by Fred Whittlesey
Principal Consultant
A recurring question about the effectiveness of equity compensation
centers around performance plans: Are
these truly performance incentives or
merely pay delivery vehicles that provide some comfort to shareholders that
equity compensation gains realized by executives will be aligned with some
indicator of corporate performance?
I was invited to present my perspective on this question this
month at the Employee
Share Ownership Centre’s 14th Global Employee Equity Forum in Davos. My session, titled “Performance
Plans in Current US Compensation Practice,” included my view that
never has the concept of “pay for performance” been more poorly designed and
operated than the current crop of performance equity plans in use in the US.
The audience, mostly from the UK and Europe, contributed
some great comments and questions; here are snippets of several sections of the
session:
1 – The Problem with Prevalence - The headlines about the
purported “prevalence” of performance plans misrepresents the true extent of
their use. While conferences are filled
with sessions touting performance plans as the “hottest topic” and “biggest
trend” the fact is that most companies are dabbling in attaching one or more
performance features to equity awards for a relatively small number of
executives to be able to “check the box” that “yes, we’re granting performance
equity.” True, but a bit of a ruse in
many cases. It often is granted to a small number of people in the organization
(sometimes only one, the CEO), is applied to a small proportion of total equity
granted to them that year (I’ve seen as little as 5%), and may be done one year
but not the next (what I call “piñata plan design” – take enough swings at
equity compensation and everyone will eventually get candy).
2 – Governance Ups and Downs of Performance Plans (see the
article on this here)
- The “performance” that an increasing number of plans is rewarding is a
lottery-like outcome of “relative TSR” – the company’s stock price performance
relative to that of a peer group or index.
People in my audience were fascinated with the data presented about the
lack of influence executives actually have over their company’s stock price,
due to factors including the dominance of high frequency trading, ongoing
financial and market turmoil in Europe, currency fluctuations, and several
other issues.
3 – Key Issues for Boards of Directors - Exacerbating the
randomness of relative TSR is the mentality – furthered by proxy advisory firms
like ISS and Glass Lewis – that the company’s fiscal
year is somehow a meaningful fixed window of return for investors. Which of course it is not. What makes this worse is that about 70% of US
public companies have a fiscal year ending December 31st. This makes the measurement period for
executive “performance” – for both the company and its peers - coincide with
the week of the year (between Christmas and New Year’s) with the thinnest
market trading volume, the most manipulation by mutual funds (as the SEC is currently investigating last-second
trades) and other investors to portray their annual return positively, and
otherwise a general inattention to the stock market by other traders who are
out for the holidays. (Those who are
following my developments in Conscious Compensation®
know that one of the first things that have to go for a company to fully
realize the value of a conscious approach is to ditch the external mandates of
a fixed fiscal year as a meaningful basis for compensation.)
4 – The Continuing Debate:
Incentive or Pay Delivery - Unfortunately, most of the people designing market-based
performance equity and other incentive plans are not students of equity market
dynamics but rather lawyers, actuaries, and consultants who encourage companies
to bend to the will of ISS, reinforce the risk-averse check-the-box mentality
of many RemCos (we call them Compensation Committees in the US), and then
accept the random pay outcomes that so enrage shareholders and the public. Yet they’re eager to discuss, debate, design,
and opine on performance plans based on equity market dynamics that they know
little or nothing about. They may be
intending to design incentives, but it’s just another pay delivery scheme (more
in the US sense of the word “scheme” than as used as a synonym for “plan” in
the UK). RemCos are doing this under pressure, executives are skeptical and
disengaged, and employees fear that this will soon trickle down to them – as it
has in some companies in which as many as 15,000 (yes, fifteen thousand)
employees now have their equity compensation fate tied to a performance measure
that has absolutely nothing to do with them.
Which I suppose also is true of stock options, but that discussion is
for another Effective Equity blog post.
5 – Understanding Valuation - Perhaps the most interesting
discussion with the audience was the section on valuation. I borrowed some data from my friend and
colleague Terry Adamson at Aon Hewitt which is included in our presentation “Value
and Valuation: Making Sense of Long-Term
Incentive Data” (we presented this at WorldatWork’s 2012 annual conference, the
NASPP 2012 annual conference, and the NASPP Boston Chapter meeting, and this month I’ll team
up with Terry’s colleague Jon Burg to present it at the NASPP
Silicon Valley Chapter meeting).
Because accountants, investors, and regulators continue to believe that the accounting-based numbers actually represent “pay” (which they do not), the valuation of a performance award becomes the other key input for determining whether pay-for-performance exists. An entire cottage industry has developed around this fallacy. To highlight how much the calculated value for “pay” can be influenced by the type of performance measure used, Terry’s exhibit shows a series of four performance awards, with valuations ranging from 37% to 143% of target value (generally, number of shares paid at target times stock price at the date of grant). So if I intend to pay you a dollar, the valuation consultants may decide that I really paid you 37 cents or $1.43, or another value in-between, and the proxy advisors will take that number and assume it should be related to how the company’s stock performed over the previous 1, 3, and 5 years. When in fact I have not “paid” you anything as that event may be 3 or 4 years in the future. That is way too much variation for such a critical metric that say-on-pay votes and shareholder litigation are being based upon it.
Because accountants, investors, and regulators continue to believe that the accounting-based numbers actually represent “pay” (which they do not), the valuation of a performance award becomes the other key input for determining whether pay-for-performance exists. An entire cottage industry has developed around this fallacy. To highlight how much the calculated value for “pay” can be influenced by the type of performance measure used, Terry’s exhibit shows a series of four performance awards, with valuations ranging from 37% to 143% of target value (generally, number of shares paid at target times stock price at the date of grant). So if I intend to pay you a dollar, the valuation consultants may decide that I really paid you 37 cents or $1.43, or another value in-between, and the proxy advisors will take that number and assume it should be related to how the company’s stock performed over the previous 1, 3, and 5 years. When in fact I have not “paid” you anything as that event may be 3 or 4 years in the future. That is way too much variation for such a critical metric that say-on-pay votes and shareholder litigation are being based upon it.
The Forum - It was a great session with lively interaction, with
the Europeans asking questions on topics ranging from Warren Buffett to Steve
Jobs to Barack Obama. We discussed Apple and J.C.Penny, IPOs and LBOs. Sometimes it’s fun to be the foreigner in the
room.
There is a lot more technical detail in this presentation
which you can view at the link above, but the takeaway is that performance
plans in the US are not Effective Equity.
They are what happens when you have a beautiful but fragile crystal
bowl, that was doing a fine job of being a beautiful crystal bowl, break it
into pieces by tossing it on the floor because it was deemed to be failing as a
crystal bowl, and then have a group of 5-year-olds glue it back together with
elementary school glue. It still
somewhat resembles a bowl, leaks, has sharp edges that cut those who hold it,
and looks awful. But people nod and say,
“yep, that is definitely a bowl, much better now.” A bowl, but not an effective bowl.
Performance plans – in some rare cases pay-for-performance and in some other
rare cases, Effective Equity. But mostly neither. Like those Venn Diagrams from math
class long ago, performance equity plans, pay-for-performance outcomes, and Effective Equity have a small common overlap.
Thanks to the folks at the Employee Share Ownership Centre for including me in
their program. I learned a lot and made
a lot of new friends.
And yes, the skiing
was amazing.
