In setting exec pay, face the facts: many compensation committees lose their way with wrongheaded responses to the factual circumstances.

• Author: Ellig, Bruce R.
• Position: COMPETITIVE EDGE

STOCK PLANS were created in the 19th century to make professional managers think like owners. Acquired stock was not to be sold until leaving the company, preferably at retirement age. But today many boards and their compensation committees have lost their way. They permit executives to cash out stock options and stock awards, thereby breaking the link with the shareholders. And to make matters worse, some companies have approved incentive plans that pay out lavishly in the presence of major risks, thereby threatening the sustainability of the company.

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In structuring executive pay, the board and its compensation committee should focus on appropriate actions given the facts. Here are 12 such factual considerations:

1. Fact: The annual bonus is more subject to fluctuation than the salary, which is rarely reduced and only modestly increased.

   Action: Place sufficient emphasis on salary to moderate the temptation to inappropriately maximize the bonus in high risk situations.

2. Fact: Qualitative as well as quantitative goals will continue to be important in determining executive pay, especially short-term incentive.

   Action: Since qualitative performance will not meet the quantitative performance requirements of Section 162(m), negative discretion plans (which set a fund based on a formula which is used to pay out subjective awards) will grow in usage.

3. Fact: Heavy emphasis on the annual incentive plan will focus the executive's attention on the short-term rather than the long-term results.

   Action: The long-term incentives have to be at least equal, and preferably greater, than the short-term plan to balance the executive motivation.

4. Fact: Payout targets proposed by management will always be suspect because they are the basis of payments to management.

   Action: Incentives, especially long-term, should be based on performance relative to peer companies, not absolute targets proposed by management (although approved by the board and its compensation committee).

5. Fact: As the long-term incentive performance period nears its end it can be expected the participant will attempt to maximize performance and resulting payout.

   Action: A new multi year long-term incentive plan should begin each year because the overlap makes it difficult to "game" the payout. With an annual startup of a five-year plan, any one year is only one-fifth of the total payout of five different plans.

6. Fact: Executives share shareholder interest in stock...