NBR L.E.K Shareholder Scorecard: Executive compensation can benefit shareholders too

Friday 14th December 2001

"Bosses' pay on the rise again" has become an all-too-familiar headline. This has been highlighted again with the recently announced incentives paid to senior executives of Air New Zealand as the company suffered near terminal decline.

Clearly the incentives paid were not aligned with sustainable performance and value creation. While the executives may have worked very hard, the final outcome was disastrous for shareholders, as well as many employees, suppliers and customers.

Nonetheless, there is now a highly competitive global market for senior executive labour, and market rates for pay will continue to prevail. Like it or not, companies must continue to offer sizeable salaries to attract and retain the most talented managers, and this will include both fixed salary and incentive plans.

Accordingly, all shareholders and boards need to ensure executive reward, particularly the incentive component, is genuinely aligned with long-term shareholder value creation. The intent is common, but in reality it is not often achieved. Some of the worst performers in the Scorecard have an inverse relationship, with increased high incentive pay and poor performance.

Implementing an effective incentive pay system that truly aligns rewards with value-creation is a significant but critical challenge. It requires addressing the three key questions:

What to pay for?

How to pay?

How much to pay?

L.E.K. advises a wide range of its clients on issues of executive compensation, and it has observed some common difficulties that organisations encounter when trying to achieve an effective value-based reward system.

Problem 1: Poor goal clarity and review disciplines

An effective value-based system relies on a base level of human resource infrastructure. Most particularly, it needs timely and disciplined objective setting, as well as a rigorous annual performance review process right up to CEO level. If these disciplines are not in place, a company is unlikely to be getting much bang for its bonus buck.

Problem 2: Focus on short-term financial performance alone

Delivering this year's financial target is important, but there may be positive and negative strategies for achieving this outcome (for example, there may be a trade-off between adding profitable new customers and slashing marketing expenditure). Shareholders desire long-term value creation, and overemphasising short-term financial performance creates a risk of inappropriately motivating managers. Reward programmes need to reflect both short-term and long-term financial measures, as well as non-financial measures that are leading indicators of value-creation (such as customer acquisition or community perceptions).

Problem 3: Metric fixation

For the reasons outlined above, short-term financial performance is important but ultimately a relatively poor predictor of long-term value creation.

Whether a company chooses to measure single- year performance in terms of profit after tax, return on capital employed, economic profit (EP) or some other measure is to some extent inconsequential.

Certainly there is benefit in moving to an EP-type measure that includes more of the factors that are important to shareholders. But irrespective of which single-year measure is chosen, it needs to be appropriately balanced with tracking of underlying value-drivers and longer-term incentives. Agonising over the adjustments to a single-year financial year performance measure quickly becomes futile.

At the highest level, shareholder return is the most appropriate measure for some part of variable pay and should be compared to an overall sector performance, not as an absolute score or compared to NZSE and ASX overall indices.

Also, the incentives must have some form of accumulation in that all rewards are not paid out in one year, but paid over (say) a three-year period. This accumulation process ensures that everyone is focused on long-term performance, not a quick fix that may ultimately destroy value.

Problem 4: Gaming

Implementing pay for performance requires establishing some form of performance benchmarks. While there are many options for establishing benchmarks at company level (such as peer performance or analysts expectations), at business unit level there are rarely any other performance benchmarks available except the internally generated budget or strategic plan. If this is to be used to benchmark performance for variable reward, gaming can be an inevitable consequence.

Equally unproductive can be over-ambitious single-year budgets imposed by the head office, which are unachievable and potentially de-motivating at the coalface.

Both of these problems can only be overcome or mitigated with high-quality strategic planning which makes explicit the key drivers generating the financial outcomes allowing productive debate around the level of stretch implicit in the plan. Having appropriate planning disciplines in place is therefore a prerequisite for effective alignment of rewards with value creation.

Companies seeking to swim against the tide in executive salaries will risk losing out in the war for talent.

Therefore, ensuring that variable rewards are genuinely aligned to value creation is an absolute must for boards. This will more closely align the interests of shareholders and executives.

The growth in share options and share issues as part of executive compensation is in itself another major issue that needs to be aligned with overall value-creation, not as being "in the money" for executives immediately.

Research suggests those organisations which have introduced a value-based approach throughout the organisation with a direct linkage to a variable compensation scheme actually do create value. As investors contemplate their investments and executive remuneration they should consider the following questions:

Is there alignment between the organisation incentive programmes and those of creating value for the shareholders?
Are the rewards in place to secure and retain the best talented executives and ensuring commitment?
In a downturn, what processes are in place to secure talent?
How can an organisation minimise the shareholder costs of an incentive program?

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