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Here we are in 2005, and the pressure on executive compensation from shareholders, regulators, and the media shows no signs of subsiding. Boards and senior management seek tools and approaches that will serve several objectives. They need to ensure their executive pay program can withstand the most intense scrutiny, further the company’s strategy and attract and retain great talent.

Is it possible? Compensation Committee members and executives hope so. We believe it is possible, but...a company cannot get there by relying on traditional, familiar and comfortable solutions. As shown in Exhibit 1, we believe creating an airtight executive pay approach requires business-based compensation design and effective pay program governance, with the aim of ensuring sound pay/performance relationships.

Exhibit 1—UNASSAILABLE EXECUTIVE PAY

This article provides some ideas and approaches to strengthen executive compensation programs and the logic underlying them in order to make the programs as unassailable as possible.

If you would like a free diagnostic conducted of your company’s pay/performance alignment,  click here.

Look for Sound Pay/Performance Relationships
The traditional approach to determining pay levels has been to benchmark pay against the market. Because of the significant latitude in how the market is defined (i.e., which peers to choose), where pay is positioned relative to the market, and the “bootstrapping” that occurs as peer companies increase their own pay, market benchmarking has been a primary culprit in the escalation of executive pay. This pay escalation often occurs without a commensurate increase in company performance.

In recent years, some leading companies have gone a step further and tried to ensure that pay and performance were aligned relative to a peer group (i.e. 50th percentile pay for 50th percentile performance; 25th for 25th, etc.). We at Sibson have been a strong proponent of this approach. And while we continue to believe alignment is necessary, our work has shown us that alignment alone is not enough. If a whole peer group is egregiously overpaying, relative pay level alignment does little to ensure the amount of pay being shared with executives is appropriate given company performance.

We believe a new set of rules is now needed to help managers and Boards ensure their companies’ pay programs can withstand intense scrutiny and deliver appropriate rewards in return for the performance achieved. It all comes down to ensuring sound pay/performance relationships. Companies can assess the strength of their pay/performance relationships by examining three issues:

• Is pay varying with performance?
• Is an appropriate amount of value being shared?
• Are payouts and performance aligned with peers?

The answers to these questions can be found in the results of a three-part test that comprehensively assesses the pay/performance relationship.

Test #1: Pay/Performance Correlation
Executive pay should show a high correlation¹ with company performance. Test #1 is internally focused, examining whether pay and performance move together. If highly correlated, the more performance increases, the more pay increases (and vice versa). The correlation can be tested by comparing the relationship between changes in total cash compensation (TCC)² and company financial results such as earnings and cash flows over time. In addition, changes in both gains on long-term incentives (LTI) and total direct compensation (TDC)³ over time can be compared with changes in total return to shareholders (TRS). Sibson has studied the S&P 500 and has found that correlations well in excess of 0.9 can be achieved by well-designed executive pay programs.

Test #2: Value Sharing
Companies should share an appropriate amount of the value they create with senior executives. Value sharing can be evaluated from three perspectives:

• The percentage of total value (i.e., earnings and shareholder return) created for shareholders that will be allocated to the top five executives
• Changes to that percentage given time and circumstances, and
• A comparison of the value percentage across companies to confirm the sharing relationship is appropriate.

Value sharing does not focus on absolute pay levels, but rather on the split between executives and shareholders. Value sharing can be tested by examining TCC as a percent of both earnings and cash flows. Also, LTIs and TDC can be computed as a percent of TRS. A Sibson study of S&P 500 companies shows the following range of results for sharing percentages for the top five executive officers (see Exhibit 2).

Exhibit 2—VALUE SHARING RATES AT S&P 500 COMPANIES, 1999 – 2003⁴

These sharing percentage benchmarks serve as a helpful starting point. However, the “right” sharing percentage for a given company should be calibrated according to a company’s business circumstances, talent needs and performance and rewards strategy. Exhibit 3 presents an illustrative (but not exhaustive) list of the types of factors that should—and should not—influence value sharing rates, and gives companies a framework for determining whether their sharing rates might be expected to fall closer to the higher or lower end of the competitive range.

Exhibit 3—TYPES OF FACTORS THAT COULD INFLUENCE VALUE SHARING RATES

Types of factors that should not influence value-sharing rates

• Poor goal setting
• Mix of total pay biased to fixed (not variable)
• Inappropriate leverage in incentive plans
• Use of equity vehicles that vary less with performance
• Unjustified pay positioning versus market
• Wrong performance measures in incentive plans

Test #3: Peer Alignment
Relative pay and relative performance compared to a peer group should be aligned. Test #3, which we refer to as the Sibson Pay Paradigm, is one we have advocated for over 10 years. Its purpose is to determine whether the relative positioning of pay levels for the CEO and other top five executives corresponds to the relative performance positioning when compared to the company’s peer group. Alignment means that pay at the median should be backed up by company performance at the median, and pay at the 75th percentile would require performance at the 75th percentile.

What the Test Results Reveal
Exhibit 4 shows the results of the three tests for one company. Taken together, the test results show an appropriate relationship between TDC (total pay) and TRS (long-term company performance). However, the relationship between TCC and cash flow, which gives an indicator of the appropriateness of annual salary and bonus compensation “raises red flags.”

Tests #1 and #2 show, respectively, that the company’s TDC is well-correlated with TRS (86th percentile), and that its total compensation spend on the five highest-paid executives is close to the median (52nd percentile) of the comparator group. In addition, as Test #3 shows, TDC and TRS are extremely well aligned (75th and 80th percentiles).

In contrast, this company’s historical correlation between TCC and cash flow is fairly low relative to its peers (31st percentile), as shown in Test #1. In addition, the company is sharing a disproportionate amount of its cash in pay to its executives (79th percentile), as illustrated by Test #2. The lack of alignment between TCC and cash flow (60th vs. 27th percentile) as shown in Test #3, is also indicative of a potential problem in this area.

The implications of the test results are as important as the results themselves. This particular company had struggled historically with annual goal setting and favored discretionary bonuses, which led to annual payouts that did not track well with demonstrated financial performance. On the other hand, its long-term (primarily stock-based) compensation levels constituted the majority of total executive pay and thus, TDC was highly correlated with company returns. Further, because long-term compensation levels were very conservative relative to opportunities at similar companies, overall TDC was appropriate (i.e., sharing rates and alignment) in light of the company’s returns. This company would benefit from a critical review of its goal setting process and use of discretion. Once the annual incentive is addressed, the company should also re-examine its long-term pay opportunities to ensure TDC sharing rates remain appropriate and TDC and TRS remain aligned.

It is worth noting that the comparatively weak relationship between TCC and cash flow is not always “inappropriate”. A company in turnaround or an early-stage venture, for instance, may need to pay relatively high levels of pay (when compared to financial results) in order to retain and attract key talent in the short-term. Even in this type of case, however, we would expect the relationship between pay and performance to harmonize over time if the compensation design were truly unassailable.

Exhibit 4—THREE-DIMENSIONAL TEST: CORRELATION,
SHARING RATES, AND ALIGNMENT

Although we cannot attribute causality, our data indicates that if a company passes these tests the Board and managers should feel comfortable that the pay program is unassailable. Further, we find that the companies with the best results on these tests realize better financial results.⁵ The average TRS for companies with pay/performance correlations (Test #1) in the top third of the S&P 500 is 13.5%; the middle third, 5.4%, and the lower third, 2.3%. We are still testing the statistical significance of these differences.

It is our experience that companies often display a profile like the one detailed in Exhibit 4 where the pay and performance relationship is not empirically “perfect,” but neither does it fail all tests of unassailability. Many companies already have well-aligned program designs that can be improved even further, and the results of the three tests can help identify these areas for improvement. Exhibit 5 illustrates several example outcomes from the test and potential interpretations:

Exhibit 5—INTERPRETATIONS OF PAY/
PERFORMANCE ALIGNMENT TEST RESULTS

Develop Business-based Compensation
As mentioned above, the three tests provide clues as to how well the executive compensation program is designed. Failing one of more of the tests indicates that re-evaluation is needed. Two areas in particular will warrant careful investigation: 1) is pay distributed according to strategic impact and 2) does the incentive design meet the company’s unique business situation?

Distribution of Pay Levels
Traditionally, most companies position pay for all jobs at the same percentile of the market (e.g., all jobs at median). However, we believe such a homogeneous approach presents a potential missed opportunity by failing to provide an optimal allocation of compensation investment. We believe that pay should be distributed differently to different roles depending on their strategic impact. Under the new rules, executive pay should reflect the reality that within an organization, some executive positions are more vital to achieving that strategy than others.

We call this business-focused approach to determining executive pay Strategic Work Valuation (SWV). SWV challenges a company to identify which of its executive positions have the most impact on strategy. Positions that are more critical to driving strategy would receive pay opportunities above the market, while those with lesser impact would be managed to a lower pay point.

SWV is customized to each company. It balances external market analysis and alignment with internal business strategy, enabling companies to better align talent and business strategies and spend compensation dollars on positions that yield the greatest return on investment when it comes to business results.

SWV is a valuable approach for determining executive salaries and incentives, both annual and long-term. SWV aims to maximize the efficiency of the compensation budget.

Incentive Design
An executive pay plan that fails the test of “soundness,” may emphasize competitiveness, costs and pay delivery but be unable to motivate executives to achieve the business strategy. As we survey executive compensation programs, we see many plans that merely follow conventional wisdom about “good” pay design: that is, they just copy typical practice or those of purported industry leaders. Such “borrowed” plan designs frequently do not deliver as expected because they fail to embrace a company’s unique needs and circumstances.

As shown in Exhibit 6, the key to creating a “company-centric” design is to reflect a company’s unique design objectives; take into account business characteristics, talent characteristics and performance and rewards strategy, and of course, be consistent with legal and cost constraints.

Exhibit 6—CREATING BUSINESS-BASED COMPENSATION DESIGNS

In the last several years, a strong focus has been placed on LTI design. While LTIs will continue to draw attention, we feel that annual incentives will increasingly share the spotlight, with the goal being to ensure the entire incentive package sends complementary messages.

We also believe that increasing attention will be placed on getting incentive goals and measures right. After all, measures and goals are at the heart of good incentive design. Annual goals and measures must be built upon what is necessary for the business near-term to support and drive longer-term value creation. Long-term incentive goals must focus on critical intermediate and long-term outcomes.

Focus on Drivers of TRS
While the ultimate measure for all companies is TRS (typically addressed through long-term incentive plans), other financial, strategic and operational measures can help reinforce the short- and intermediate-term results that contribute to TRS performance. These additional measures, which can be incorporated into annual incentives, create line of sight and aid understanding of the plan and the goals. Additionally, they also help foster the collaboration necessary at operational levels.

Deciding which specific results to measure starts with identifying the economic drivers of TRS and the strategic and operational drivers that contribute to financial results. The objective is to identify the key measures that contribute to creating value for shareholders.

Determine High Priority Measures
The process of identifying drivers will yield more measures than could be included in incentive plans or performance management, so prioritization is critical. Therefore, once measures have been identified, the next step is to prioritize those that have the greatest impact on TRS. Sensitivity analyses (i.e., percent change in economic value, profits, returns associated with a one percent change in the measure) plus the review of key analyst metrics and business strategies can provide intelligence on which drivers have the greatest potential to impact TRS. Careful consideration should also be given to determining which measures represent the highest priority areas for improving success with customers, and most importantly, represent an opportunity to improve versus competitors.

Establish Appropriate Levels, Timeframes and Targets
Once the measures are identified, a company faces three more decisions: the organizational level for measuring results, e.g., corporate, division; the timeframe; and the performance standards or targets. Level of measurement should take into account the decision autonomy and shared accountabilities and resources among business units as well as affordability. Timing should consider lead-time, lag time and the residual impact of the consequences that result from the executive decisions. A company must be careful not to reward short-term results that have potential negative future consequences.

When it comes to setting targets, we advocate a three-pronged view.

• A top-down focus on what companies should do. The top-down perspective reflects the company’s obligations to shareholders—what a company should do to justify its continued independence and management’s continued stewardship. Three relevant benchmarks companies should consider when establishing top-down goals include historical performance, future expectations and continuous year-over-year performance improvement.
• A bottom-up view to identify what the company can do based on their current business model. Identifying the potential for improvement should be guided by three types of relevant benchmarks. The first is internal comparison to best performing units and locations. Internal benchmarks are appropriate if the company has multiple locations or similar units and can determine how much improvement would result if lower-performing units matched the benchmark. The second is technical limits. Technical limits take an engineering approach to identifying the optimal level of performance. They examine key processes and see how close results can get to optimal performance (e.g., reducing downtime). The third type of benchmark is external comparison—how peers have done.
• Reconciliation of the top-down and bottom-up views to determine what management will do.

• Evaluate current compensation committee membership against the skills and experience required to make sound leadership reward decisions. Develop a talent profile for the ideal compensation committee member in terms of expertise, and then rate current and potential new members against this profile to ensure the members are knowledgeable about the issues and trends affecting leadership rewards. All Committee members may not exhibit every one of the skills in the ideal committee profile. However, the Committee should be staffed with individuals who possess complementary skills. The ultimate objective is to create an ideal profile in aggregate.
• Identify the key decision areas for which the compensation committee is responsible and the level of decision accountability vis-à-vis other parties (e.g., entire board, senior management, other committees). Create a decision rights matrix that summarizes who is responsible for what decisions. Exhibit 7 illustrates a compensation committee decision rights matrix.

• Provide education/development opportunities to compensation committee members, including useful tools and relevant, timely articles and information to support decision-making. Today’s executive compensation environment is evolving, and the compensation committee needs to be kept up to speed on the most recent leadership rewards developments and their impact on the company’s practices and programs.
• Call on the company’s human resource capabilities to provide guidance and/or support to the compensation committee. The HR department is an often overlooked, yet valuable and cost-effective, resource for providing information related to executive rewards.
• Provide the Committee with full information about the complete impact of executive pay decisions as well as a periodic “report card” on how the program is working. Allowing committee members to see the “all in” impact of disparate executive pay decisions will help foster better discussion about the implications of any given approach. In addition, sharing the results of the three pay for performance tests on a regular basis will provide a report card to help the committee understand how the program is working in practice and where tweaks might need to be made.

Final Thoughts
While it may be difficult to create fully unassailable executive pay, companies need to periodically kick the tires of their program to make sure it’s delivering the right value, moving the business forward and attracting and retaining the right talent. When a company builds an unassailable foundation for executive pay, it should take credit for getting it right and promote the philosophy and plan design in the proxy statement. Let those who have an interest know that every effort is being made to pay for impact and results and balance the interests of the company, the shareholders and the executives.

1 A correlation is a number between –1 and +1 that indicates the strength of a relationship between two variables. A +1 correlation indicates a perfect correlation (ideal for pay programs), and a –1 indicates a perfect inverse correlation.
2 Base salary plus annual incentives.
3 Base salary plus annual incentives plus gain on long-term incentives.
4 Source: 2005 in-progress study of value sharing rates being conducted by Sibson Consulting and Equilar, Inc.
5 Source: 2005 in-progress study of value sharing rates being conducted by Sibson Consulting and Equilar, Inc.