Linking executive pay with performance

Choosing performance targets a challenge for exec team

As investor activism grows, the focus on corporate governance is becoming more acute. One major concern of institutional investors has been the link between executive pay and company performance.

As HR professionals, directors and compensation consultants become more familiar with the latest trends in pay and performance, many have also experienced the bumps.

Many companies have moved to long-term incentive plans that incorporate the use of real or phantom shares, also known as share units. Many of these equity-based plans vest at the end of three years based on a specific performance measure. However, a major issue associated with these plans is setting an appropriate performance objective three years in advance of the vesting date.

These performance objectives typically fall into one of two broad categories:

Relative performance targets: Corporate performance is measured against the performance of a group of peer companies, or perhaps a market index (such as the TSX composite index or one of its sub-indices) over the same period of time.

Absolute performance targets: Corporate performance (usually a financial measure) is measured against specific pre-determined targets.

Relative performance targets

One clear advantage of relative performance targets is strong relative performance can be a transparent and easily supportable justification for incentive plan payouts. A company that consistently outperforms its peers or “beats the market” may more easily make the claim its executives have earned their pay.

However, there are a number of complicating factors. For many large Canadian organizations, there are only a handful of other companies that compete in the same sector or have a similar business model. When these competitors are investigated in further detail, additional complications are often uncovered — either the scope of operations is different (geographically or based on product mix), the competitor has other operating divisions in unrelated sectors or financial data for the competitor is not available (it may be a subsidiary of a global multinational or a private company).

Similarly, the use of a market index (such as the TSX composite index) has its own pitfalls. Chief among these is the fact that macro-economic factors, which are outside of management’s control, may affect companies within the index quite differently. For instance, exchange rate fluctuations will have a very different impact on companies that export a large proportion of their goods or services, compared with those that do not.

While market indices have a good deal of intuitive appeal, especially if a company is contained in the index, care must be taken to assess whether the share price movement of the companies in the index are in fact correlated with the company’s share price movement. If not, it may only be good luck if equity awards vest at the end of the performance period even if performance has occurred. This is hardly the intention of any compensation committee.

Absolute performance targets

Absolute performance targets may also present their own challenges, both in the selection of performance criteria and in the setting of specific performance targets.

Some companies use share price growth as the performance measure. While this has the advantage of being aligned with shareholder interests, it presents the problem of determining how much growth is representative of good performance.

Share price is also subject to a variety of factors that may be outside of management’s direct control and will influence the difficulty of achieving a specific growth target. For instance, share price growth of eight per cent per year may be easy to achieve in a bull market (and, therefore, may only represent average performance on the part of management), while the same eight per cent may prove to be exceedingly difficult to achieve during an economic downturn.

Alternatively, an accounting-based measure, such as revenue growth, return on assets or any number of others, may be more directly controllable and, therefore, be seen as a better measure of performance.

Nevertheless, setting a specific target for any of these measures three years in advance can be a challenge for even the best management team as these measures can, and will, be affected by unanticipated external factors such as changes in the economy, the competitive landscape or the company’s own strategic direction.

Naturally, it is the executive team’s job to manage a company in the best interest of shareholders, regardless of the external environment. A top performing executive team is expected to anticipate changes in the marketplace and adjust strategy accordingly. As a result, fixed performance targets should be adjusted regularly.

The target-setting process should incorporate a thorough review and understanding of the competitive marketplace, the overall business environment, the company’s historical performance and its strategic objectives.

Gordon Frost is a principal in the Montreal human capital advisory services business at Mercer Human Resources Consulting. He can be reached at [email protected] or (514) 841-8949. Jane Craighead, is the vice-president, compensation and benefits at Alcan Inc. and a former senior consultant of executive compensation at Mercer Human Resources Consulting.

Latest stories