Compensation committees should add a key item to their summer agendas: reviewing the structure of long-term incentive plans for senior executives.
That’s the advice of Bruce Ellig, who worked at pharmaceutical giant Pfizer Inc. from 1960 to 1996, spending the final 12 years as corporate vice president and head of worldwide human resources.
Ellig and other executive-compensation experts say it’s time for companies to revise the design of long-term incentives and peer groups used for comparisons.
Companies should base senior executives’ long-term bonuses on relative performance goals — comparing company performance to a predetermined peer group — instead of internally setting goals such as revenue growth, Ellig said. The data is available in the financial statements of the peer companies as long as they’re publicly traded, he said.
“By tying it into competitor performance, you get away from executives designing their own payout plans,” said Ellig, author of the recently updated “The Complete Guide to Executive Compensation.” “Let’s take it out of the hands of the CEO or top management and let’s go to the marketplace.”
Ellig advocates using a two-dimensional payout schedule based on earnings per share and total shareholder return, which is stock price appreciation plus the reinvestment of dividends over a defined period.
In this approach, a company calculates its total shareholder return, and for each company in its peer group it pays an award based on its rank relative to its peer group. The upper-right-hand corner would be the top payout. The bottom-left-hand corner would be zero payout.
The annual bonus should remain based on achieving internally developed targets such as earnings goals, Ellig said.
He bases his idea on a Pfizer plan during his tenure.
“All of the discussions got down to stock price and the impact on earnings,” Ellig said. “You didn’t have 30 items you had to look at. You had two items. We were always looking at where are we vis-à-vis our peer groups.”
Long-term incentives are the largest component of the typical executive compensation package, said David Wrangham, a Denver-based consultant with HR consultancy Towers Watson & Co.
In recent years, they have gained the attention of proxy adviser firms such as Institutional Shareholder Services Inc.
For the first time, by mid-2013 total shareholder return was the most prevalent performance metric for long-term incentives at the 250 largest U.S. companies, according to a report by Frederic W. Cook & Co. Its increased use likely reflects the importance given to the measure by proxy advisory firms.
Take Chevron Corp. Its board approved an incentive plan in January linked to the performance of oil industry peers. The board granted 50,000 performance shares to CEO John Watson that will result in a cash payout based on Chevron’s total stockholder return for a three-year period compared with total stockholder returns for a peer group that includes BP, ExxonMobil Corp. and Royal Dutch Shell.
In contrast, Los Angeles-based Boingo Wireless uses absolute measures. The Wi-Fi operator gave performance-restricted stock units in March to executive officers, with vesting based on annual revenue growth.
“Absolute goals are still far more common, but relative goals are gaining in popularity,” said Peter Lupo, managing director at pay consultants Pearl Meyer & Partners.
But the review shouldn’t end there, Lupo said. Companies also need to review their competitors.
Historically, compensation committees have looked at companies similar in size based on revenue. But Lupo said two other criteria are more important: business model and cycle.
Why? Take a company whose cycle involves peaks and valleys. If it peaks when companies in its peer group are in valleys, then its performance comparisons would be skewed.
“If you’re measuring performance against peers that do not behave the same way, then you may overstate or understate your relative performance,” Lupo said. “It could be very misleading. If your incentives are tied to relative performance, you could have a problem with payouts being too high or too low.”
A company also wants to make sure the firms in its peer group make money the same way as it does, such as an insurance company. If a reinsurance company includes property and casualty insurers in the peer group, the reinsurance company would want to take a closer look and see if their inclusion makes sense, Lupo said. They could perform differently.