32% 14% Performance Awards. Does performance-based pay for CEOs promise success for companies? Salary

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1 Veer.com/ElnurAmikishiyev, istockphoto.com/malewitch 32% Awards Does performance-based pay for CEOs promise success for companies? Salary

2 % The Magazine of WorldatWork Stock options EXPLORING THE LINK BETWEEN CEO Pay & Short-term incentives T here was a time when large companies simply paid CEOs an agreed upon salary for their work and possibly, a bonus to mark a successful year. However, most notably in the 1980 s, compensation packages became larger and more complex, with shareholders demanding that pay be based on performance, mostly in the form of options to purchase company shares. Shareholders believed that if executives held company shares, management s interests would be more closely aligned with their own. By Dana Martin and Kevin McLaren, Hay Group 2015 WorldatWork. All Rights Reserved. For information about reprints/re-use, copyright@worldatwork.org may 2015 workspan 45

3 The true test of these programs and the pay and performance relationship will only be seen during a period of reverses, or when shareholders lose value. Currently, companies and shareholders are determined to fine-tune the link between pay and performance. -based long-term incentive (LTI) plans are receiving the most focus in the push for better alignment. In this article, we will track the trend of performance-based LTI since the 2008 Great Recession. We will then take a look at how the 300 largest companies are designing their LTI portfolios. Finally, we will assess how company stakeholders are measuring the pay and performance link. The rise of performancebased long-term incentives Only 14 percent of the average CEO pay package is made of his or her salary. Conversely, 63 percent of the package, the largest portion, is the CEO s LTI in the form of equity in the company. And, remarkably, in 2013, half of the CEO s LTI is now performance based. This shift to performance-based pay began in earnest in 2008 and the pace has increased every year since. It is important to note that the pattern shows an increase in performance-based pay with an offsetting reduction in the use of stock options and other forms of equity. This marks a significant shift in pay practices that has not been seen before. Thoughts and implications We have seen this move to performance within a time period that has seen strong corporate profits and stock performance. The true test of these programs and the pay and performance relationship will be seen only during a period of reverses, or when shareholders lose value. It will be in that period where pay programs are put to the test. Will shareholders continue to support a say-on-pay program in a year where they ve lost significant value? Will boards see their executives realizable pay decline and look to reload the lost value the next year? Only time will tell. Integrating performancebased pay into CEO compensation programs In its most basic form, a performance- based equity plan involves the issuance of company shares, with the number of shares actually delivered defined by performance levels relative to established goals. Typical performance periods range from three to five years. Common measures used in performance plans include earnings per share (EPS) and total shareholder return (TSR), measured as an absolute value or relative to a selected group of companies. awards are now considered by shareholders to be the most important element within a CEO s pay package because these plans only have value when performance goals are met, therefore enhancing the pay for performance link. In the quest to link pay and performance accurately, the 300 largest companies have developed a wide variety of LTI portfolios to incent their CEOs. Each portfolio weights Figure 1 CEO pay mix for the largest 300 U.S. listed companies Awards 22% 20% 19% % 18% Restricted Stock 20% Stock Options 19% Short-Term Incentives 31% 32% 17% Sources: Wall Street Journal, Hay Group CEO pay survey, conducted in 2014 reflecting 2013 pay practices Salary 46 workspan may 2015

4 stock options, restricted stock and performance-based awards differently. As evidenced in Figure 2, plans that evenly integrate performance-based pay with stock options and restricted stock are now the most common. Many companies also opt to mix performance-based pay with either stock options or restricted stock. However, only 15 of the 300 companies reviewed still use a portfolio made up exclusively of stock options and restricted stock. Thoughts and implications As performance-based equity plans evolve, more companies are using the plans to align the senior team with strategic execution-based performance goals. Additionally, companies are trending toward moving from using all three vehicles at once. A performance plan coupled with restricted stock is likely to create a minimum value to the executive. Measuring pay for performance: How do we determine if there is a link? With scrutiny on executive pay programs increasing, demonstrating alignment between pay and performance has become a necessary exercise. In general, there is not an accepted method of measuring alignment. However, shareholders and companies currently employ an array of quantitative and qualitative techniques to evaluate whether pay is commensurate with performance. Figure 2 Companies that use a mixed compensation portfolio Awards Restricted Stock Stock Options 40% 29% 31% Stock Options, Restricted Stock & Awards (n=88) 59% 62% 41% 38% Stock Options & Awards (n=73) Restricted Stock & Awards (n=51) 100% Awards (n=37) Sources: Wall Street Journal, Hay Group CEO pay survey, conducted in 2014 reflecting 2013 pay practices 49% 51% Stock Options & Restricted Stock (n=15) It s comprehensive. It s effective. It s fast. Limited Seats. Enroll Today! April Atlanta June Chicago SOLD OUT SOLD OUT July Phoenix September Phoenix This program will give participants the kind of insights, experience and knowledge that would take 3-5 years of on-the-job training to get, and they get it all in a 5-week program. Brit Wittman, CCP, CECP, Director, Executive Compensation and Corporate Compensation Design, Intel Corp. may 2015 workspan 47

5 Figure 3 $2,500 Absolute Alignment 140 Relative Alignment $2,000 $1,500 $1,000 $500 $ Total Compensation (% Rank) 100% 75% 50% 25% 0% 25% 50% 75% 100% Total Compensation Total Shareholder Return Total Shareholder Return (% Rank) Quantitative approaches to date generally involve the use of absolute and relative measurements to see if the company s pay aligns with its own performance and how it compares with other companies. Shareholders define performance as total shareholder return (i.e.,stock price appreciation plus dividends), and measure it over a multiyear period. With respect to say on pay, shareholder advisers employ these approaches on a standardized basis. These tests can negatively affect voting recommendations for companies that do meet threshold levels of alignment. Qualitative approaches to measuring alignment generally involve the review of the compensation program, the plan design provisions and the To achieve a commitment to strong alignment, it should include... performance-based compensation... identification of risk-mitigating factors. To achieve a commitment to strong alignment, it should include high proportions of performance-based compensation, clear and transparent disclosure of targets, actual performance and payout levels, and an existence of clawback policies. Implications and thoughts As evidenced by the evolution of proxy disclosures, companies are adopting a shareholder perspective in reviewing, rationalizing and communicating pay decisions. The initial paragraph of today s Compensation Discussion and Analysis, while formerly a statement of philosophies and objectives, is now largely devoted to a review of prior year performance. Additional tables have emerged that attempt to quantify how much compensation has been realized, reflecting an effort to supplement the definition of total compensation provided in the Summary Compensation Table. To date, these disclosures have generally shown favorable alignment with periods of strong performance and increasing pay levels. As previously discussed, these disclosures will be tested during periods of reverses and/or where shareholders lose value. While further evolution is expected, so is consistency. Conclusion Since the Great Recession, we have seen a significant shift in the way top executive pay is delivered to increase the alignment between pay and performance. The growth in alignment has been primarily driven by the increase of performance based LTI plans. Many stakeholders have taken interest in measuring and demonstrating the alignment. With the 2014 proxy season almost upon us, we will see different views of the pay and performance link, an increase in performance awards and various ways of demonstrating the performance link. Reach Dana Martin is a senior principal at Hay Group in Chicago. He can be reached at dana. martin@haygroup.com. Reach Kevin McLaren is a consultant at Hay Group in Chicago. He can be reached at kevin.mclaren@haygroup.com. resources plus For more information, books and education related to this topic, log on to and use any or all of these keywords: CEO pay executive compensation performance management. 48 workspan may 2015