Pay for performance: rethink your metrics: companies that outperform their peers approach pay design differently.

• Author: Friske, Doug
• Position: COMPETITIVE EDGE

RECENT TOWERS WATSON research confirms what many observers feared would be an outcome of say on pay and growing advisor influence: greater conformity in pay program design among U.S. public companies. In particular, U.S. companies continue to shift more of the long-term incentive mix toward grants with explicit performance conditions and increasingly use total shareholder return (TSR) as a performance measure.

These trends reflect an appropriate emphasis on "pay for performance" in designing executive compensation programs. But, with the growing focus on TSR, companies may run the risk of overpaying for past performance and market-based fluctuations in share price, rather than rewarding executives for sustainable company performance and differentiated value creation.

While market trends and proxy advisor views are important, it is critical for compensation committees to resist the urge to default to a single, simplistic measure of performance. Instead, they need to take a more holistic view to ensure that their pay programs do, in fact, drive future performance by focusing executives on the right strategic priorities. In addition to paying for performance, boards also need to remember to pay for strategy.

Race to the middle

Companies' growing use of TSR as a performance metric represents a race to the middle in incentive plan design. Towers Watson's recent analysis of proxies filed by 270 S&P 1500 companies as of the end of March shows just how widespread the use of TSR has become in the say-on-pay era. While a small number of companies use TSR as either a circuit breaker (14%) or a modifier (17%) in their long-term performance plans, the vast majority (82%) use it to measure executive performance. What's more, over 60% of these companies use it as the only performance measure.

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The advantages of TSR are its transparency, simplicity, and strong alignment with shareholders over time. And since proxy advisor Institutional Shareholder Services uses it as a key factor in assessing pay-for-performance alignment, it's probably a safe choice for companies seeking positive say-on-pay voting recommendations. However, TSR offers at best a weak "line of sight" in terms of motivating executives, and the outcome of TSR-focused incentives is often driven more by when TSR is measured than by TSR itself.

Given the imperfect correlation between TSR and corporate operating and financial performance, it's...