Setting executive pay in the 'hard spot'; The big challenge: when financial performance is strong but the stock price has not yet responded to reward shareholders. What should the compensation committee do in this scenario?

• Author: Kay, Ira T.
• Position: EXECUTIVE COMPENSATION

BEYOND THE SWEEPING MYTHOLOGY that now surrounds executive compensation, the reality is that boards at the vast majority of U.S. companies appropriately reward CEOs who perform well and punish those who do not with comparatively lower compensation or termination. Our extensive research, conducted over two decades, shows that this performance-driven approach to executive pay has played a major role in the success of the U.S. corporate model, which has generated enormous wealth for shareholders, millions of jobs, and exceptional economic growth.

Despite empirical support for the effectiveness of the pay-for-performance model, some shareholders and executive pay critics remain skeptical. They pose several arguments, but one of the most strident, popular, and seemingly persuasive is that companies still pay too much for executive "failure."

Two examples of "pay for failure" are commonly cited and used to undercut the efficacy of the model itself. The first involves the substantial severance and accelerated stock incentive value that some executives receive at termination, even when the company performed poorly. We agree that these incidents of "pay for failure" must be addressed very carefully by boards and management.

In fact, many companies are now revisiting their severance plans, spurred on in part by the new SEC disclosure rules, and changes are already occurring. For example, some companies are reducing cash severance payments and eliminating change-in-control-related excise tax gross-ups.

The second example of "pay for failure" cited by the critics focuses on large cash and stock payments made to active executives when the stock price performance is mediocre. This example, which might be called "pay for disappointment," usually unfolds in one of two scenarios. In the first, a company experiences both poor operating/financial performance and poor stock price performance. In the second, the company experiences strong operating/financial performance, but that performance has not yet generated strong stock price performance. This second scenario is the "hard spot" in setting executive pay.

Understanding the challenge

To evaluate the efficacy of the pay-for-performance model and understand the challenges that compensation committees face, we must make a clear distinction between pay opportunity and realizable pay. Pay opportunity is what the compensation committee actually controls and sets, namely target annual bonus opportunities and the fair (economic) value of new long-term incentive awards, including stock options, time-vested restricted stock, and performance shares. The compensation committee also approves the financial performance goals, typically after a review and discussion of management recommendations.

In contrast to pay opportunity, realizable pay is the actual cash bonus paid, the in-the-money value of stock options, the real value of restricted stock, plus the payout of performance plans. Realizable pay is therefore ultimately determined by the actual financial performance of the company plus stock price appreciation. The theory is that if both financial performance and stock price appreciation are weak, realizable pay will be very low. If realizable pay is not very low, the compensation...