Designing an Effective Executive Compensation Program
Good Insight leads to Good Decisions
The defining principle for all public and private companies is straightforward. The leadership team and board are expected to pursue investment opportunities where the anticipated returns on capital exceed a fair return on investors’ funds, given the risks taken.
The defining principle holds today as it has for prior generations. However, companies in the 21st century are confronted with ever greater complexity. From an operating perspective, shareholders want companies to grow earnings, to manage by their core values, to maintain a respectful and merit-based work environment, to reduce the negative effects on the environment and, to deliver high quality products and services.
From a capital market perspective, companies are confronted with two growing challenges – the valuation of equities and the role of institutional investors in setting compensation and governance policies. As greater amounts of stock purchases flow through ETF funds, traditional yardsticks of performance like Total Shareholder Return (TSR) and relative TSR may not at times reflect the true performance of the company. Furthermore, computer-driven program trading can create short-term aberration in the valuation of the company. The upshot is often a disconnect between operating performance and share valuation, challenging the fundamental idea of an “efficient market” where shares are accurately priced to reflect the value of expected future risk-adjusted cash flows.
To add more complexity to the decision-making processes of compensation committees and boards of directors, large investment funds with dedicated departments to evaluate proxy statements, as well as, proxy advisors articulate their preferences and dislikes regarding pay and governance. Directors must now rely on fact-supported analysis to demonstrate that they are acting in the best interests of shareholders and to balance the different interests of executives, investors and proxy advisors.
It is in this complex environment that Gressle & McGinley excels at helping committees and management develop effective executive compensation programs.
Strategy drives shareholder value; designing an effective compensation program should start with strategy
Strategic intent should be the starting point for designing an executive compensation program. Strategy sets the course the company will pursue to meet customers’ needs and describes how the company will make money and create value for investors. Strategy is defined in various ways. At one level, strategy describes the financial and operational objectives that collectively focus the organization on improved customer experiences and cash flow growth. At another level, strategy can articulate a blueprint for industry transformation - how the company hopes to re-shape its sector. A company’s strategy can be an expansion plan built around existing core competencies; it can also be a growth plan built around the core competencies that the company wants to develop or acquire in order to take advantage of new opportunities.
Strategic intent not only captures how the company wants to grow over time, but also the milestones that represent the successful execution of the plan. Strategy forms the basis for a performance management system which includes how a company defines and measures success (performance metrics and targets) as well as the characteristics of the reward system – how management shares in the wealth they create for investors.
Performance Management Drives the Reward System
Performance management defines success both in financial terms as well as strategic terms. Performance management also defines how success is compensated. In short, how does management share in the wealth they create for shareholders? At the same time, an effective executive compensation program must also balance market pay opportunities against retention risk and the cost to shareholders.
We always seek to balance three competing objectives:
Of upmost importance in compensation design are the incentives that align interests between shareholders and executives to motivate exceptional performance. At the same time, the design of the program needs to accommodate the trade-offs between growth and risk, short-term results and long-term resiliency, and financial performance and customer satisfaction, quality and environmental stewardship.
An uncompetitive compensation program increases the risk that talent will be bid away by more pay from a competitor. Reducing retention risk can be especially challenging in situations where the value of the executive to the company is greater than the compensation paid to the executives of peer companies selected by the proxy advisors. Compensation committees in these situations have their work cut out for them in doing what is in the best interests of shareholders. In short, the operative motto is grit wins!
The cost to shareholders is at one level easily quantified. At another level, the question of cost should be viewed in context - how much of the value created over time for shareholders is shared with the management team. The question we answer is - is the sharing ratio fair to both management and shareholders?