Aligning Executive Pay With Company Performance

From an executive compensation perspective, boards have an important duty to pay executives appropriately in line with the underlying performance of the company. The age-old issue of paying for performance seems more complex than ever—and more highly scrutinized!

The design of short-term and long-term incentive programs needs to align with a company’s business strategy, and contain goals that have sufficient stretch, to incent value creation without creating an excessive risk scenario. These programs also need to focus on the most appropriate financial measures to properly align with desired company performance. In deciding how performance should be defined, should these incentive plan goals be based upon growth or return measures, using GAAP, or materially adjusted non-GAAP figures? Or should setting pre-established goals be avoided entirely by using stock price growth, plus dividends, (i.e., Total Shareholder Return, or TSR) either on an absolute or relative basis?

The types of long-term incentives now available also provide a range of possible outcomes and incentive focus. Should stock-based incentives reward only for share price appreciation (like a stock option), or provide a retention aspect by providing the initial underlying stock value plus appreciation (like restricted stock), or should equity grants be earned only if pre-established financial goals are achieved over a specified performance period? And if performance goals are to be used in the long-term incentive plan, how should they relate to, or be different from, the goals used in the short-term incentive plan?

The probability of your pre-established incentive programs being fully aligned with future company performance on a consistent basis is always at risk due to the wide range of unexpected events, which can impact an otherwise well thought out design and goal-setting process. External market scrutiny comes in after the fact, where the conclusions are known and opinions are easy.

Thus, boards need to spend the time, and conduct the proper amount of diligence, in designing executive compensation incentive programs and in selecting and establishing the right financial goals and targets to increase the odds that the pay for performance connection is consistently valid and properly aligned.