Exec Comp: The Ultimate Decider

Despite politicians and their debt problems pushing executive compensation off the business pages in recent weeks, there is still much debate bubbling away on the subject (including recent travails for Allied Irish Bank executives and Morgan Stanley employees). The range of views, from ill directed public opinion to the informed concerns of institutional investors, ensure exec comp remains a major challenge for large firms. This challenge will intensify in the next few months as boards of directors prepare for annual shareholder meetings and, in firms with U.S. operations, write public annual proxy statements detailing executive and board compensation.

Below the board level is now a large number of managers that have an interest in exec comp. This includes CFOs and heads of investor relations that need to constantly explain their firm’s compensation policies to investors, HR managers struggling to understand what effect the increased focus on risk and compensation is having on executive labor markets, and risk and audit professionals trying to understand the relationship between compensation and risk-taking behavior.

And it is the relationship between compensation and executive behavior that should underpin the approach to exec comp for everyone involved, from the chairman of the board to a journalist looking to dig up a story on the topic. The fundamental question we should all consider is:

“Will this executive compensation policy provide meaningful incentives for executives to create long-term shareholder wealth without incurring excessive risk.“

Senior executives may be talented and driven people but they still have similar motivations and desires to everyone else. Executive compensation will not transform them into risk-taking maniacs that play fast and loose with shareholders’ money nor will it turn them into perfect executives with 20/20 foresight. Rather, it should direct them to make informed trade-offs between competing and beneficial courses of action for the firm.

Exec Comp Research (Updated)

Exec comp design should therefore be less about motivation and more about calibration. Executives by and large don’t need incentives to help them work harder, they need rational policies that will help them make decisions that are good for the long-term health of their firms, and therefore good for their shareholders. We conducted research on exec comp at the beginning of this year by identifying the best performing firms in Europe and America and then comparing their exec comp policies with industry peers.

We recently updated this research to see how exec comp policies have changed in the past year. The most obvious change has been in the length of vesting periods. At the beginning of 2010 we noted that high performing firms tend to employ longer vesting periods than their counterparts (four years versus three years) but these have converged in the past year, with average vesting periods of non high-performers rising from 3.25 to 3.78 years.

Research on the Best Exec Comp Policies

The recent research can be summed up in six main points, and CFO Executive Board members can access the in-depth research in this webinar replay, as can Audit Director Roundtable members, Risk Integration Strategy Council members, Investor Relations Roundtable members, Controllers’ Leadership Roundtable members, FLEX-Elite members, and Corporate Strategy Board members.

1. Calibrating Compensation: The ideal exec comp plan is less about motivation than about providing guidance to executives as they navigate ambiguous decisions.
2. No Silver Bullets: Do not put faith in any one policy, such as mandatory share ownership, for aligning executive and investor incentives. Use a mixture of long-term metrics appropriate for your company.
3. Reasonable Ceilings: While setting stretch targets for annual variable cash compensation, high performers also impose a reasonable ceiling to discourage unchecked risk taking.
4. Longer Vesting: The executive labor market is increasingly converging on longer vesting periods of four or more years.
5. Balanced Equity Vehicles: Executives can over-optimize to any individual metric, including share price. Embrace some extra complexity to encourage a more three-dimensional view of firm performance.
6. Objective Performance Measures: Reduce the role of board discretion in your compensation; use more objective metrics, even for soft factors like customer satisfaction and employee engagement.

CEB clients should feel free to contact me if they want to discuss any of this.