In contemplating compensation plan design, boards would do well to remember the adage, “Be careful what you wish for.” Recruiting top talent, driving bottom-line results, boosting production, fostering transformational change, increasing diversity, hitting safety targets—incentive pay can be tied to a virtually endless list of objectives. Which ones compensation committees decide to measure and reward becomes a powerful lever, one equally capable of aligning an entire organization behind the right goals—or sending it sideways. Just ask Wells Fargo.
While setting sales goals that inadvertently backfire is an extreme example of incentives gone wrong, there are plenty of potential pitfalls when tying pay to financial and nonfinancial performance metrics, agreed directors gathered for a CBM roundtable discussion on compensation practices held in partnership with Semler Brossy. “One of the things we’ve found challenging is constructing compensation in a way that attracts and retains the best executives and keeps them aligned with the objectives of the organization but also separates out luck and factors outside of their control,” said Kathryn Hayley, a director at Concentrix and Old National Bancorp. “In banking, for example, interest rate changes make a big difference in financial performance.”
Across industries, some of the companies that succumbed to outside pressure to incorporate ESG metrics into incentive pay programs in recent years are now questioning their haste, added Blair Jones, managing director at Semler Brossy. “We watched ESG measures and incentive plans move very rapidly, going from 50 percent to 72 percent in prevalence in recent years,” she said. “And you have to wonder, when you think about compensation as a tool to motivate people, whether that was really motivating performance. So, from a trend perspective, that suggests this is a good time for companies to step back and say, ‘What are we really trying to measure and reward with our compensation plans?’ Your compensation program discussion can be the tail wagging the dog, where, by asking the right questions, you actually get a lot clearer on strategy.”
That process, however, can require patience. Determining what to measure, how to measure it and how best to not only introduce that metric into an already-complex compensation program but also communicate the change to executives and investors takes time. For example, Kathleen Ligocki, who serves on the boards of Lear, PPG and Carpenter Technology, reported facing challenges incorporating innovation metrics into a company’s incentive pay program. “We wanted to focus on product innovation and cascade it in a very global company with 250,000 employees,” she recounted. “It took us a year and a half to actually come up with a construct that made sense.”
At the same time, several directors observed that a thoughtful approach to compensation practices can be effective in driving desired behaviors and even shaping culture. “I truly believe that culture in the long term determines the success of the company,” said Caroline Chan, a board member at EnerSys. “And this is where nonfinancial metrics come in—and they have to have some teeth in them—in terms of what it is that you are driving.”
Ana Dutra, who serves on the boards of Pembina Pipeline, CarParts, Amyris and Lifespace, agreed, pointing to broader acknowledgement of the role pay practices play in underscoring organizational priorities. “I’ve seen a refocus in compensation philosophy, which had been for a period of time, ‘What do we do in the short term?’” she said. “I see a shift now toward saying, ‘Listen, if we nail the compensation philosophy, everything else becomes easier.’”
Identifying Imperatives
Understanding the company, the operating environment and the economic climate should be paramount when contemplating compensation program design, added Colleen Brown, former CEO of Fisher Communications and a board member at TrueBlue and Big 5 Sporting Goods, who pointed out that traditional metrics can be problematic for businesses when sales revenue is vulnerable to external factors. At the media company she steered, political advertising could account for between 10 percent and 20 percent of revenue in an election year, making traditional annual performance metrics problematic.
“You can’t give someone a windfall just because of political spending, so you have to look at it as a two-year cycle,” she said, explaining that the company measured success in retaining and growing business against its peers to address the concern. “So, it was a hard cliff on political [advertising], so they don’t get the windfall but with the opportunity to make it up the following year by how well they did holding onto advertisers against the competition.”
Circumstances such as high turnover in an industry, a merger or a leadership transition also often warrant a closer look at compensation practices. Raquelle Lewis, a board member at CenterPoint Energy, recounted her company going through a CEO succession that prompted incentive pay program changes aimed at encouraging key executives to stay on through the transition. “We’ve got a young CEO and a young and talented executive team, and we know that this transition presents an opportunity for them to be real targets for other companies,” she explained. “So, we’re trying to make sure that we compensate them strategically so that their investment with us stays at the forefront of any other options or opportunities presented to them.”
Trends also play a part in which changes comp committees contemplate, noted Paula Cholmondeley, CEO of The Sorrel Group and a board member at Terex and Bank of the Ozarks, who has observed a move away from wide distribution of equity incentives in recent years. “On my bank board, we pulled back on how far down into the organization we hand out equity,” she explained. “In conversations with senior management, we learned that a lot of our lower-level employees, middle managers, didn’t know how to properly value the equity they were being given.”
Practices vary, however, depending on the degree of difficulty recruiting and retaining talent and other industry-specific factors, she noted. “In the biotech sector, a trend we’ve seen is actually giving more equity in the recruiting process but tying it to delivery of results. For example, if you’re recruiting a chief technical officer, he might get an incremental equity bump that’s unique to him if he’s willing to sign up to deliver a certain set of results…. So, we’ll give you more equity, but it’s not just for joining the company, it’s for joining the company and producing a specific set of results within a two- to three-year period.”
In a similar vein, companies undergoing major transformations often look to implement incentives that will drive desired changes. Wendy Lane, who has served on 13 boards, including four currently, recounted her experience at a company that introduced a substantial three-year cliff vest on long-term incentives and a substantial upside [for] performing above peers in earnings per share and total shareholder return. “We tripled the share price in two and a half years,” she said. “It was a dramatic change.”
At another company, the board, at shareholder request, replaced adjusted EBITDA with cash flow to get focus on cost efficiencies as well as growth. “Initially, like many young companies, as well as focusing on revenue growth, it had been adjusting out certain software development and stock-based compensation costs for its EBITDA metric,” Lane explained. “As a more mature company, it needed a new approach, focusing on the economic bottom line as well as revenues. The change brought positive cash flow and favorable shareholder response.”
Given the level of scrutiny that pay practices often receive, being able to articulate a clear rationale behind whatever compensation metric is being deployed is increasingly critical. Compensation committees weighing potentially controversial measurements or concepts should vet them carefully and plan to provide a comprehensive explanation to stakeholders, agreed roundtable participants.
“The best thing is to hire an objective third-party firm to review a potential change and give their opinion,” suggested Dutra. “If you’re introducing new metrics or concepts that are not a clear win for the CEO and the management team, you are going to meet resistance. So, explaining why it makes sense, showing the trends, showing what the peer group is doing and how key stakeholder groups—proxy advisors, regulators, legislators, employees, customers—are going to react can go a long way.”
“One good exercise is to go through the analysts call and earning call notes and see what concerns are coming up,” added Jones. “Another is to look internally and say, ‘What are we saying strategically, both externally to our investors and internally to our people? And do we have measures aligned with all of those things?’ That’s a really helpful exercise for the board, because if you have some holes, or if analysts are pointing out that you’re falling behind competitors, that gives you something to focus on and can foster some really good discussion about how to move forward.”
The Disclosure Dilemma
When introducing changes, compensation committees also need to consider their communications strategy. “Don’t just disclose a laundry list of metrics,” advises Jones. “Bolster why you’re doing what you do. One thing investors worry about is that you’re just putting in give-me measures that would give you the chance to correct the payout if the financials don’t turn out the way you want. So, you want to say, ‘This is an important initiative for the company, and we’re putting our money where our mouth is.’”
Companies that make changes in incentive programs inspired by retention concerns may need to proactively engage with investors to justify the decision. When CenterPoint Energy made adjustments to its pay program to incentivize its new CEO and ensure that key team members stayed on board for the transition, the company made informing stakeholders a priority, explained Lewis. “Trying to strategically build that compensation plan, share the narrative with our analysts to protect us from criticism and then make a transition that would fairly and appropriately compensate a brand-new CEO has been a whirlwind for us over the past couple of years,” she reported. “So, the necessity to make sure that the industry and analysts have literacy on our decision-making and be able to give us the time to transition through resonates completely with me. It’s been a lot to manage, and compensation has certainly been key to our strategy.”
Boards should also resist the urge to revisit compensation too frequently. “We have to be mindful that you can’t change your compensation plan every year,” said Lane. “It looks like you don’t know what you’re doing. So, it’s important to have a fundamental true north that you’re guiding toward and to stick with that as opposed to saying, ‘It’s revenue this year and cost efficiency next year.’ And that can be a tricky thing to adjust to, because investors do change their focus from revenue growth to bottom line and back again.”
Finally, boards should guard against being overly aggressive about modifying compensation practices in response to shifting conditions or introducing new incentives. Without careful vetting, incentives based on a cash flow metric or goals around growing a new unit, hitting revenue goals or cutting costs, for example, can lead to flawed decision-making. “I’ve seen unintended consequences from incentives based on achieving revenue goals where revenue was recognized when product leaves a plant or warehouse,” noted Dutra. “It might be material weaknesses or inventory just retained in a distribution center somewhere. So, when you’re rewarding for very specific goals or creating a retention strategies, you always have to be thinking about the potential unintended consequences.”
“As board members, you need to be the chief skeptics about what can go wrong,” summed up Jones. “As directors, you need to be thinking, if we play this out, what could go wrong? Because compensation works—it works for the good, but it also works for the bad.”
