exclusion of the full board in the companies that I’ve been associated with. I like the way (Continued)

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my companies deal with these issues. The people at these companies tend to be developed from within, and we have a lot of discussion about people down the ranks who we think are particularly high potentials and therefore could be retention risks.” According to Laurie Siegel

“You have to get the board’s input in a constructive way. I think by taking a step back and understanding where their sensitivities are. You have to do this in a way such that it’s not intrusive throughout the year, because the compensation committee has to do its job. They’re responsible. They have a charter for making decisions. They do their homework. They track things. So you want guidance from the full board, but you need to let the committee do their job.”

16 CREATING AND MAINTAINING ALIGNMENT What I Know Now I wish I knew then what I know now. When I think back to the story I told at the beginning of this book about the compensation committee making an egregious mistake in judgment, making a mega-grant of restricted stock to an already well-rewarded CEO as well as to others on the top executive team, and then seeing it all go down in flames a year later, I am struck by how things might have gone differently if we had all been smarter about alignment. Maybe everyone was caught up in the euphoria of the day—the stock market defying the law of gravity, the unbounded ambitions of the corporation, the insatiable desire for more of everything. Or maybe it was naivete—not understanding how badly this could all turn out. Or maybe it was just hubris. Whatever it was, I can’t help but think, “What if?” What if we had the Alignment Model back then, with great data that could tell a story in pictures and fast forward to the ending? What if I had discussed this picture with the CEO and the compensation committee, asking them whether this was really where they wanted to end up? What if we had tackled the philosophy of performance and pay alignment or even the corporate culture before getting into the weeds of a retention grant? What if the compensation committee had checked in on its assumptions about CEO retention and the role of compensation in keeping people happy? Was compensation really the problem? Admittedly, it was harder back then. Boards were not so independent. They were handpicked by CEOs and “fired” by CEOs. Governance committees had not yet gotten their legs from Sarbanes-Oxley. One false move and a board member 231

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could lose his or her post. I saw it happen more than once. The standards of propriety were in motion. The greater fool theory for purchasing executive talent seemed to be alive and well, fueled by the specter of retention risk. So would the answer have been different? I don’t know. What I do know is that now we live in a different era. It’s a post-Sarbanes-Oxley era. It’s a post-crash era. Two big instances of adversity—the dot.com bomb of 2000 and 2001 and the financial meltdown of 2008 and 2009—have taught us a lot. Directors are now independent. Shareholder advisory groups have real influence. And compensation committees are spending untold hours overseeing executive pay. I have made the case in this book that CEOs by and large are not overpaid. But we still have abuse. We still see outliers and their effect on the reputation of corporate America. I also have shown that just as pay level, on average, is not the problem, neither is alignment. But that’s on average. The problem comes when we start to break it down into thousands of parts— when we look at all of the decisions that create a real pattern of alignment, or lack thereof, year after year, company by company. This is where we see alignment break down. This is why, despite all of the design efforts we’ve made, we still don’t have enough alignment. What we are missing is a more consistent approach to evaluating alignment. Yes, there are some who might dismiss alignment as a worthy objective, but these also are the people who don’t really value fair pay. Regardless of our personal biases, it’s the job of boards and managers to listen to investors. Investors tell us that they value fair pay and want more alignment. So alignment it is. To achieve better alignment, we need more guidance. We need tools that make alignment accessible and easy to understand. We need tools that give us more than direction, but also tell us time, distance, temperature, and terrain. We also need to understand what takes us off course, and what gets us back

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on. Companies need this kind of guidance without putting themselves in a straightjacket. They need this kind of guidance from an “outside in” perspective, from the perspective of their investors.

Pay and Power According to Bob Monks

“I have seen compensation as a function of corporate power, and I see the functioning of compensation committees and compensation consultants as a measure of the power essentially of the CEO to get the result that he wants and of the failure of the corporate governance system to have any counterforce that interposes either expert information or expert counterforce within the governance structure. It’s like independence, which is always worshipped by governance people, but very rarely present. So number one, my thought is that the controlling element is power. Until one deals with that controlling element, it’s quite difficult to think realistically of what standard would improve the present system because the standards really are simply a reflection ultimately of an underlying reality, a tectonic reality.”

For the Greater Good Given that alignment is all over the map, it is difficult to know what effect alignment has on performance. We do, however, know that alignment is considered to be what’s fair. We also know that unless we all strive for better alignment and adhere to standards that are befitting to our company’s size, industry, and performance, then the entire market for executive talent will continue to be rather undisciplined.

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Alignment Reports Cut Down on the Work What we need is the ability to arrive at better executive pay decisions with less work. I have spoken with a number of compensation committee members who can’t believe how much time they’re spending on compensation issues, not to mention the fact that the technical aspect of compensation requires an education in and of itself. Alignment Reports cut to the chase. They create a roadmap that tells you where you’ve been, where you are, and where you’re going. If a company’s alignment pattern looks good, then there’s a shortcut answer to the fact that the pay programs and processes are working. If the alignment pattern is less than ideal, or there are surprises, then there is probably more work to be done. Either way, the Alignment Report can be very clarifying. Is the Alignment Report a total panacea? Of course not. We know firsthand that determining compensation, with or without the Alignment Report, can be a messy business. Armed though we may be with facts, figures, and Alignment Reports, we must still confront the human factor. As Richard Boyatzis puts it, “A great deal of business is really about people.” But the Alignment Report does help us in our march forward toward making the right, defensible, and fair decisions around pay. Agree on Philosophy I have discovered over the years that it’s better to do the work up front before issues get out of hand, rather than after the fact. Once issues spin out of control, they take more time to handle than if they had been dealt with in the first place. Such is the case with compensation philosophy. Moreover, I have found that having philosophical discussions in a vacuum without real data also sends us back to the drawing board once the facts emerge. The Alignment Report is a great conversation starter and a good picture to show for having discussions about pay philosophies.

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Alignment, once we break through the technical aspects of it, is a philosophical point. It does away with the agency problem which says that shareholders and the managers they employ often have divergent objectives. It’s a way to help everyone get on the same page. Ed Breen feels strongly that this philosophical approach to compensation is important and worthy of regular discussion with his full board. He says, “At almost every meeting, we discuss compensation because everybody on the board cares about it. It’s one of the topics on the agenda. And by the time we get to our September meeting where we’re kind of locking things down, the full board discusses it and we have about forty-five minutes laid aside on the full board agenda to talk about the compensation philosophy.” Laurie Siegel adds, “Once decided by the board, the company’s compensation philosophy must be communicated without sugarcoating. We spend a lot of time with our senior leaders individually and as a group talking about compensation issues. Part of my job is to present to them what the board sees as challenges from a compensation solutions and design standpoint.” Finally, a critical part of any philosophical discussion on compensation and alignment is to have a deep discussion, one that drills down to first-, second-, and third-order questions. A surface discussion just means more work later when everyone discovers that this, that, or the other thing wasn’t really what was meant by “alignment.” Exhibit 16.1 shows a list of philosophical questions to guide the discussion (page 238). Design to Align As I’ve shown companies their Alignment Reports and started to probe their philosophical foundation, it throws a spotlight on many issues. Alignment helps clarify whether more of the same is needed or whether corrections are needed. In either case, the research we’ve done helps us determine whether our decisions and decision-making processes help or hurt alignment.

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As you make compensation decisions, the Alignment Report can reflect how your decisions will affect alignment over time. I showed one executive the Alignment Report for his company and asked him to explain some of the data points. Was the pay aligned in a way that he had intended it to be? He said, “No, not really.” He was expecting to see more alignment than that which was shown. There was a random shotgun pattern of data points, and there were clear differences in the way in which the company had compensated his predecessors. Clearly, the company hadn’t had a strong philosophical grounding on alignment. But there was hope. The executive explained to me all of the work he had done over the past two years to tackle the alignment issue. He spent time on philosophy with his compensation committee and his full board, with consultants, and with his internal HR and finance teams, and then implemented a new pay program design. I then showed the executive what the new pay program design looked like on the Alignment Report, using an analysis of how financial measures of performance most likely would translate into various levels of TSR. He looked at the new line and a smile came over his face. “That’s exactly where we had intended to be with this new plan. It just took us two years to get there.” It’s important to note that two or three years from now, the Alignment Report for this company will show what actually happened under the new pay plans. It will be interesting to see whether the outcomes look fair to both investors and management alike.

Convergence As I reflect back on my own work in executive compensation over the past thirty years and what I’ve learned, I can see a number of ways in which this research can be helpful to all of us in the future. This old dog is still learning new tricks.

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As long as alignment is the goal, then all of the work that we have done on this subject will add clarity as to how we might achieve this goal. It might also help to get everyone on the same page. Going forward, I can see a new language cropping up around alignment—one that can be used by investors, compensation committee members, and management. Developing ways of communicating with one another will become more important than ever before as we enter a new era of “say on pay.” What I am really driving for here is some level of convergence. Not one size fits all, but convergence. As long as investors, compensation committees, consultants, executives, and shareholder advisors rely on best practices that only relate to inputs, there can be no agreement on what are the right outputs; that is, on whether the pay results for the performance delivered were fair over time. What I am hoping to achieve is general agreement around what can be considered a fair and reasonable range of outcomes. Through my work over the years, including conducting the interviews for this book, I have taken counsel from executives, including HR and finance professionals, board members, compensation committee members, shareholder advisors, academicians, the press, and investors themselves. And in the end, I have taken my own counsel. All of us need a better way of working on the issues, including investors, who have been criticized for wanting only short-term gains. And all of us need to voluntarily come to the table to undertake the reforms that are needed. Investors in particular need to play a role in the solution by calling out those who are reckless, no matter how outsized their own immediate returns may be. If we don’t do this, not only will the reputation of our corporations be tarnished, but worse, government intervention will make it even more difficult for our free market economy to work effectively. Alignment is a fair and worthy place to start.

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Exhibit 16.1. Pay Philosophies that Strengthen Alignment Philosophical Questions

Philosophies That Strengthen Alignment

1. Does competitive pay mean the 50th percentile of a reasonable peer set, or some other percentile positioning? Is this pay positioning for executives as a group or by individual?

• 50th-percentile pay positioning on total compensation for the executive group as a whole

2. How should actual pay positioning vary from target based on performance?

• Actual pay level varies with actual TSR • Relative pay positioning varies with relative performance

3. What do we mean by performance? • Strong direct tie (for example, through equity) to shareholder Shareholder, financial, strategic, value and strong indirect tie (for or all of the above? What example, through financial or benchmarks are we using? Internal, strategic measures) to the drivers relative, or both? If the company of sustained value is a good performer among a poorly performing group, is this • Goals set within relative context good or bad performance? Should internal or relative performance be given the heavier weight? If our company is a good performer among a poorly performing group, should we pay lower than, at, or above target? What is the role of individual performance? 4. Over what time horizon should awards be realizable (that is, payable)?

• Performance measurement cycles and vesting geared to investment time horizon of the business • Financial risks recognized in measurement or vesting requirements • Limitations on accumulation of long-term rewards driven by secular market conditions

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5. How does the company feel about using discretion inside of plans or outside of plans that take it into the upper or lower Alignment NOzone? What types of situations would warrant the use of such discretion?

• Bounded discretion used inside of plans • Limited and infrequent discretion used outside of plans

6. Does the alignment objective trump the retention objective or vice versa?

• Alignment trumps retention

7. To what extent should the company rely on strong mission and good management development and succession plans versus compensation for retaining top talent?

• Talent retained through “portfolio approach” that involves management development, succession planning, and compensation linked to performance

8. Should the compensation committee define its charter to be broader than compensation, that is, covering management development, succession, or the broader human capital issues (such as employee engagement)? Should the compensation committee be renamed to reflect this broader charter?

• Development, succession, and broad human capital strategies are part of the board or compensation committee portfolio • Broader compensation committee charter is reflected in its name

9. Under what conditions might your company find it acceptable to land in the upper NOzone, that is, be out of alignment?

• Company pays in the NOzone (upper or lower) in rare situations where it is deemed to be in shareholders’ best interests • Examples are identified up front

EPILOGUE Holding Companies Accountable

We’re not home yet. “CEOs, and the way they are paid, have done more to damage capitalism than Karl Marx,” says Nell Minow, editor and cofounder of The Corporate Library. That’s a powerful statement. However, in my view, capitalism is in much better shape than Minow might have us believe. In fact, most of the people we interviewed for this book agreed that while the majority of companies are still misaligned, we have made progress when it comes to executive performance and pay. One of the major factors that has compelled this progress is that shareholder organizations like Minow’s are being listened to. While institutional investors ultimately make up their own minds on how to vote their shares, shareholder advisors give at least some guidance on where to start. In addition, boards and executives alike are acting more responsibly. I think this came across quite clearly in our interviews. Boards and executives are putting a tremendous amount of effort into discerning where the lines intersect between a fair return for shareholders and fair pay for executives. Now the Alignment Model provides an even more powerful tool for finding this centerpoint. Even with these improvements, we are not home free. Warren Buffett is fond of saying that the best antidote to overpaying executives is embarrassment. In this respect, the media

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has not been shy about obliging Buffett and his point of view. Stories abound in the media about star-studded executive talent being overpaid at poorly performing companies. And yet, with all due respect to Buffett, if accountability is the goal, embarrassment should not be the mechanism by which it is achieved. Some of the public furor has been fueled by the media’s obsession with outliers. Outlying executives are the poster children for bad compensation practices, and deservedly so, as long as the pay data have been calculated properly and these data are put in the context of long-term performance. But sometimes it seems as though the media would have the American public believe that all companies are outliers, which of course is not and cannot be true. What is needed is more balanced reporting. We also are not home yet because America’s populist sentiment has taken on the specter of an angry mob. Some of this anger has been fueled by a weak economy in which the majority of people are feeling pain—pain that they perceive has been caused by those who were in lofty positions, but used those positions to unduly profit when everyone else suffered. Yes, there are those who are guilty as charged. But again, those who unfairly profited despite the recent collapse are the exception and not the rule. The notion that America’s wealthy people have become wealthier by virtue of seizing wealth from others instead of creating it is just simply misguided logic. Even though we have made progress, now is not the time for complacency. And even though we have a way to go, now is not the time for overreaction either. All interested parties— shareholders, investors, boards and their compensation committees, executives, shareholder activists, and government representatives—need to step back and consider how they can help converge on a solution, and how they can hold themselves accountable to that solution, rather than becoming even more polarized than they already are.

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Message to Investors Investors, while they are the owners, also need to be part of the solution. We will have a better economy if shareholders make long-term investments and compel the stewards of these investments, the executives who work for them, to deliver sustained performance over time. Investors also will have a better rationale for voting their shares if they take the time to understand the Alignment Reports for their companies and vote their shares on the basis of whether their companies demonstrate responsible patterns of aligned compensation over time. My view is that not only is this a statement about compensation, it also is a broader statement about the culture of the organization. To get these points across, I have written a letter directly to investors.

Dear U.S. institutional and individual investors: I am writing to share with you my view on what you can do to help make our economy healthier over the longer term, thus enhancing the stability and reliability of your own investment returns. This involves compelling the management team of the companies in which you invest to manage for the long-term health and creation of value in the enterprises they lead. An economy built on short-term speculative moves, or management teams who swing for the fences for short-term results, is built on matchsticks. Speculation, coupled with undue risk-taking, will only serve to fuel extreme market volatility and likely not create any real value over time. As a result, a healthy economy starts with your commitment to invest for the long term. Paying too much attention to backward-looking quarterly earnings does more damage than anything else I can think of. My observation is that too much weight is put on quarterly results. Instead, it would be far better to focus on understanding the strategy, risks, and (Continued )

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prospects of the organization to determine the success and value of the enterprise, as well as the long-term track record of management in earning fair returns for investors. You then need a commitment to voting your shares, in other words, using your voice, as the primary way to influence the organization, and then using your feet—selling your shares—as the last way to influence the organization. Your ability to influence the organization through your voting rights has become stronger as more companies adopt “say on pay.” This provision gives you, as investors, the opportunity to voice your approval or disapproval of the executive compensation arrangements. As always, you’ve tried to judge whether or not the interests of the executives who run your companies are aligned with your own interests. If the total compensation is too high for the returns delivered to you over the long run, then you are paying too much for these executives. Conversely, if the total compensation is too low for the returns delivered, then you are paying too little, and you leave yourself vulnerable to losing your executive team. If the rewards for the executive team are not generally consistent with the pattern of your own returns over time, then pay is not sufficiently sensitive to performance. None of these scenarios is in your best longterm interests. The key is to pay appropriately for the performance delivered. Until now, you’ve been reliant upon criteria that provide strict limits on dilution and other factors. But you would be better served by broadening your perspective and considering a more dynamic context. The Alignment Report can help you do this. It indicates the cumulative effect of all of the compensation decisions that were made relative to the returns that you received. It also indicates whether or not the company has a track record of delivering compensation in a reasonable range, called the Alignment

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Zone, and indicates whether the company’s current compensation arrangements put the company in the Zone in the future. This indicator, coupled with other information that you receive on compensation, including dilution, time horizon of measuring performance and delivering pay, and HR strategy can, in aggregate, tell you whether or not the compensation programs are fair and reasonable and whether they reinforce a long-term perspective on the part of management. It may be tempting to vote for executive pay programs that seem out of line, or out of the Alignment Zone, when performance is high. Why mess with success? But oftentimes, this success is not sustainable, and eventually, performance will come back down to earth. So don’t let quick gains blindside your judgment. If in fact superior performance is long-lived, then the pay system, if designed properly, will pay above market, and appropriately so. Finally, you have elected the board of directors so that they can apply judgment on your behalf—judgment on complex issues around executive compensation and HR strategy. This is a much more efficient system for determining executive pay than your influencing pay decisions directly. Your job is to make a considered and rational decision, using all of the tools that are available to you, in voting your shares. Sincerely yours, Robin A. Ferracone

Message to the U.S. Government The rising tide of populist sentiment against executive compensation has been growing for the past twenty years. More recently, with the severe economic hardship that many are suffering, we have seen the wave of public sentiment turn into a tsunami of

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rage and resentment. Over the years, the government has tried to control runaway executive pay, or at least limit pay to what it considers to be acceptable levels by changing tax policy. Currently, we are saddled with a veritable alphabet soup of regulation, including IRC Sections 280G, 162(m), and 409A. All of these regulations were borne of good intentions. But the road to hell is paved with good intentions, and all of these regulations have carried unintended consequences. For every rule trying to limit executive pay, there are ways to circumvent this rule that create other problems. For example: • 280G: In 1984, Congress slapped a special 20% excise tax on “excess value” that was received by executives pursuant to a material change in the ownership (a change in control) of the company. Because of the uneven effect of the excise tax, companies responded to this legislation by offering gross-ups on the excise tax for executives. These gross-ups were a tremendously inefficient way for shareholders to deliver compensation to executives. Today, because these payments are so inefficient, gross-ups are taboo. So at this point, will companies start eliminating their gross-up provisions, but make up for this in other ways? Who knows? But this is the type of crossfire that we can get ourselves into with this type of legislation. • 162(m): In 1993, Congress attacked executive pay by removing the tax deductibility on “non-performancebased” compensation above $1 million for the top five executives of publicly traded companies. Limiting one type of compensation (nonperformance-based) has encouraged the overuse of other types of compensation, such as stock options. Has this really been good for shareholders? • 409A: The purpose of this ruling, enacted in 2005, was to prevent individuals from removing money prematurely from their deferred compensation programs, especially those provided for retirement. As a result, the 409A provision

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imposes a 20% excise tax on individuals if they take their deferred compensation at the wrong time. The problem is that this provision doesn’t only affect deferral accounts. The net is cast wide and affects stock-based plans, retirement payouts, severance payouts, and other forms of non-qualified deferred compensation. The upshot is that all three of these rules have had distortive effects on executive compensation. Moreover, all have created a cornucopia of work for lawyers, accountants, and consultants. Haven’t we learned that you can’t solve problems of executive compensation with tax code? Haven’t we learned that the cure is worse than the disease? My view is that executive compensation should mostly be a matter that is between shareholders and the executives they employ. That’s the best way for the free markets to work, from a capital, talent, or goods and services perspective. As a result, there are three valid roles for the government to play. First, the government needs to make sure that shareholders have the rights they need to appropriately influence the companies in which they are invested. For example, shareholders need to be able to buy and sell their shares in a level exchange process in which all investors have the same information. In addition, they need to be in a position to elect board directors and vote on key proposals that affect their equity. They don’t need to vote on proposals that help management choose the color of the carpeting. Second, the government should ensure that investors have the information they need in order to make rational decisions in prosecuting their votes. This includes their votes on all matters of executive compensation, requiring accounting, proxy, and other disclosures. Third, the government has a legitimate role, if it chooses to exercise it, in directly determining executive compensation for specific companies in which it has invested taxpayer money.

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I think this is consistent with the notion that executive compensation should be a matter between shareholders and executives. With the recent TARP funding of certain companies, for example, the U.S. government is an investor in these companies, and has deemed it appropriate to appoint a pay czar to directly oversee executive compensation at those companies. Not only is the pay czar directly influencing how TARP companies are paying their executives (and perhaps other employees as well), but I also think he is influencing how corporations think about executive compensation. A broad influencing role makes sense, as long as it doesn’t turn into a legislated forcing function. But on the specific actions of the pay czar, has the quest for conservative pay gone too far? The objective should be to establish fair pay, not to institute bargain basement prices for executive talent. If these organizations do not appropriately motivate and compensate their talent, I am concerned that their businesses will not be competitive and they will have trouble paying back the TARP funds. Further, I am concerned that if TARP-company executives feel undercompensated, then there may be a backlash to make up for lost time after the taxpayer money is repaid. Reversion to excessive compensation practices would not be in anyone’s best interests either. In summary, I support our government requiring better and clearer disclosures so that shareholders can make good decisions about who is representing them and how to vote their shares. I also support encouraging long-term holding periods for investors through lower taxation of long-term gains compared to short-term gains. I even support having a government-appointed paymaster to approve compensation arrangements for those companies that have taken TARP money. But this is where it stops. I do not support the government deciding on what pay levels are fair and applying tax code to try to enforce those pay levels. Investors have the information they need to vote on matters of executive compensation. In a free market economy, the market should decide on the price of talent, not the government.

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It is our job, as participants in this free market, as investors, board members, and executives alike, to protect our free market rights by acting responsibly.

Vision for the Future With the alignment research, we can now provide breakthrough data that raise our collective consciousness about how well a company’s pay and performance are aligned and how much Performance-Adjusted Compensation is appropriate for the performance delivered. Given these data, my vision is that investors, boards, and executives alike will converge on standards of what is appropriate and acceptable. Without this convergence, the market for executive labor may continue to ratchet upward with all of us engaging in the proverbial arms race. With this convergence, I envision a market that pays differentially on the basis of company size (an indicator of impact), industry sector (an indicator of the economics of types of businesses the company is in), and performance (primarily an indicator of the returns to owners over time). In my view, we can then all engage voluntarily in making the adjustments to executive pay that are needed, rather than suffering the reputational risks and social costs that over-reaching executive pay carries with it, or worse, suffering from increased government intervention. I also envision that using an Alignment Model will help to balance the power between key constituencies. When we spoke with Bob Monks, he noted a historical imbalance of power between shareholders, the board, and executives, and noted that the power of the CEO historically has been paramount. I have a vision that the guidance provided by the Alignment Report that we created, built on years of empirical data and observed norms, will establish an emerging standard that investors, boards, and executives alike can rely on and converge toward.

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FAIR PAY, FAIR PLAY

When each party involved looks at an Alignment Report, they should see something in it that is relevant for them: • Executives: Executives should be able to look at their Alignment Report and know whether or not they are getting a fair deal, and whether they are being paid in accordance with the deal that was agreed to by all parties up front, before performance happened. By understanding how well they are aligned, my hope is that executives will be able to focus less on how well they are paid vis-à-vis their competitors and more on how well they are paid on the basis of the value that they create for their shareholders. This shift in perception will be made possible by providing clearly understandable data on alignment. • Boards and compensation committees: Boards and compensation committees should be able to use the Alignment Report to help them realize their pay objectives and communicate with shareholders on whether the pay programs and actions have met these objectives. In addition, they should be able to use the report to more easily explain why they paid their executives what they did. • Shareholders and shareholder advisors: Shareholders and their advisors should be able to use the Alignment Report as an additional means for judging the fairness of executive pay, and to do so in an inexpensive and straightforward way. Moreover, through standard methodologies, they should be able to compare alignment across companies and relative to relevant peer groups. Finally, they should be able to see whether they are getting a fair ROI on executive pay. Nell Minow feels strongly about the concept of executive ROI, saying, “The very first question that you have to look at with pay is like any other asset allocation made by the board; you have to look at it in terms of return on investment. If the CEO isn’t beating his cost of capital, if he is not a

EPILOGUE

251

competitive investment with the money that you spend on marketing and R&D, then you’ve got the wrong person in the job.” With better information about alignment, my hope is that investors will shift from a short-term, vote-withyour-feet perspective to a longer-term, vote-with-your-voice perspective, and that their capital will be allocated more readily toward those organizations that have a long-term competitive orientation. • Media: While it is true that making alignment information available would aid the media if they wish to embarrass executives or boards, my vision is that the Alignment Report will provide better information to the media, moving it from “gotcha” stories about executives to a more thoughtful analysis of the steps, or lack thereof, that a company is taking to create higher levels of alignment. • Government: Where government has inserted itself directly in the determination of executive pay (such as with the TARP companies), I would hope that the Alignment Reports would provide a guidepost in determining the level and performance sensitivity of the proposed programs, and would help establish fair pay reflective of a competitive market for executive talent. Overall, my vision is that corporations will use an Alignment Model to self-monitor and adjust their executive pay practices, and that voluntary reform will obviate the need for additional government intervention and allow government to go back to helping solve other problems in our society, such as issues in education and the environment. My view, and the reason we’ve invested in the development of an Alignment Model, is that solid and consistent analysis, not embarrassment, or numbers that have been manufactured to make a point, is the surest way to increase the number of companies that are in the Alignment Zone.

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FAIR PAY, FAIR PLAY

I realize that this is a big vision. People have been talking about performance and pay alignment for a long time, but at no time have we been closer to “cracking the code.” Our alignment research and model help convert this talk into action. It’s not only about deciding in what direction we want to go, but also about having a guidepost, a GPS of sorts, to tell us whether or not we’re getting there. I believe that if all of us—investors, boards, compensation committees, and executives—adopt the fair pay and fair play methods suggested in this book, we would have healthier companies that would be less dependent on pay for gaining competitive advantage and more focused on generating a sustainable and fair return to shareholders over the long term—a result that would benefit us all.

APPENDIX A ANALYTIC METHODOLOGIES PAC Methodology Illustration Total Three-Year Actual Cash Compensation Actual Salary (S)

Actual STI (STI)

2007

$110,000

$80,000

$20,000

2006

$110,000

$0

$15,000

2005

$100,000

$120,000

$15,000

Total

$320,000

$200,000

$50,000

Year Earned

Other Compensation

Total Three-Year Restricted Stock (Performance-Adjusted) Value Restricted Stock (#)

Stock Price at End of Three Years

2007

10,000

$35

$350,000

2006

20,000

$35

$700,000

2005

10,000

$35

$350,000

Year of Grant

Total

Restricted Stock (RS)

$1,400,000 Total Three-Year Stock Option (Performance-Adjusted) Value

Stock Options (#)

Grant Price per Share

Black-Scholes Value at End of Three Years ($35 Price)

2007

100,000

$30

$18

$1,800,000

2006

100,000

$25

$15

$1,500,000

2005

100,000

$20

$13

$1,300,000

Year of Grant

Total

Stock Options (SO)

$4,600,000 Average Three-Year Performance-Adjusted Compensation (PAC)

Actual Salary (S)

Actual STI (STI)

Other Compensation

$ 320,000

$200,000

$ 50,000

Restricted Stock (RS)

Stock Options (SO)

Total Three-Year PAC

$1,400,000 $4,600,000 $6,570,000

Average Three-year PAC $2,190,000

253

APPENDIX B GICS SECTORS Global Industry Classification Standard (GICS) Sector

Industry Group

Energy (10)

Energy (1010)

Materials (15)

Materials (1510)

Industrials (20)

Capital Goods (2010) Commercial & Professional Services (2020) Transportation (2030)

Consumer Discretionary (25)

Automobiles & Components (2510) Consumer Durables & Apparel (2520) Consumer Services (2530) Media (2540) Retailing (2550)

Consumer Staples (30)

Food & Staples Retailing (3010) Food, Beverage & Tobacco (3020) Household & Personal Products (3030)

Health Care (35)

Health Care Equipment & Services (3510) Pharmaceuticals, Biotechnology & Life Sciences (3520)

Financials (40)

Banks (4010) Diversified Financials (4020) Insurance (4030) Real Estate (4040)

Information Technology (45)

Software & Services (4510) Technology Hardware & Equipment (4520) Semiconductors & Semiconductor Equipment (4530)

Telecommunication Services (50)

Telecommunication Services (5010)

Utilities (55)

Utilities (5510) 255

APPENDIX C LIST OF INTERVIEWEES Name

Roles

G. Chris Andersen

Founder and partner, G. C. Andersen Partners, LLC Partner, Andersen, Weinroth & Col, LP Lead director, Terex Corporation Founder and trustee, Garn Institute of Finance Director, Millennium Cell, Inc. Director, United Artists Theater Company Director, United Waste Systems Inc.

Dan Ariely

James B. Duke Professor of Behavioral Economics, Duke University Visiting professor, MIT Program in Media Arts & Sciences Fellow, Diamond Management and Technology Consultants Author, Predictably Irrational: The Hidden Forces that Shape Our Decisions

Richard E. Boyatzis

Professor, organizational behavior, Weatherhead School of Management at Case Western Reserve University Professor, human resources, ESADE, Barcelona

Edward D. Breen

Chairman and CEO, Tyco International, Ltd. Director, Comcast Corporation

Graef “Bud” S. Crystal

Author, The Crystal Report Former vice president and member of the board of directors, Towers Perrin Former professor of industrial relations and organizational behavior, Haas School of Business, University of California at Berkeley

Kathryn A. DCamp

Former senior vice president, Human Resources, Cisco Systems, Inc. (Continued) 257

258

APPE ND IX C

Ronald M. DeFeo Chairman and CEO, Terex Corporation Director, Kennametal Inc. Robert E. Denham

Partner, Munger, Tolles & Olson Director, Chevron Corporation Director, Fomento Economico Mexicano, S.A. de CV (FEMSA) Director, The New York Times Company Director, Oaktree Capital Group LLC Director, Westco Financial Corporation Co-chairman of The Conference Board Task Force on Executive Compensation

Robert A. Eckert

Chairman and CEO, Mattel, Inc. Director and chairman of the compensation committee, McDonald’s Corporation Advisory Board member, J. L. Kellogg Graduate School of Management

Charles M. Elson

Director, John L. Weinberg Center for Corporate Governance, University of Delaware Visiting professor, University of Illinois College of Law, The Cornell Law School, and the University of Maryland School of Law Vice chairman, ABA Business Law Section’s Committee on Corporate Governance Director and chairman of the governance committee, HealthSouth Corporation Former director and chairman of the governance committee, Autozone, Inc.

Ursula O. Fairbairn

President and CEO, Fairbairn Group, LLC Retired executive vice president, Human Resources, American Express Company Director, Air Products & Chemicals Director and chairman of the compensation committee, Centex Corporation Director and chairman of the compensation committee, Sunoco Inc. Director and chairman of the compensation committee, VF Corporation

APPENDIX C

259

Rajiv L. Gupta

Retired chairman and CEO, Rohm & Haas Company Director, Hewlett Packard Director, The Vanguard Group Director and chairman of the compensation committee, Tyco International Ltd. Co-chairman of The Conference Board Task Force on Executive Compensation

Jill S. KaninLovers

Former senior vice president, Human Resources, Avon Products Inc. Director and chairman of the compensation committee, Heidrick & Struggles International Inc. Director and chairman of the compensation committee, First Advantage Corporation Director, Dot Foods, Inc.

Jay W. Lorsch

Louis E. Kirstein Professor of Human Relations, Harvard School of Business Chairman, Harvard Business School Global Corporate Governance Initiative Former director, Brunswick Corporation Former director, Reckitt Benckiser Group

Vernon R. Loucks Jr.

Chairman, The Aethena Group LLC Retired chairman and CEO, Baxter International Director and chairman of the compensation committee, Emerson Electric Co. Director, Segway LLC Former director and chairman of the compensation committee, Anheuser Busch Companies Inc. Former director, Edwards Lifesciences Corporation

Patrick S. McGurn

Vice president and special counsel, RiskMetrics Group, Inc.

Nell Minow

Editor and cofounder, The Corporate Library Former president, Institutional Shareholder Services, Inc. (Continued)

260

APPE ND IX C

Robert A. G. Monks

Shareholder activist and corporate governance advisor Shareholder and advisor, Trucost Founder, Lens Governance Advisors Cofounder, The Corporate Library Founder, Institutional Shareholder Services, Inc. Founder, Hermes LENS Asset Management Company Chairman, Governance for Owners—G40

Stephen W. Sanger

Retired chairman and CEO, General Mills, Inc. Director and chairman of the compensation committee, Wells Fargo & Company Director and chairman of the compensation committee, Target Corporation Director, Pfizer, Inc.

Laurie A. Siegel

Senior vice president, Human Resources and Internal Communications, Tyco International, Ltd. Director and chairman of the compensation committee, CenturyLink Advisory Board member, Cornell Center for Advanced Human Resource Studies

Notes

1. Restricted stock is a grant of stock that vests (is earned) on the basis of continued employment with the company over a given period of time. Vesting of restricted stock is not contingent upon performance, so if the value of the stock goes down, the grant is still worth something to the recipient. This is why restricted stock is an effective retention vehicle. 2. A stock option is the right to buy a share of stock at a given price over a given period of time. For example, a stock option with an exercise price (that is, purchase price) of $10 and a ten-year term allows the holder to purchase a share of stock at $10 for ten years from the date the stock option was issued, regardless of the market price of the stock. 3. This figure represents $300 million in Performance-Adjusted Compensation, as defined in Chapter Three of this book. It does not represent the target compensation value or the value that Chambers actually received when he exercised his stock options. 4. Underwater options are options for which the current price is below the exercise price. 5. Why three years? Three years is easy to understand and trace, and picks up a sizable portion of an executive’s typical tenure in his or her job. Through extensive analysis, I found that four-, five-, and even ten-year data are no more helpful in understanding pay fairness and alignment than three years.

261

262

NOTES

6. The Black-Scholes Stock Option Pricing Model determines the expected present value of an option based on stock price at time of measurement relative to the exercise price, the stock price volatility, the dividend yield, the remaining option term, and the risk-free rate. 7. Due to limitations in the database, the values for performance share plans are for actual awards earned and received, rather than the end-of-period value of grants made. The grant valuations are available through custom analyses for specific companies and will be available in future versions of the model. 8. Benefits include the annualized value of company-paid items, such as health insurance; life insurance; deferred compensation earnings; and perquisites, such as car allowances, club fees, and financial planning services. 9. GICS stands for Government Industry Classification Standard, which establishes a common, global standard of industry classifications for companies worldwide. There are ten primary sectors—Energy, Materials, Industrials, Consumer Discretionary, Consumer Staples, Health Care, Financials, Information Technology, Telecommunication Services, and Utilities—and twenty-four industry sectors. Our regressions used the twentyfour industry sectors, shown in Appendix B. 10. We chose $2 billion because it is roughly in the middle of our sample set. The data allow us to derive a PAC line for a company of any size. 11. The 1996 and 1997 data points are not shown, because Mackey McDonald was a new CEO during those years and we discard data points for any CEO who hasn’t been in his or her position for the entire three years. Also, the 2008 data point is not shown for Eric Wiseman because he was a new CEO in that year. 12. Credit default swaps are financial derivatives used to hedge againt debt contract default.

NOTES

263

13. In contrast, below-market pay positioning also could be the root cause of Lowlier status. 14. Oracle will be approximately $35 billion in sales and moving into the system infrastructure business once it consummates its acquisition of Sun Microsystems. 15. EBITDA is an acronym for earnings before interest, taxes, depreciation, and amortization. 16. The Lake Wobegon effect refers to the public radio program A Prairie Home Companion, created by Garrison Keillor, where in the mythical town of Lake Wobegon “all the children are above average.” 17. Cash-out period refers to the point at which the stock can actually be liquidated, and the compensation profit realized by the executive. Some companies require executives to hold the stock they acquire via equity incentive plans for a given period of time, net of paying taxes. The “cash-out” amount is the pre-tax value of profit realized. 18. A holdback is when equity cannot be liquidated immediately after it is vested or earned, but needs to be held (on an after-tax basis) for a predefined period of time, generally six months to a year. 19. Ownership guidelines refer to the requirement to hold company stock for the period over which the executive is employed by the company. 20. Value-based equity grants are equity grants denominated in a target dollar value. 21. Fixed-share equity grants are equity grants denominated in number of shares. 22. Discretion in incentive plans need to be carefully designed to maximize the opportunity for tax deductibility of awards under Section 162(m). 23. Compensation committees usually have the prerogative to apply complete downward discretion in incentive plans.

Acknowledgments

In some ways, I began writing this book thirty years ago when I was a young associate at Booz Allen & Hamilton (now Booz & Co.) in the Strategy Consulting Practice. There, I collaborated with and was mentored by Gary Hourihan, head of Booz Allen’s West Region Organization and Compensation Consulting Practice, and others at Booz Allen to help our clients link their people strategy to their business strategy. I learned a great deal about compensation and its power to focus the mind, and worked with clients who took it seriously. I learned a lot from those early days. Later, when Gary and I cofounded SCA Consulting, along with Peter Mullin as our financial sponsor, I was ably assisted by a strong group of partners and colleagues. When we sold SCA to Mercer, I again led people passionate about getting the talent model right for our clients, about which compensation was a big part. Over that time, we worked tirelessly with some of the world’s greatest companies and with the people who led them. In operating these businesses, some large, some small, I “ate my own cooking” in terms of compensation programs and alignment. We got paid if we created value and vice versa. Collectively, my experiences as a leader and as a consultant in service to clients have been the best teacher, and prepared me for launching Farient Advisors, my current firm, and for writing this book. Many individuals contributed to the work in this book. Specifically, I’d like to thank my colleagues at Farient Advisors. My partner at Farient, Ron Bottano, with whom I also worked 265

266

ACKNOWLE D GMENTS

at SCA, did a great deal of the analytic work and was a deeply thoughtful sounding board for me on this project. Ron’s insight and sharp mind have contributed mightily to the creation of this whole new platform for alignment research and consulting. Other colleagues at Farient—John Borneman, with whom I also worked at SCA; Todd Gershkowitz, who was a client of SCA’s in the early days; and Eva Shah—also contributed their ideas, pushed our thinking forward, read versions of the manuscript, and sat through long conference calls during which we discussed our philosophical points of view and what should go into the book. Steve O’Byrne, managing director of Shareholder Value Advisors, who is one of the most innovative thinkers in our business, created the data sets and quantitative models that went into this work. Steve’s work led us to the very first company Alignment Report. Joel Kurtzman, of the Kurtzman Group, helped with conceptualizing the book and conducting the interviews, and walked me through the publishing process. I’d also like to thank the many clients, who are too numerous to mention by name, that I’ve served over the years. Together with my clients I have explored philosophies, ideas, and solutions while also testing them, however creative, against the practical realities of their business, regulatory, and organizational constraints. And finally, I’d like to thank my husband, Stewart Smith, who was patient with me beyond any level that I could have reasonably expected during this process when I practically lived at the office to focus on this ambitious project. I’d also like to thank our interviewees, whose insights are reflected in this book. Among them are G. Chris Andersen, Dan Ariely, Richard E. Boyatzis, Edward D. Breen, Graef “Bud” S. Crystal, Kathryn A. DCamp, Ronald M. DeFeo, Robert E. Denham, Robert A. Eckert, Charles M. Elson, Ursula O. Fairbairn, Rajiv L. Gupta, Jill S. Kanin-Lovers, Jay W. Lorsch, Vernon R. Loucks Jr., Patrick S. McGurn, Nell Minow, Robert A. G. Monks, Stephen W. Sanger, and Laurie A. Seigel.

The Author

Robin A. Ferracone is founder and executive chair of Farient Advisors LLC and founder and CEO of RAF Capital LLC. Farient Advisors helps clients make performance-enhancing, defensible, and timely executive compensation decisions that are in the best interests of their shareholders. Prior to forming Farient, Ms. Ferracone was president of the Human Capital business of Mercer, a business that includes human capital consulting, software, and data services globally; chairman of the U.S. West Region for Mercer’s parent company, Marsh & McLennan Companies; market leader and Worldwide Partner at Mercer; president and chairman of SCA Consulting, a firm she cofounded in 1985 and sold to Mercer in 2001; and senior associate with Booz Allen & Hamilton, now Booz & Co. With over thirty years of consulting, leadership, and board experience, Ms. Ferracone has designed and implemented business and talent strategies, executive compensation programs, and value management and performance measurement systems for hundreds of organizations. Ms. Ferracone has authored numerous articles and has been quoted frequently in national publications. She has been a frequent presenter for prominent organizations and testified before a Congressional subcommittee in Washington, D.C., regarding the salary of the president of the United States. In 2003, Ms. Ferracone received the 2003 WorldatWork Distinguished Service Award.

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THE AU THOR

Ms. Ferracone is a member of the Duke University Board of Trustees, the PayScale, Inc. Board of Directors, World Presidents’ Organization, The Committee of 200, and the International Women’s Form. In addition, she has served on the boards and chaired the compensation committees of Candle Corporation, Harvey Mudd College, and Worldwide Compensation. Ms. Ferracone received an M.B.A. from the Harvard Business School, where she was a Baker Scholar, and a B.A. summa cum laude in management science and economics from Duke University, where she was elected to Phi Beta Kappa. Ms. Ferracone can be reached at robin.ferracone@farient .com.

Index

A Absolute up-front goals, 169, 182 Ad hoc decisions: backbone of compensation committee and, 215; changing pay plans with economic conditions, 212–213; Compensation Flatliners and, 105, 200; discretionary decisions outside of the pay plans, 209–212; planned and bounded discretion versus, 205–208, 214; as a root cause of misalignment, 121–123, 205; two flavors of, 205; what to do about, 213–214 Adair, J., 148 Adversity, as a teacher, 187 Aggressive target pay: bad analytics and, 129–130, 138–139; combatting, 142; four reasons for, 129–130; implicit pay positioning and, 130, 140–141; peer group abuse and, 129, 133–135, 136; as a root cause of misalignment, 121, 122–123; stated pay positioning and, 129, 130–133 AIG, 117–120, 124, 199 Aligned pay, defined, 11–12, 21 Alignment: creating and maintaining, 231–239; defined, 11–12, 21, 61–63; fair play and, 16–17; questions and answers, 63–68; searching for, 12–14 Alignment design choices, 199–200, 204 Alignment Model: as analytic tool, 14–16; portfolio approach and, 34; using, 74–75; zone used in, 34–35

Alignment NOzone, defined, 61, 62 Alignment Report: aggressive target pay and, 142; AIG, 117, 124; Cheesecake Factory, 175, 185; Copart, 149, 155; goal-setting and, 173–177; merits of, 79–80; Oracle, 132, 143; peer group abuse uncovered by, 134–135; reactions to, 103–104; reading the, 75–79; time horizon and, 195; Tyco, 85, 88, 89; VF Corporation, 77, 82; as work-saving tool, 234 Alignment Zone, definitions and descriptions of, 34–35, 61–62, 69, 81 Amazon, 201 Analytic tools, 14–16 Andersen, G. C., 188 Apple, 147 Ariely, D., 4, 5, 36, 218, 219 Aspen Institute report, 187–188 Assumptions, false, 221–224 Asymmetric information bias, 221 Asymmetric performance attribution bias, 217–219

B Bad analytics and aggressive target pay, 129–130, 138–139 Balanced scorecard, 27 Benmosche, R., 119, 120, 124 Berkshire Hathaway, 201 Bezos, J., 201 “Big hit” incentive plans, 147, 152

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270

INDEX

Black-Scholes Stock Option Pricing Model, 44, 53, 262 Board: Alignment Report and, 250; role in compensation, 229–230 Boyatzis, R., 19, 27, 234 Breen, E., 17–18, 79, 86, 87, 88, 89, 160, 205, 235 Buffett, W., 84, 201, 241, 242

C Causes of misalignment: ad hoc decisions, 122–123, 205–215; aggressive target pay, 122–123, 125–142; conventional goal-setting, 122–123, 157–178; decisionmaking influences, 122–123, 217–227; defined, 115, 122–123; flattening the curve, 122–123, 199–202; short-term gain; long-term pain, 122–123, 187–197; turbocharged upside, 122–123, 145–154 CEO data, reason for using, 15 CEO decision-making, 36–37 CEO pay: at AIG, 117–120, 124; best-selling book on, 7; drivers of CEO compensation, 64, 70; at General Motors, 52; industry sector and, 65, 71; of internally promoted CEOs, 48–49; outliers, 7–8, 9–10, 68, 83, 232, 242; PAC pay mix, 49–51, 55; performance alignment and, 69; performance-adjusted, 8, 20, 41–46; real issues with, 8; separating out pay for new CEOs, 140; size of company and, 47–48, 54; at Tyco, 84–89 Chambers, J., 9, 10, 147 Cheesecake Factory, The, 174–175, 185 Cisco Systems, Inc., 9–10, 147 Clawbacks, 195, 196–197 Compensation: aligned pay, 11–12, 21; performance-adjusted, 20, 41–55; persistent problems with, 6–8; role of, 4–6, 17–19; strategic planning and, 166–167. See also CEO pay; Incentives; Performance-adjusted compensation (PAC)

Compensation committees: Alignment Report and, 250; Alignment Zone and, 35; backbone of, 215; role of, 227–229; stories about, 3–4, 60; subtle transgressions and, 13–14 Compensation discussion and analysis (CD&A), 57, 58, 190 Compensation Dogleg, description of, 92, 96–98, 107, 118, 122 Compensation Flatliner, description of, 92–94, 105, 122, 200–201 Compensation Highflier, description of, 92, 99–102, 108, 122, 125 Compensation Lowlier, description of, 92, 102–103, 109, 122 Compensation philosophies that strengthen alignment, 234–235, 238–239 Compensation Riskseeker, description of, 92, 94–96, 106, 122, 146 Conference Board Task Force on Executive Compensation, 18, 73, 127, 158, 258–259 Conventional goal-setting: equity grants and, 161; mark-to-budget goal-setting system, 163, 164, 165–166, 167–168, 181, 183; motivational goal-setting system, 163, 181; as a root cause of misalignment, 122–123; Section 162(m) requirements and, 157, 158, 218; unconventional goal-setting versus, 167–168; what to do about, 178 Convergence, 236–237 Copart, 148–149, 155, 213 Cost of equity, defined, 32 Crystal, G., 7, 65 Crystal Report, The, 7 Culture of misalignment, 115–121

D Data point, defined, 81, 236 DCamp, K. A., 79, 136, 153, 170, 193, 225, 228–229 Decision-making influences: asymmetric information bias, 221; asymmetric performance attribution bias, 217–219; defined,

INDEX 217; false assumptions, 221–224; peer comparison bias, 219–221; personality biases and group dynamics, 225–226; as a root cause of misalignment, 122–123; what to do about, 226–227 Decisions, quality of CEO’s, 36–37 DeFeo, R. M., 19, 28, 48, 116–117, 188–189, 209, 227–228 Denham, B., 18, 29, 74, 161–162 Design choices, alignment, 199–200, 203 Discretionary decisions outside of the pay plans, 209–212 Doglegs, Compensation, 92, 96–98, 107, 118, 122 Dot Foods, 13, 167, 259

E EBITDA (earnings before interest, taxes, depreciation, amortization), 25–26, 37, 134, 263 Eckert, R. A., 13, 164–165, 168, 170, 223, 226 Ego-driven people, 19 Eisner, M., 136 Ellison, L, 130, 131, 132, 133 Elson, C., 6, 153 Embarrassment factor, 84, 241–242 Emerson Electric, 18, 170, 194 Englander, D., 148 Enrico, R., 147 Entitlement, example of, 10 Executives and Alignment Report, 250 External hires versus internally promoted CEOs, 48–49 Extreme risk-oriented pay mix, 146, 147–149 ExxonMobil, 99–102, 108, 153

F Fair pay (aligned pay), defined, 11–12, 21. See also Performance-adjusted compensation (PAC) Fair pay problems: exactly pinpointing, 7–8; outliers and, 7–8, 9–10, 68, 83, 232, 242

271

Fair play and alignment, 16–17 Fairbairn, U., 23–24, 34, 127, 213 Fairness doctrine and an outraged public, 43 False assumptions, as decision influencer, 221–224 Farient Advisors, 6, 14–15, 23, 28, 73, 75, 137, 226 Farient’s Alignment Model, 15–16 Feinberg, K., 119 50th-percentile pay positioning, 126–128, 142 Financial Accounting Standards Board (FASB), 42 Five pay design forces, 115, 122–123 Fixed-share versus value-based grants, 200, 203, 263 Flatliners, Compensation, 92–94, 105, 122, 200–201 Flattening the curve: as a root cause of misalignment, 122–123; what to do about, 201–202

G General Mills, 11, 171 General Motors (GM), 52, 147 Gestalt of what companies are about, 80 Goal-setting: Alignment Report and, 173–177; better guidance for, 177–178; competitive context for, 171; definitions of, 169, 170, 182; frustration over, 157–158; long-term, 194; no perfect system for, 171–172; open-mindedness about, 169 Goal-setting, conventional: equity grants and, 161; mark-to-budget goal-setting system, 163, 164, 165–166, 167–168, 171–172, 181, 183; motivational goalsetting system, 163, 181; as a root cause of misalignment, 122–123; Section 162(m) requirements and, 157, 158, 218; unconventional goal-setting versus, 167–168; what to do about, 178 Government: Alignment Report and, 251; message to, 245–249 Government intervention in executive pay, 6

272

INDEX

Grant frequency and performance cycles, 194–195 Greenberg, H., 117, 118, 119, 120 Gupta, R., 43, 68, 79, 87, 98–99, 196, 207, 229

H Hewlett-Packard (HP), 140 Highfliers, Compensation, 92, 99–102, 108, 122, 125 High-performing companies and alignment, 67, 72 Holdbacks, 196, 263 Hurd, M., 140

I Implicit pay positioning, 130, 140–141 In Search of Excess: The Overcompensation of American Executives, 7 Incentives: “big hit,” 147, 152; highly leveraged, 146, 149–150; modeling incentive plans, 153; PAC pay mix, 49–51, 55; role of compensation, 4–6, 17–19; simplicity and, 35–36. See also Turbo-charged upside Incremental size versus incremental performance, 66–67, 71 Industry sector: alignment patterns and, 65, 71; total shareholder return (TSR) and, 30–31, 39 Internal CEO successors, 48–49 International Rectifier, 140 Investors: message to, 243–245; shorttermism among, 187–188, 191–192; view of pay, 5, 8–9, 31. See also Shareholders IRC Section 162(m), tax code, 49, 50, 157, 158, 218, 263

J Jobs, S., 147 Johnson, W., 148, 149

K Kanin-Lovers, J. S., 13, 14, 129, 166–167 Kaplan, R. S., 27 Keillor, G., 263 Khaykin, Mr., 140 Kozlowski, D., 84–86, 88

L Lake Wobegon effect, 141, 263 Long-term goals, setting, 194 Long-term success and total shareholder return (TSR), 24, 28–30 Lorsch, J. W., 10–11, 35, 191, 197, 215 Loucks Jr., V. R., 18–19, 59, 80, 193, 194, 224–225 Lower Alignment NOzone, 62, 69, 102 Lowliers, Compensation, 92, 102–103, 109, 122 Low-performing companies and alignment, 67, 72 Lublin, J., 84, 85

M Market intercept, defined, 78, 81 Mark-to-budget goal-setting system, 163, 164, 165–166, 167–168, 171–172, 181, 183 Mark-to-shareholder goal-setting approach, 164, 165–166, 167–168, 171–172, 181, 183, 184 Marx, K., 241 Mattel, 13, 168 McDonald, M., 78, 262 McGurn, P. S., 8, 25, 31, 80, 82, 84, 170, 191–192 Microsoft Corporation, 58, 98 Minow, N., 32, 33, 51, 59, 94, 134, 136, 169, 241, 250 Misalignment: culture of, 115–120; defined, 21, 91; root causes of, 115, 122–123. See also Root causes of misalignment Misalignment patterns: Compensation Dogleg, 92, 96–98, 107, 122;

INDEX Compensation Flatliner, 92–94, 105, 122, 200–201; Compensation Highflier, 92, 99–102, 108, 122, 125; Compensation Lowlier, 92, 102–103, 109, 122; Compensation Riskseeker, 92, 94–96, 106, 122, 146; root causes of misalignment and, 122–123 Monks, Robert A. G., 7, 64, 85–86, 100, 233, 249 Motivation: compensation’s role in, 4–6, 17–19; power of incentives, 4–5; virtuous circle of compensation and, 41, 53 Motivational goal-setting system, 163, 181

N Named executive officers (NEOs), 15, 46

O Oracle, 130–133, 143, 263 Outliers, 7–8, 9–10, 68, 83, 232, 242 Overcoming Short-Termism: A Call for a More Responsible Approach to Investment and Business Management, 187 Overton, D., 174 Overton, E., 174 Overton, O., 174 Ownership guidelines, 196, 197, 263

P PAC. See Performance-adjusted compensation PAC line, defined, 81 PAC outcome, defined, 81 Patterns of misalignment: Compensation Dogleg, 92, 96–98, 107, 122; Compensation Flatliner, 92–94, 105, 122; Compensation Highflier, 92, 99–102, 108, 122, 125; Compensation Lowlier, 92, 102–103, 109, 122; Compensation Riskseeker, 92, 94–96, 106, 122, 146 Pay: aligned, 11–12, 21; investors’ view of, 5, 8–9, 31; power and, 233; role of compensation, 4–6, 17–19; spotlight

273

on, 10–11; true measure of, 116–117. See also CEO pay; Performanceadjusted compensation (PAC) Pay mix: extreme risk-oriented, 146, 147–149; PAC, 49–51, 55 Pay outliers, 7–8, 9–10, 68, 83, 232, 242 Peer comparison bias, 219–221 Peer group abuse, 129, 133–135, 136 PepsiCo, 57, 147 Performance and pay alignment zone: alignment as stated objective, 57–59; measuring performance-pay alignment, 61–62 Performance-adjusted compensation (PAC): analysis of performance across broad market and, 63–65, 69; calculating, 43–46, 53; CEO, 8, 9, 20; description of, 41–42; outliers and, 9–10, 20; pay mix, 49–51, 55; percentage of CEO PAC by position rank, 54; virtuous circle of compensation and, 41, 53 Personality biases and group dynamics, individual, 225–226 Philosophies that strengthen alignment, 234–235, 238–239 Planned and bounded discretion, 205–208, 214 Portfolio approach to performance measurement, 31–34, 40, 239 Power and pay, 233 Problems with pay: old and persistent, 5–7; pinpointing, 7–8 Psychological effect of equity, 188–189 Pugh, L., 78, 82

R Rawl, L., 100 Raymond, L., 100, 101, 108, 153 Relative, after-the-fact goals, 170, 182 Restricted stock, defined, 261 Retention: argument, 224–225; as overstated issue, 13, 222–223 Riskiness of executive pay package, 49–51 Risk-oriented pay mix, extreme, 146, 147–149

274

INDEX

Riskseekers, Compensation, 92, 94–96, 106, 123, 146 Root causes of misalignment: ad hoc decisions, 122–123, 205–215; aggressive target pay, 122–123, 125–142; conventional goal-setting, 122–123, 157–178; decision-making influences, 122–123, 217–227; defined, 115, 122–123; flattening the curve, 122–123, 199–202; short-term gain, long-term pain, 122–123, 187–197; turbo-charged upside, 122–123, 145–154

S Sanger, S. W., 11, 36, 47, 59, 162, 171, 229–230 In Search of Excess: The Overcompensation of American Executives, 7 Sears Roebuck, 7 Shareholder value: financial performance and, 25–26; industry sector and, 30–31; long-term success and total shareholder return (TSR), 24–25, 28–30; narrow financial metrics and, 27; portfolio approach and, 31–34 Shareholders: Alignment Report and, 250–251; compensation committees and, 35; as owners, 23–24; stakeholder value and, 27–28. See also Total shareholder return (TSR) Short-term gain, long-term pain: as a root cause of misalignment, 122–123; what to do about, 196–197 Short-termism: bad timing and, 189–190; in executive pay, 190; investors and, 187–188, 191–192; ways to mitigate, 196 Siegel, L., 46, 86, 87, 88, 171, 196, 208–209, 230, 235 Simplicity and determining incentives, 35–36 Size of company and CEO pay, 47–48, 71 Slope of the PAC line, 81 Stakeholder value, 27–28 Starr International Company (SICO), 118 Stated pay positioning, 129, 130–133

Stock option exchanges, effect of, 175–177, 186 Stock options: bad timing and, 189–190; in calculation of performanceadjusted compensation, 44, 45, 53; at Cisco Systems, 9–10; defined, 261; government intervention and, 6; indexed, 150; as payout currency, 147, 151–152; runaway pay and, 50–51; as subtle transgressions, 13–14; time window for, 193–194; uncapped upside and, 150–151 Strategic planning and compensation, 166–167 Sustainability of TSR (total shareholder return), 32–33

T TARP funding, 120, 248 Tax code, IRC Section 162(m), 49, 50, 157, 158, 218, 263 Terex Corporation, 19, 188–189 Tillerson, R., 102, 108 Time horizon and Alignment Report, 195 Time horizon of executive pay system, weighted average, 192, 198 Total shareholder return (TSR): defined, 24; financial performance and, 25–26, 37; by industry sector, 30–31, 39; longterm success and, 28–30; management and, 25–26; merits of, 24–25; sustainability of, 32–33; three-year TSR for the S&P 1500, 29, 37, 38 Transactional versus transformational leadership, 19 TSR performance outcome, defined, 81 Turbo-charged upside: alignment issues with, 153–154; “big hit” incentives, 147, 152; extreme risk mix, 146, 147–149; highly leveraged incentives, 146, 149–150; as a root cause of misalignment, 122–123; stock options as payout currency, 147, 151–152; uncapped upside, 146, 150–151; what to do about, 154 Tyco, 17, 46, 84–89, 91, 104, 115, 199

INDEX

275

U

Virtuous circle of compensation, 41, 53

Uncapped upside, 146, 150–151 United States Steel Corporation, 57 Upper Alignment NOzone, 62, 69 Utilities and total shareholder return, 30

W

V Value-based versus fixed-share grants, 200, 203, 263 VF Corporation, 76–79, 82, 91, 104

Wagoner, R., 52, 147 Williams, S., 79 Wiseman, E., 76, 78, 79, 262

Z Zone, Alignment, 34–35, 61–62, 69, 81

PRAISE FOR FAIR PAY, FAIR PLAY “I like the way that Ferracone tells real-world stories on executive compensation, as recounted by board members and executives on the front lines, and she backs up these narratives with well-researched statistics. Her way of looking at performance-adjusted pay is highly innovative and offers insights that we had previously not seen.” —ROY J. BOSTOCK, non-executive chairman of the board, Yahoo! Inc. “This book is the best authoritative source on executive compensation today. It takes an extremely complex topic and boils it down to its simplest terms: alignment between pay and performance. Ferracone’s Alignment Model gives us a way to test and analyze alignment in our companies. In a word—it is superb! The Alignment Model is a tool that boards, executives, and investors alike can use. This book is required reading for every compensation committee member, CEO, head of HR, and institutional investor in America.” —ALEXANDER L. CAPPELLO, chairman and CEO, Cappello Capital Corp. “Ferracone provides a set of principles combined with actual accounts of how companies can achieve pay-for-performance alignment on a sustainable basis. Making this happen is critical to building trust and a high-performance culture.” —RICHARD FLOERSCH, chief HR officer, McDonald’s “Ferracone does an excellent job of describing how executive performance and pay should be aligned. She combines quantitative research with qualitative commentary from those who are on the front lines in determining executive compensation. This combination makes the book eminently readable and a very useful guide.” —ED LAWLER, author, Rewarding Excellence “By constructing a highly fact-based and thoughtful road map, Ferracone has taken the emotion and fear out of executive compensation decision making. Following the recommendations and analyses contained in this book will enable struggling boards and compensation committees to execute better, and well-performing boards to flourish.” —ANNE C. RUDDY, CCP, president, WorldatWork

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