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Neil Amato
Neil Amato

Incentive plans work, but execs seek more than cash

Want to keep the brass happy? Four tips for responsible management of executive pay.

September 6, 2012
By Neil Amato

Executives—their pay increases, in particular—have long endured scrutiny by politicians and shareholders. And, perhaps not surprisingly, executives themselves don’t tend to say much about their compensation packages, which increasingly have grown more incentive-based.

But now they’re talking. More than 1,100 executives globally took part in a recent PwC report, which studied how incentives motivated the executives themselves. The results, from 43 countries, offer a mixed message.

The report looked first into the reasons incentive-based pay is growing globally.

First, performance pay is more flexible, which is crucial in an uncertain economy. Shareholders in a poor-performing company would not be happy if the CEO made $15 million annually, guaranteed, with no incentive to improve.

Second, as companies in emerging markets seek to compete with those in developed regions, they adopt their practices. As competition grows for top-notch executives, so have incentive packages. This has also led to incentive packages growing more complex, the report says, to provide a stronger link between company performance and the executive’s total compensation.

The report’s key findings:

  • Executives are risk-averse: Just 28% would swap fixed pay for a less-certain bonus. They’ll take the known over the unknown, even if it means less pay.

  • Complex incentive plans have limited effectiveness: Twice as many executives would prefer a less complex but smaller reward than a hard-to-understand, larger reward.

  • Longer wait, less worth: If the incentive plans had a long deferral period, they were seen as less valuable.

  • Fairness is fundamental; executives wanted to be paid comparably to the rest of their peer group.

  • Cash matters, but many executives would take a substantial pay cut for their ideal job.

  • Long-term incentive plans work best when they include recognition.

Emma Swain, CPA, the CEO of St. Supéry Vineyard in Rutherford, Calif., says she loves incentive packages. Half the survey respondents agree with her. Swain, who wasn’t interviewed for the survey, believes employees earn a salary to do their job well and that reaching a “stretch goal” should result in more pay.

“I’m always pushing, ‘How can we improve?’ ” Swain says. “There’s always a number of things that each person on my management team has as their goal for the year. It helps you focus on what needs to be done. For some people who are comfortable in their role, they need that incentive to change things.”

Charles Elson, the director of the University of Delaware’s Weinberg Center for Corporate Governance, says restricted stock and other incentives tied to a company’s performance are the best options for determining an executive’s pay. If the executive doesn’t want to take a measured risk for the good of the company, then investors shouldn’t back that executive, Elson said.

“For a CEO to say, ‘I want my cash up front’ is a little appalling,” Elson said. “It suggests a complete lack of confidence in your own ability. It’s not the kind of person I’d want to invest with. Someone who has no confidence in themselves doesn’t inspire confidence.”

In the survey, hypothetical scenarios about peer-group pay and absolute pay showed that executives are highly competitive about their salary. PwC found that, by a 2-to-1 margin, executives felt that getting paid more than their peers was more important than making more money in absolute terms.

Elson said that sort of thinking—being more interested in how one stacks up against someone else than how one’s company stacks—is a symptom of the world’s recent global ills.

“It’s not a horse race against your peers,” Elson said. “It’s not themselves, but the company that matters. But when someone becomes that self-interested, when the person and the company interests diverge, that’s where you have problems. That’s why you pay officers in restricted stock. It brings the self-interest into line with the shareholders’ interest.”

Swain said neither absolute pay nor her standing among peers was important.

“I really don’t care what my peers make. Some people are competitive,” she says. “My competition is for me. How do I improve what I’m doing? I’m not worried about them making more money. I’m worried about how I maximize efficiency where I am.”

Better management of executive pay

Pearl Meyer & Partners, an independent compensation consultancy, offers tips for responsible management of executive pay. Among them:

  • Understand your company’s pay-for-performance links: To gauge an executive’s potential pay increase, companies must first be able to properly measure companywide success. Total shareholder return takes into account more than just a company’s stock price. Other indicators, such as the metrics of long-term performance plans, should be evaluated.
  • Understand total executive compensation: An understanding of “what-if” scenarios is vital. For example, if an executive is terminated without cause, what is the severance agreement? This knowledge should cut down on “pay for failure” results. Incentive plans should be fully evaluated, as should the effect of other what-ifs, such as acquisitions or restructuring.
  • Balance short- and long-term incentives: Assess the relationship between these performance metrics and the creation of value for investors. If the incentives are not intertwined with value for stakeholders, then the executive likely will focus more on individual goals and less on what’s best for the investors. An interdependency of short- and long-term incentives helps balance the goals and can produce sustained returns for shareholders.
  • Test your pay philosophy against its stated objectives: The measures used to evaluate company success should be the same metrics that produce rewards for executives. Goals should be aligned with business objectives, linking individual rewards to positive company results.
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Neil Amato is a Journal of Accountancy senior editor.