When considering compensation plan design, boards would be wise to remember the adage, “be careful what you wish for.” Incentive compensation is tied to a virtually endless list of goals: attracting top talent, increasing revenue, improving productivity, driving change, increasing diversity, meeting safety goals, etc. The compensation committee's decision on which goals to measure and reward can be a powerful lever that can move the entire organization toward the right goals or sidetrack it. Just ask Wells Fargo.
While setting sales targets that unintentionally backfire is an extreme example of an incentive gone wrong, there are many potential pitfalls in tying pay to financial and nonfinancial performance metrics, agreed directors who gathered at a CBM roundtable on compensation practices, held in partnership with Semler Brossy. “One of the things we've found challenging is structuring compensation in a way that attracts and retains the best executives and aligns them with the organization's goals while isolating them from luck and factors outside their control,” said Katherine Haley, a director at Concentrix and Old National Bancorp. “For example, in banks, changes in interest rates can make a big difference in financial performance.”
Semler Brossy Managing Director Blair Jones added that some companies, across industries, that in recent years have succumbed to outside pressure to include ESG metrics in their incentive compensation programs are now beginning to question their haste. “ESG measures and incentive plans are changing rapidly, with penetration rates rising from 50% to 72% in recent years,” he said. “If you think of compensation as a tool to motivate people, you have to wonder if it's really leading to improved performance. So, from a trend perspective, it's a good time for companies to take a step back and ask themselves, 'What are we really trying to measure and reward in our compensation plans?' Compensation program discussions can be a case of the dog wagging the tail. Asking the right questions can actually make the strategy much clearer.”
But the process requires patience. It takes time to determine what to measure, how to measure it, and how best to communicate the change to executives and investors, as well as to implement the metrics into an already complex compensation program. For example, Kathleen Ligocki, who serves on the board of directors of Lear, PPG, and Carpenter Technology, reports that she faced challenges in incorporating innovation metrics into her company's incentive compensation program. “We wanted to focus on product innovation and instill that in a very global company with 250,000 employees,” she recalls. “It took us a year and a half to come up with a structure that actually made sense.”
At the same time, several directors noted that a thoughtful approach to compensation practices can be effective in encouraging desired behaviors and shaping culture. “I truly believe that in the long run, culture determines the success of a company,” said Caroline Chan, a director at EnerSys. “And that’s where non-financial metrics come in. And they need to have some persuasive power in terms of what you’re driving.”
Ana Dutra, who sits on the boards of directors for Pembina Pipeline, Car Parts, Amyris and LifeSpace, agreed, noting that there's widespread recognition of the role pay practices play in underscoring an organization's priorities. “I've seen a renewed focus on compensation philosophy, which for a while was about 'what are we going to do in the short term,'” she said. “Now I'm seeing a shift toward 'listen, if we get our compensation philosophy solid, everything else becomes easier.'”
Identifying essentials
“Understanding the company, the business environment and the economic climate is paramount when considering compensation design,” added Colleen Brown, former CEO of Fisher Communications and a board member at True Blue and Big 5 Sporting Goods, noting that traditional metrics can be problematic for companies when revenue is easily influenced by outside factors. At the media companies she led, political advertising could make up 10% to 20% of revenue in election years, making traditional annual performance metrics problematic.
“You can't give a lot of money to someone for political spending, so you have to think in two-year cycles,” she said, explaining that to address concerns, the company measured its success in retaining and growing its business against its peers. “So that was a hard cliff on political spending.” [advertising]So, while they don't get a windfall, they do get an opportunity to make up for it the following year based on how well they retain advertisers against their competitors.”
High turnover in an industry, mergers and leadership transitions also often necessitate a closer look at compensation practices. CenterPoint Energy director Raquel Lewis said a CEO transition prompted the company to change its incentive compensation plan to encourage key executives to stay on through the transition. “We have a young CEO and a young, talented executive team, and we know this transition is an opportunity for them to become a real target for other companies,” she explained. “So we're trying to pay strategically to ensure that investing in our company is first and foremost above other options and opportunities.”
Trends also influence the changes compensation committees consider, says Paula Cholmondeley, CEO of Sorrell Group and a director of both Telex and Bank of the Ozarks. She notes that in recent years, there has been a move away from broad distribution of equity incentives. “My bank's board of directors has been cautious about how far down the organisation we distribute equity,” she explains. “In conversations with senior management, we've found that many junior and middle managers don't know how to properly value the equity that they're being given.”
But she noted that approaches vary depending on the difficulty of recruiting and retaining talent and industry-specific factors. “In biotech, we're seeing a trend towards awarding more equity in the hiring process and tying it to achieving results. For example, if you're hiring a chief technology officer, they may get a specific equity boost if they agree to deliver certain results. So you give them more equity, but not just for joining the company, but for delivering certain results within the first two to three years of being there.”
Similarly, companies undergoing major transformation often seek to introduce incentives to drive desired change. Wendy Lane, who has served on 13 boards, including four currently, spoke of her experience at a company that introduced three-year cliff vests and significant upsides in its long-term incentives. [for] It outperformed its peers in earnings per share and total shareholder return. “The stock price tripled in two and a half years,” she says. “It was a dramatic change.”
At another company, at the urging of shareholders, the board of directors replaced adjusted EBITDA with cash flow and focused on cost efficiency and growth. “Initially, like many startups, we focused on revenue growth and excluded certain software development and stock-based compensation expenses from our EBITDA metric,” Lane explains. “As a more mature company, we needed a new approach that focused on the economic bottom line, not just revenue. This change led to positive cash flow and was met with a positive shareholder response.”
Because pay practices often come under intense scrutiny, it is increasingly important to be able to explain the clear rationale behind whatever compensation standards are adopted. Compensation committees considering potentially controversial standards or concepts should vet them carefully and plan to provide comprehensive explanations to stakeholders, roundtable participants agreed.
“Your best bet is to hire an objective third-party firm to review and provide input on potential changes,” Dutra suggests. “If you introduce a new metric or concept that doesn't have a clear benefit to the CEO and executive team, you're going to meet resistance. So explaining why it makes sense, illustrating trends, showing what your peer group is doing, and how key stakeholder groups (proxy advisors, regulators, lawmakers, employees, customers) might respond will go a long way.”
“One good exercise is to look at analyst conference calls and earnings call notes and see what concerns are coming up,” Jones added. “Another is to look internally and ask, 'What are we communicating strategically to both external investors and internal employees, and are we taking steps to align with all of that?' That's a really useful exercise for boards because if there are holes or analysts point out that you're lagging behind your competitors, it gives you an area to focus on and can foster a really good discussion about how to move forward.”
The disclosure dilemma
When implementing changes, compensation committees should also consider their communications strategy. “Don't just disclose a long list of metrics,” Jones advises. “Highlight why you're doing it. One of the concerns investors have is that you're just introducing a vehicle that gives them an opportunity to revise the dividend if the financials don't meet expectations. So you want to say, 'This is an important initiative for the company, and we're not just talking about it, we're walking the walk.'”
Companies that change incentive programs due to retention concerns may need to proactively engage with investors to justify their decisions. When CenterPoint Energy adjusted its compensation program to incentivize its new CEO and ensure key team members stayed on through the transition, Lewis explains, the company made keeping stakeholders informed a top priority. “Strategically structuring our compensation plan, keeping analysts in the loop to protect against criticism, and making a transition that fairly and appropriately compensated our new CEO has been a hectic past few years for us,” she reports. “So the need to ensure the industry and analysts understand our decisions and give us enough time to transition is something I completely empathize with. There's a lot to manage, and compensation was certainly key to our strategy.”
Boards should also resist the urge to review compensation frequently. “You have to keep in mind that you can't change your compensation plan every year without looking like you know what you're doing. So rather than saying revenue this year and cost efficiency next year, it's important to set fundamental goals to aim for and stick to them. Investors change their focus from revenue growth to profit growth and back, and that can be hard to adjust to.”
Finally, boards should be careful not to be overly aggressive in changing compensation practices or introducing new incentives as circumstances change. If not carefully considered, incentives based on cash flow metrics or goals like expanding into new divisions, hitting revenue targets or cutting costs can lead to poor decision-making. “We've seen unintended consequences where incentives were based on hitting revenue targets and revenue was recognized when the product left the factory or warehouse,” Dutra notes. “It could be a material weakness or inventory sitting in a distribution center somewhere. So when you're rewarding for very specific goals or creating a retention strategy, you always need to think about potential unintended consequences.”
“As directors, you have to be the most skeptical about what could go wrong,” Jones summarized. “As directors, you have to think about what could go wrong if you did this, because compensation works. It works for good, but it also works for bad.”