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Performance Culture Starts in the Boss’ Office

In adopting pay for performance, firms that fail to first hold the CEO accountable risk losing credibility with their employees.

April 28, 2006
As companies get serious about tying employee pay with performance, many are starting at the top.

   Last year, 30 out of 100 major U.S. companies based a portion of stock granted to CEOs on performance targets, up from 23 in 2004 and 17 in 2003, Mercer Human Resource Consulting reports. Companies that are trying to create a pay-for-performance culture have to begin with their chief executive officers or they’ll face the wrath of the rank and file, says Diane Gerard, a vice president at Aon Consulting.

   "If employees feel they are being treated differently than their CEOs, they are going to complain bloody murder," she says.

   This is a big issue for employers that have terminated their companywide stock incentive plans, because those employees often resent the CEO who continues to get options when they do not, says Ira Kay, global director of executive compensation consulting at Watson Wyatt Worldwide.

   These employees will pay more attention to how CEOs are paid next year, when the Securities and Exchange Commission rule requiring companies to disclose what metrics they use to align executive pay with performance takes effect, says Mark Reilly, a partner at 3C-Compensation Consulting Consortium in Chicago.

   In the past, companies have just handed executives stock option grants. But the recent accounting rule change that requires companies to expense those options in their financial statements has prompted many companies to move away from these compensation tools. That trend, along with increasing shareholder criticism that options do not truly align executive pay with performance, means that companies are setting more specific performance metrics, says Doug Friske, managing principal at Towers Perrin.

   In many cases, companies are replacing stock options grants with performance-based restricted stock. By doing this, companies provide a timeline with their performance targets. If the company reaches its targets early, the CEO receives shares early, but they may vest at a later date.

   For example, the company could advise the CEO that if the firm reaches a certain performance target within the next 12 months and the CEO stays for two more years, the executive will receive 1,000 shares of stock. But if the company does not meet its goal, the CEO will only receive 500 shares of stock. "More than half of large companies are doing this today, up from one-third two years ago," Kay says.

   Some companies are taking a more aggressive stance and adding forfeiture clauses to their performance targets. Under this arrangement, the CEO would not receive equity grants unless the company meets certain performance goals. Thirty-three percent of large U.S. companies are using this approach, says Jamie McGough, a principal at Hewitt Associates. This is going to be the more prevalent practice for companies from now on, he says.

   The challenge for employers is maintaining a balance between setting the CEO’s pay for performance and making sure that the goals to which pay is tied are reasonable, Kay says. With CEO turnover rising, turnover is an issue that every company has to take seriously.

   "If you make the carrot too hard to bite, there could be unintended consequences," he says.

 

CEO COMPENSATION TRENDS

CEO compensation changes in 2005 were modest, according to Mercer Human Resource Consulting.
Pay and corporate performances were "closely aligned."
PERCENTAGE CHANGE FROM PREVIOUS YEAR
YearCEO annual compensation (salary and bonus)Exempt employee annual compensationCorporate profitsAnnual CPI
19965.2%4.0%11.0%3.0%
199711.74.28.92.3
19985.24.25.01.6
199911.04.215.12.2
200010.04.28.93.4
2001-2.84.4-17.82.8
200210.03.814.81.6
20037.23.619.22.3
200414.53.423.02.7
20057.13.613.02.4
Source: Mercer Hunan Resource Consulting

Workforce Management, April 24, 2006, p. 33 -- Subscribe Now!