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Best performers emphasize stock options, targeted performance measures
High-performing companies design their executive compensation programs differently from many other organizations, according to a new study by consultancy Towers Watson.
Enduring High-Performing Companies Take the Road Less Traveled in Executive Compensation Design, found that high-performing organizations, unlike other companies in the overall S&P 1500, place a greater emphasis on stock options, target compensation levels at market median rates, and do not take a one-size-fits-all approach to their executive pay program design.
“We conducted this study to see if companies with truly sustained high performance follow practices that differ from other companies,” said Todd Lippincott, North America executive compensation leader at Towers Watson. “The short answer is they do. In fact, we found that many high performers take approaches and differentiate their pay programs in ways that many observers, including proxy advisory firms, would view unfavorably.”
The study examined the executive compensation programs at the 50 companies with the most sustained and consistent outperformance in total shareholder return versus the S&P 1500 over the past 15 years. The study found some of the following practices that differentiate high-performing companies.
Stock options are an integral part of long-term incentive (LTI) program design.
While there is strong movement in the market to adopt long-term performance plans, high-performing companies place a greater emphasis on stock options, both in terms of prevalence and LTI mix. Among these companies, stock options represent about 50 percent more of the LTI mix than in the broader market. In addition, the high performers place less emphasis on long-term performance plans (e.g., LTI plans that have explicit performance measures such as relative total shareholder return).
“This is one of the more surprising findings. Stock options, in particular, are often singled out as a symbol of short-term management thinking. It’s interesting that companies that actually sustained performance over time have embraced them. The prominence of stock options among this group, with their stronger share price performance, also explains why they are able to deliver higher actual (versus target) compensation than the market,” said Lippincott.
High performers target market median compensation and leverage incentive plans.
The study revealed that
targetpay opportunities (target total direct compensation) were generally very similar between high performers and the overall market median, adjusted for company size. But despite the median target opportunity, their
actualrealizable pay exceeded market median levels, often significantly—by 43 percent among large companies and 28 percent for small companies. Greater upside in bonus and LTI payouts supported these enhanced payouts.
The study noted that this finding supports the point that effective program design can ensure appropriate rewards for high performance; it also raises questions about the need for companies to adopt above-median target pay philosophies.
Compensation designs evolve as a company grows and matures.
The study reinforced the importance of considering a company’s development stage when determining the appropriate executive compensation design. For example, early in their life cycle, high performers used fewer annual incentive plan metrics (often one or two measures) and added metrics as they grew. Similarly, high performers used fewer LTI vehicles earlier in their life cycles—often only one—and added vehicles as they grew.
“The implications of these findings are significant. First, they reinforce the importance of considering company size when assessing the appropriateness of pay programs. Often, we see commentary about pay that doesn’t consider the company’s development stage. Second, these findings suggest that high-performing companies with revenues of $500 million to $2 billion are more likely than their similarly sized competitors to retain the less complex incentive practices associated with smaller start-ups and early-stage companies. In short, they keep it simple and focus on a few key goals,” said Lippincott.
The study also identified other pay practices that high-performing companies emphasize, including the use of return metrics (e.g., return on invested capital, return on equity) when long-term performance plans are used and a stronger long-term pay orientation.
Stephen Miller, CEBS, is an online editor/manager for SHRM. Follow him on Twitter
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