Executive pay.

• Author: Ericson, Richard

Over the past few years, pay at the top of the house has been heavily recomposed. Stock options have been cut way back, offset by other forms of long-term incentives (LTI) like restricted stock and performance-based plans. Most of pay is now goal-contingent. "Relative TSR"--total shareholder return compared to peers--is now the most common LTI metric. Change-in-control payments have been pruned way back. Historically, stock market conditions and regulatoiy changes were the big drivers of executive pay trends. But in the past few years, ISS (Institutional Shareholder Services) and other proxy advisors have taken the wheel. Pay complexity is at a bewildering new peak, so participant discounting--the "wastage" of executive pay--is high as well.

We see this not merely as an era of quirky, rapid change nor just one of heightened complexity. It is also an era of widespread, deep misunderstandings and strange decision-making. Today, large swaths of the landscape appear to be ruled by innumeracy or delusion - by myth. Myths are making pay policy less effective, efficient and compelling. To make progress, step one is to expose the myths.

MYTH #1 FINANCIAL PERFORMANCE TARGETS ARE TOO HARD TO SET IN AN LTI CONTEXT

ISS is often blamed for the market "mandate" to add performance conditions to long-term incentive grants. But this admonition has been around a long time. Corporate interest groups and watchdogs have been demanding this sort of accountability for years (a range of opinions of governance advocates are summarized in The New Standards by Richard N. Ericson).

Shortcuts are in demand, for LTI target-setting. Relative TSR is a popular one--peer median TSR often can act as target. So are one-year performance periods, threshold-only or "gate" style goals, and trailing averages of annually-set bonus goals. These methods often are used for good but temporary reasons. However, none is faithful to the key idea of performance-based LTI, to the basic governance contract in which executives make long-term business performance commitments in exchange for potential long-term wealth. Companies have something to gain from true goal-based LTI. Concentrating pay-outs on tangible goals and long timeframes as it does, it can create stronger, more explicit linkages between decisions, long-term results, value creation and reward. Many companies should not be going to so much trouble to avoid setting long-term goals for LTI. Goals are not actually that hard to set and run. Here's what we mean:

There are plenty of sources of help. Sector perfounance nouns are worth a close look, applying balanced and complete metrics and focusing on persistent trends. Stock analyst forecasts are worth a look, though the user must be on guard for sellside bias. Capitalization multiples, too, can indicate high or low future earnings growth expectations (or higher or lower risk or free cash flow).

The LTI plan structure itself can be helpful as well, to ensure payouts align with economic performance over time. New goals are set for every cycle so there are entry points for any needed course corrections. Variable LTI expense accruals tend to reduce payout variances too (example later). Adjustments for big events like M & A can tame their volatile effects while preserving accountability. Long-term gains are earned across a series of multi-year grants, with heavy averaging effects that continually extend the timeframe. Most performance-based LTI plans are stated in shares, so the share price acts as arbiter of earnings quality. No one gets a "Mulligan," but there are plenty of ways to manage targeting variances and keep outcomes proper. Uncertainty per se does not make it harder to set workable goals. Normally, it just requires a wider margin of error--that is, wider performance ranges. Goals themselves can be set up to work flexibly and adaptively over time, making plans responsive to business conditions as they play out. Most companies simply use the business plan as a quarry for performance goals. "Sandbagging" is a concern here, but one often offset by the chance of optimistic bias.

Here's the key thing about LT1 plans: you do not pay the awards out until the period is over and you know what happened. This creates tolerances much wider than in other types of forecasting. LTJ pay is meant to vary across a broad central range of likely results.

MYTH #2 WE DO CONVENTIONAL PAY BENCHMARKING, SO OUR PAY IS COMPETITIVE

Traditional methods do not assure proper benchmarking for competitive pay. Benchmarking means comparing the complex bundle of claims issued by your company with those issued by peer companies. We encounter issues all the time. Examples:

Valuation methods can distort granting. Relative TSR shares, for example, tend to be valued at levels roughly 25% higher than a comparable grant of traditional performance shares (that is, ones based on pre-set financial goals, not on relative TSR). A traditional performance share grant with an expected payout of...