Testing Pay for Performance

A key pillar of most compensation philos­ophies is to pay for performance, but how do directors know if it’s working? To an­swer this question, compensation commit­tees are increasingly testing the pay and performance alignment after the payouts have been made. This feedback process is vital to ensure the continued effectiveness of the compensation programs.

Rationale for Testing Alignment

Typically, when compensation commit­tees benchmark their company’s executive pay, they focus on the target opportunity. This helps ensure that the company is pro­viding competitive opportunities to attract and retain qualified talent. However, this ignores the payout determination process (goal-setting, subjective assessment, etc.) and what is eventually realized from these compensation programs. Testing the align­ment can help ensure that your company is setting goals that are not substantially more or less challenging than your peers’, thereby impacting the competitiveness of the program.

Additionally, testing the alignment helps the company understand its pay for per­formance story (i.e., how pay and perfor­mance are aligned). This can guide proxy disclosures and critical shareholder out­reach efforts.

Testing the Alignment

There is no silver bullet analysis that will definitively determine whether pay and performance are aligned at every compa­ny. However, there are a number of ways companies can test the pay and perfor­mance alignment relative to peers or his­torical results. A few examples include:

• Testing annual bonus payouts and key performance indicators relative to peers. Example: actual bonus as a percentage of target compared to operating margins.
• Testing aggregate officer bonuses as a percentage of key income or cash flow metrics relative to peers or historical re­sults. Example: aggregate officer bonuses as a percentage of earnings before inter­est, taxes, depreciation, and amoritization tracked over time.
• Testing total realizable compensation and shareholder-return performance rela­tive to peers. Example: CEO total realiz­able compensation for the past three years relative to three-year shareholder return (similar to recent Securities and Exchange Commission (SEC)-proposed rules).

When reviewing these analyses, it is important to understand the assumptions made and the key drivers of the results. By reviewing this information, directors can use their judgment to assess whether the information indicates appropriate align­ment and degree of stretch, or not.

Translating to Action

If the analysis does not tell the story di­rectors were expecting, changes may be needed in terms of program structure, goal setting, or pay levels. By understand­ing the key drivers of incentive plan out­comes, the compensation committee can discuss an action plan for improvement. For example, if the company has per­formed near the top of its peers, but real­izable pay is near the middle of its peers, it could be a result of not enough leverage in the program, goals that were more dif­ficult than peers’, or target pay levels set lower than the market.

If directors conclude that pay is appro­priately aligned with performance, this analysis can help in the development of proxy disclosures in a couple of ways. First, the compensation committee can disclose that it regularly reviews the alignment of pay outcomes with performance, demon­strating its focus on strong governance of the compensation programs.

Secondly, it can help the company de­scribe how its pay is aligned with perfor­mance. This will be particularly impor­tant after the SEC’s new rules on pay and performance disclosures are finalized. The rules as currently proposed may create confusion for shareholders about the align­ment of pay and performance, so compa­nies with a clear and compelling story will be able to more effectively demonstrate pay and performance alignment to their shareholders.

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Chris Havey is a partner and James Limmer a consultant at the executive compensation consulting firm Meridian Compensation Partners in The Wood­lands, Texas.

This article originally appeared in NACD Directorship magazine.