Pay for performance or pay for results? The challenge for boards: managing the balance between management impact and shareholder return.

• Author: Borneman, John
• Position: COMPENSATION MATTERS

For the last few decades, the focus of executive compensation has been to align pay with performance. Nearly every company includes "pay for performance" as a core principle of the executive compensation design, and compensation committees consider managing the pay for performance relationship as one of their primary governance responsibilities.

But what exactly does "pay for performance" mean? For most companies, pay for performance has traditionally meant the following: identify key business metrics; set challenging but attainable performance objectives; and deliver pay for achieving those objectives.

In concept, this is a perfectly rational approach to executive pay. If the selected performance metrics align with the drivers of long-term value creation, then ultimately management's pay will align with the interests of shareholders. Deliver a large portion of the pay in stock to further align the interests of executives with shareholders, and everybody wins. What could be wrong with that?

By itself, nothing is wrong, except that more and more often public company shareholders are telling boards, "Pay for performance is not good enough. We want pay for results!" From a shareholder's perspective, good goal setting and performance measurement do not matter if they are losing money. They don't see the value in delivering millions of dollars of pay to top executives for achieving business objectives that do not result in share price performance.

Investors are responding to this dissatisfaction. In the most obvious cases, when pay and shareholder performance become extremely disconnected, shareholders express their dissatisfaction through a negative "say on pay" vote. In a recent study of say on pay results, we found that companies performing in the bottom quartile of shareholder returns were four times more likely to fail say on pay than their better performing peers.

But we are also seeing other evidence of shareholder focus on executive pay: scrutiny of incentive plan goal setting is rising, activist investors are taking more interest in executive pay, and, of course, total shareholder return has become the most frequently used metric for long-term incentives. This is not just a reaction to the policies of proxy advisors --shareholders have expressed a strong preference for pay programs that more directly align rewards for...