Executive Pay – The How and The What

This year’s proxy season was a rough one for shareholders and CEOs alike. One of the more daunting issues is the government’s role in determining and/or legislating executive pay. We know what CEOs think about this political rhetoric but shareholders should be just as worried. Legislators with political agendas and little knowledge of compensation strategy will only exacerbate the problem and likely reduce, not enhance, shareholder say on pay. I recommend reading The Wall Street Journal Article, Are Executives Paid Too Much? by Samuelson and Stout. It is the best synopsis I have read on the subject in many years. The authors conclude that the economy didn’t tank because executives were paid too much. Rather, they were paid too much for doing the wrong things. We concur; the important issue is not how much executives get paid, but how they get paid and for what reasons.

For most public companies, annual bonus plans were based on short-term financial metrics aimed at increasing share price. On top of that, executives often received “mega” option grants with short exercise dates and no performance metrics. This effectively turned long-term incentives into highly lucrative short-term incentives. Many of the financial firms such as Lehman paid their executives in this manner. No surprise they took on massive amounts of risk, in an effort to create short-term profits and drive share prices sky high. This and other similar strategies, allowed executives to reap big rewards before the bottom fell out. The system was flawed, not human nature.

So what would a balanced compensation plan look like? Firstly, let’s address how such a plan would work and then discuss what behaviors that plan would motivate. The four components of compensation include salary, short-term incentives, long-term incentives and perks/benefits. Salaries should be targeted at market norms based on peer group review. Almost all companies use peer review today and I believe the practice is fundamentally sound. In contrast, the other three components need significant overhaul.

Short-term incentives must address essential operating metrics. Metrics such as GOP, REVPAR, debt coverage, unit growth, guest and employee satisfaction, asset integrity and so forth could be considered. Each company and its leadership must articulate their business thesis and get buy in from shareholders. Share price in and of itself should not be the metric for short-term incentives. Long-term incentives, in whatever form, should address the long-term success and health of a company. Most equity plans in the past simply addressed share price. Today, that must be coupled with managing risk, shareholder communication, transparency and volatility. Interestingly, it was often executive perks that incurred the wrath of shareholders. Private jets, lavish parties, grandiose offices and the like had shareholders up in arms. Shareholders are demanding transparency and they are going to get it. I believe that all perks should be discontinued. Let executives pay for these things themselves and submit reimbursements if they can make a case for it.

With the right balance of metrics, managerial behavior can be directed in the appropriate way. If shareholders want executives to think long-term, then they will have to change their behavior as well. Looking at stock prices every hour and demanding action will have to be curbed. We live in an instant gratification world but that hampers long-term thinking. Shareholders must simply change their investment criterion. Finally, I believe that including claw-back provisions within all incentive plans is a good way to keep all the players honest. Hopefully, the recent economic crisis will open our eyes to better compensation planning and more effective leadership.