Performance Plans and Effective Equity - Davos and Venn Diagrams

by Fred Whittlesey

Principal Consultant

Compensation Venture Group

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 14^th 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 31^st.  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.

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.