Motivating your executives: which incentives work best?

In February 2014, when Satya Nadella became Microsoft’s chief executive, he received one-time long-term performance stock awards worth an estimated value of nearly $80 million to be granted in five years. Although the value of the awards made headlines, Nadella was really just a high-profile beneficiary of one of the hottest trends in executive compensation incentives: performance share units, or a promise of stock to be paid out once certain criteria are met.

John Seethoff, vice president and deputy general counsel for corporate at Microsoft, points out that this year the tech giant’s board revamped incentives for all executives to make their equity awards based on the performance of the whole organization, not just individual business units. ‘These [performance share awards] are based on company-wide performance, which synchronizes with the CEO’s approach, challenging everyone to work together across the company and break down silos,’ says Seethoff.

He says the beauty of performance share units is that they can be very carefully aligned with specific corporate goals. In Microsoft’s case, the chosen metrics might be the number of active devices using Windows 10 by the end of fiscal 2018.

One of the abiding challenges of providing the right long-term incentives is that success won’t be seen for quite some time – and the reasons for success may never be proven. ‘With respect to executives, when you’re paying a certain amount of money for those people, you want to know how to measure whether or not they’re running the company effectively,’ says Mark Borges, principal at Compensia.

‘Investors want to know that stock shares are only being earned to the extent that they’re producing tangible results, which presumably will be reflected in the growth of the company’s stock price over time. But there’s no magic bullet to ensure that if you do X, it will translate into stock price growth,’ he adds.

The rise of performance share units

Incentives are of interest because they often dramatically overshadow base salary. In ‘CEO and executive compensation practices’, a 2015 Conference Board report, base salary paid in cash represented 23.8 percent of the total amount of a CEO’s realized pay in the median Russell 3000 company and as little as 11.6 percent in the median S&P 500 company.

Instead of granting stock options, many companies are awarding performance share units. ‘If companies had their druthers, they’d go on giving out stock options,’ says Borges. He explains that the push for performance share units comes from investors and proxy advisers that strongly believe incentives should be tied to very clear objectives being achieved, not just the vicissitudes of the market.

Because each company designs its own performance share units, it can reward executives on whatever metrics are deemed most meaningful. ‘You can set up a scoreboard any way you want, but it’s typical to use total shareholder return (TSR),’ says John Martini, chairman of the corporate and transactional advisory group at Reed Smith. While some have questioned the use of TSR as a performance measure, the Conference Board finds that it continues to be consistently used in the long-term incentive plans of 54 percent of companies.

Although performance share units are usually calibrated so that stock is at risk if an executive falls into the bottom ranges of a particular metric, they also have a mechanism for highly successful chief executives to ‘get really rich,’ notes Martini. As examples, he cites executives at companies such as Endo International and Valeant Pharmaceuticals, both of which have been on acquisition runs.

Robin Ferracone, CEO of Farient Advisors, says that while stock options dominated the incentives landscape in the 1990s, ‘we’re now seeing a long march toward performance shares.’ She attributes some of the popularity of these vehicles to say-on-pay votes, in which investors have clearly expressed their preference for executive pay that is tied to corporate performance. She estimates that 70 percent of the top 1,800 public companies in the US today have performance share plans, up from 65 percent in 2012, when Farient last studied the issue.

Borges also points out that performance shares are becoming more common because they can take relative performance into consideration. ‘Instead of evaluating executives on an absolute basis, this essentially links pay to how well management is doing in both good times and bad, relative to competitors,’ he observes.

A sector-specific option?

Peter Lupo, managing director at Pearl Meyer & Partners, notes that stock options also continue to be popular – and in some sectors more than others. Companies new to the public markets, especially those in industries like IT and life sciences, where results are very volatile, often prefer stock options ‘because it’s so difficult to set goals and select metrics,’ Lupo explains. He also notes that companies with diversified lines of business typically experience difficulties setting performance criteria and so may default to stock options.

The Conference Board finds that growth companies in the IT, materials and healthcare sectors are subgroups that continue to rely extensively on stock options. Within the Russell 3000, for instance, 34.3 percent of the total value of the CEO compensation package in the average healthcare firm is represented by stock options, compared with 2.9 percent and 4.1 percent, respectively, of the average utilities and financial sector companies.

What’s more, among extremely well-compensated chief executives, stock options are often a part of the mix. At Discovery Communications, for instance, CEO David Zaslav earned $50.5 million in stock options in 2014, more than twice the $22.5 million he earned in 2013.

On a related note, the Conference Board finds companies ‘tend to prefer a balanced approach’ to long-term incentives, so it’s increasingly common to see companies combine two or more types of long-term incentives. In fact, the Conference Board says that since 2011, approximately 30 percent of firms have consistently used all three types of long-term incentive awards: appreciation awards (including stock options), performance-based awards and restricted stock.

Tyco is a good example of this trend. Judy Reinsdorf, Tyco’s executive vice president and general counsel, explains that her firm’s long-term incentives for executives comprise three parts. The first, traditional restricted shares (for 20 percent of the equity grant), represent a ‘pure retention’ tool because the shares vest in four years. The remaining 80 percent of the long-term award is divided equally between stock options and performance share units.

Choosing the right metrics

Generally speaking, performance share units require more forethought because a company has to select the appropriate metrics to motivate executives and satisfy investors. ‘Most companies say they want to define metrics in a way that’s aggressive enough to incentivize people in the right way to grow,’ says Reinsdorf. ‘But it shouldn’t be a layup.’

Tyco uses TSR as its benchmark and has organized the payout plan according to a fairly typical scheme. When performance rises above a certain threshold compared with Tyco’s peer group, the company multiplies the stock units to be paid out by a predetermined amount, Reinsdorf explains. Similarly, when performance measured by TSR is less than average – in Tyco’s case, 40 percent below that of its peer group – the performance shares to be paid out to executives decrease by 25 percent.

Deciding upon an appropriate peer group is another tricky question. Reinsdorf notes that Tyco’s compensation peer group is slightly different from its industry sector. ‘A company like Tyco will recruit from Honeywell, which is in our investor peer group, but we may also recruit from [Johnson & Johnson], for example. There’s not always a complete match between your investor peer group and your compensation peer group,’ she explains.

Microsoft was questioned over its decision to tie executives’ pay to the performance of the S&P 500, Seethoff says. ‘We got feedback from some investors that thought a more targeted, industry-specific benchmark would be appropriate,’ he notes. ‘We’ll continue to weigh that as a consideration as we move the program forward.’

Next, board compensation committees need to consider how many years should constitute ‘long term’ when they’re establishing incentives. Although Nadella’s one-time award will vest after five years, other Microsoft executives’ long-term incentives are paid out after three years, which is generally considered the industry standard. By their very nature, long-term incentives are designed to counteract the problems of executives’ making short-term decisions to meet annual goals, but executives must still meet metrics by some stated deadline. More often these days companies are encouraging a three-year horizon, says Martini. Issuing awards on a rolling basis helps, but doesn’t completely ameliorate the problem, he adds.

In theory, Martini endorses the idea of redefining long term as five to seven years, but he acknowledges that this probably won’t happen. He points out that ‘investors are very focused on short-term horizons’ so they don’t push for protracted payout periods. ‘While a CEO may think [he or she will] be out of a job in three years, chances are people investing in that company also feel that way,’ he says.

Tyco is one company that has set a slightly longer time horizon for performance shares. Because the firm considers long-term incentives a retention tool, it has settled on four years for paying out incentives, hoping to retain talent as long as possible, Reinsdorf says.

Bold decisions in an era of say on pay?

The spotlight on incentives has certainly put an end to many common abuses of the past. For instance, rarely today will a public company have tax gross-ups, according to the Conference Board report. Shareholders also continue to frown on certain incentive practices that commonly occur. Matthew Goforth, senior research analyst at Equilar, says shareholders ‘view unfavorably certain plan features, such as single-trigger change-in-control policies, plans that allow for sizable discretionary bonuses and plans that dilute shareholder value by transferring disproportionate ownership to executives.’

More subtle – and arguably more insidious – are corporate strategies that tend to result in higher checks at payout time. Will an executive be more likely to embark upon a merger knowing the combined entity will command a higher share price, and therefore more valuable stock options or performance share units? And is a CEO or CFO prone to approve a share buyback program because it will result in higher incentive pay for that executive?

Reinsdorf is convinced the scrutiny on compensation has led to some very positive outcomes. ‘It’s a really healthy development that the compensation consultants have a bigger seat at the table than they used to,’ she says. ‘Most companies are in the same pack regarding compensation: you don’t hear the war stories you did years ago when the Hank McKinnells of the world were getting [astronomical] payouts [a reference to the former Pfizer CEO who was paid $188 million upon stepping down in 2006]. That’s a thing of the past.’

Others argue that ISS and investor advocates have made long-term incentive awards a cookie-cutter exercise – and that this is worrisome. Martini maintains that while ISS likes to see long-term awards tied to a quantifiable benchmark, in a perfect world compensation committees would have the courage to vest executives who performed well even if market conditions meant they didn’t clear certain hurdles.

He also believes the increased influence of compensation consultants is inhibiting innovation. When proxy advisers or consultants present industry statistics for how the majority of companies are using restricted stock units, ‘boards are saying, We don’t want to be an outlier. We want to fall within what other companies are doing,’ Martini says. ‘These folks cherish their board roles. It’s no sweat off their backs, so why not come within ISS guidelines?’

Martini praises Berkshire Hathaway’s willingness to plan and incentivize for 15-year time horizons, rather than the three-year norm. ‘There are a few firms that have just pushed off ISS completely and said, We’re going to do what we think is right,’ he says.

Envisioning longer time horizons might make sense, but Lupo says companies whose pay plans deviate too far from common practices must be prepared to defend themselves vigorously. ‘If a company has been successful for decades and is highly respected, it’s easier to do something different,’ he says.

In the end, the amount of latitude a company has to take a more creative approach to executive compensation incentives may come down to the company’s reputation – and its overall financial performance. Lupo emphasizes that shareholders tend to probe deeply into long-term incentive plans only when performance is flagging. ‘If you’re a successful company, investors don’t care about how you design your compensation program to get results,’ he says. ‘They care about the results.’

Elizabeth Judd, a graduate of Yale and the University of Michigan, regularly writes about investor relaions and corporate governance

This article appeared in the winter 2015-2016 print issue of Corporate Secretary Magazine