Myth vs. Reality: The Relationship

Transcription

1 There appears to be little evidence of a direct pay-for-performance relationship between top executives compensation and corporate performance. Myth vs. Reality: The Relationship Between Top Executive Pay and Corporate Performance EDWARD T. REDLING Regional Practice Director, Compensation Consulting The Wyatt Company 1Y V hat are the most critical issues facing those who administer executive salary programs? Responses from compensation executives in 65 of the top Fortune 200 companies most frequently cited the need to develop or update executive salary programs to ensure that they were paying for performance and paying competitively. However, when they took various management levels into consideration, they identified somewhat different issues. At the highest organizational levels, the salient issue was tying salary growth to overall corporate performance. At the second management tier, the issue was integrating corporate performance with competitive data and internal relationships. For management below the second tier, the key issues 16 Compensation Review, Fourth (2uarter 1981 C 1981, AMACOM, a division of American Management Associations. All rights reserved /81/ /0

2 were to ensure that salary rewards were based on individual performance, internal relationships, and competitive considerations-but only in the context of what the company could afford. It s difficult to find fault with any of these as objectives for a salary program, even though &dquo;paying for performance&dquo; has become the compensation equivalent of &dquo;mom s apple pie.&dquo; These same generalizations have been heard for many years. However, to find out whether these issues have been effectively addressed, we decided to document whether they squared with actual practice over the past several years. Specifically, we wanted to know: Are companies paying for performanceespecially at top-management levels? I As a first test, we analyzed the compensation growth of the CEO Compensation top executive in some relatively &dquo;good&dquo; and &dquo;poor&dquo; performing organizations over the past five years. We took a random sample of 100 of the largest 1,000 companies in the country and used a five-year performance ranking measure that combined earnings growth and return on shareholder s equity. This provided a composite index of both growth and profitability. We then refined this sample by using only those companies whose chief executive officer (CEO) was the same at the beginning and end of the measurement period, and for whom we were able to obtain base salary and bonus data separately. This left us with 25 companies whose five-year performance index rank ranged from just over 100 of 1,000 for our sample s best performer to a rank of almost 900 for the sample s worst performer. We compared company performance with the salary growth of these top executives during this five-year period; the results are shown in the scattergram in Figure 1. 17

3 Figure 1 The CEO s Base Salary Compared with Corporate Performance (25 companies) The greatest salary growth during the five-year period was 143 percent and the smallest was 14 percent, with a median of 60 percent. However, the CEO of the best performing company received only a 25 percent increase in salary, while the CEO of the worst performer received a 48 percent increase. The correlation coefficient between salary increase percent and five-year performance index rank was.16, obviously not very indicative of a pay-for-performance relationship. It has often been suggested that CEOs receive a significant portion of their reward for performance from their companies executive bonus plan, not just from their base salary. We investigated this notion by comparing five-year corporate performance with the five-year change in base salary combined with annual bonus in the same 25 companies analyzed previously. The scattergram in Figure 2 presents these relationships. The correlation coefficient for this data was.09, which is even 18

4 Figure 2 The CEO s Base Salary plus Bonus Compared with Corporate Performance (25 companies) lower than that resulting from the base salary vs. performance analysis. Although the greatest change here was 166 percent and the smallest was 27 percent with the median at 72 percent, the CEO of the best performing company received a fifth-year total annual cash compensation that was only 30 percent higher than the first year s, while that of the CEO of the worst performer was 38 percent higher than his first year. To take another look at pay vs. performance, we calculated the average five-year increase percentages for the ten worst and the ten best company performers and found that the CEOs of the ten best did slightly better than the CEOs of the ten worst. Comparing salaries alone, CEOs of the ten best averaged a 64 percent increase versus a 51 percent increase for CEOs of the ten worst. If we compare base salary plus bonus, CEOs of the ten best performers averaged an 86 percent increase while CEOs of the ten worst averaged 82 percent. These differences are minimal over five years, and it s doubtful that they are significant enough to be considered rewards or reinforcements for high-level performance. 19

5 Figure 3 Comparison of Top-Management Compensation with Sales, Profits, and CPI ( ) Source: The Top-Management Salary Survey of the Executive Compensation Service of the American Management Associations.,,, Because we found only minimal evidence to indicate a pay- Pay for for-performance relationship for the CEOs in our initial sam- P~onnancc― I d.d d h f f i,.- h. Performanceple, we decided to test the pay-for-performance relationship op Management of a larger executive group. For example, if we were to find that top managers experienced higher salary growth in years when the organization experienced high sales or profits than in years with low sales or profits, it might suggest some positive relationship between pay and performance. For this test, we reviewed data for 1974 through 1980 that appeared in the annual Top-Management Salary Survey published by the Executive Compensation Service of the American Management Associations. (See Figure 3.) The data suggest that salary growth never really kept pace with the good profit years, either during the good year itself or during the following year. (Salaries in the latter would have been affected in the case of a lag between performance and reward.) For example, in 1974 when wage and price controls ended, profits were up almost 25 percent; the Consumer Price Index (CPI) was up 11 percent, but salaries were up only 8.4 percent. In 1975, the first full year without guidelines, the salary growth rate increased to 9.8 percent - almost 11/2 percent more than the prior and succeeding years. But whether this was based on performance (in light of the 13 percent profit increase), or was a response to 1974 s CPI surge, or was just a catch-up after controls were removed can t be determined. In 1977, when profits were up almost 26 percent over a dismal 1976, salaries were still growing at only an 8.5 percent rate. Although data for the seven-year period do suggest some positive relationship between profit performance and bonus awards - see, for example, 1975, 1976, 20

6 Figure 4 Salary Increases Received by Executives ( ) Source: The Top-Management Salary Survey of the Executive Compensation Service of the American Management Associations. 1977, and 1980-salary growth appears to be relatively immune to overall performance. In 1980, as double-digit inflation continued for a second year, the average salary increased by 10 percent - the only double-digit salary growth rate on the table. We believe this 10 percent increase rate is a direct result of another inflation-related salary program phenomenon - that is, granting salary increases to a larger percentage of executives each year. Figure 4, which is also based on Executive Compensation Service data, shows the average increase for those executives who received an increase as well as the percentage of executives receiving increases. Although the percentage of salary increase for those executives receiving increases has remained fairly steady at between 12 and 14 percent for the past seven years, the percentage of executives receiving increases has jumped from 82 percent to 90 percent in the last two years. The growth in the number of executives receiving salary increases each year may be a direct response to the higher inflation rates, which further weakens the relationship between pay and performance. This phenomenon is even more apparent in banks. For example, a review of data from more than 1,500 participating financial organizations (representing more than 100,000 bank officers) in The Wyatt Company s &dquo;cole Surveys&dquo; revealed that almost 97 percent of these officers received an average salary increase of 13.5 percent. This represents the highest percentages ever, both for the number receiving increases and for the size of increase. But unlike general industry, banks have been granting increases each year to more than 90 percent of their officer population since at least 21

7 - terms Of course, the increases in some of those early years might reflect a conscious effort to catch up with the higher compensation levels paid in industry. While the preceding analyses suggest a general lack of relationship between pay and performance for executives, some organizations have achieved this stated goal. For example, we recently conducted a study showing that the organization involved differentiated significantly among its executives in terms of salary growth over an extended period of time. We identified 70 management individuals who had been employed by the organization for at least 30 years and for whom we had a complete salary history. The compound annual salary growth tables for this group are as follows: As indicated, the highest compound annual salary growth rate was slightly more than 16 percent per year and, interestingly enough, the Number One performer in of salary growth was the organization s present chairman. The 16 percent per year salary growth rate resulted in a thirtieth-year salary that was 86 times starting salary. In addition, although the annual growth rate at the 90th percentile of our group (11 percent) was only 1 percent greater than the 70th percentile (10 percent), the 90th percentile executive s final salary was 23 times his starting salary while the 70th percentile executive s final salary was 17 times his starting salary. The lowest salary growth rate was 6 percent per year, which resulted in a thirtieth-year salary of almost six times the individual s starting rate. Although this salary progression included both merit and promotional salary increases, we believe that promotions and promotional increases are one of the most obvious ways of rewarding good performance. In fact, we found that the key to the top growth-rate levels was regular promotional increases in addition to merit raises. The difference between 86 times starting salary and six times starting salary certainly suggests that this company did differentiate between executives in terms of salary administration. Whether these differentiations were too much or not enough is another item for consideration. But in the absence of any data to the contrary, the differentiation is believed to be based on performance - however the company defined it during those thirty years. The annualized CPI growth rate during this same thirty-year period amounted to 4.25 percent per year, so even the lowest performers succeeded in improving their 22

8 Figure 5 Compensation Elements as a Percentage of Annual Total Compensation (500 companies) standard of living as measured by the CPI during their careers. However, they would have lost ground if the 8.5 percent annual CPI growth rate of the last ten years had occurred over the entire period..mpensation Up to this point, we ve focused mainly on an executive s base The Compensation salary, but that is only one part of the executive s total cash Package compensation package - albeit the most stable element. There appears to be a consensus among compensation specialists that the other elements (annual and long-term incentive payments) are intended to be more closely based on performance. If there truly is a desire to increase the pay and performance relationship, one might assume that over time there would be a shift in the makeup of the executive s total cash- compensation so that base salary would account for a smaller portion of the package. To test this assumption, we compared the makeup of the total cash package between 1974 and 1979 at two different executive levels based on client and proxy information for over 500 companies. As Figure 5 indicates, the average $100,000 executive s base salary made up 60 percent of his or her annual total cash compensation in 1974, with bonus contributing 30 percent and the annualized value of his or her long-term incentive contributing 10 percent. This was not significantly different from 1979, during which base salary was 56 percent of the total compensation. For a $60,000 executive there was no difference. Base salary amounted to 70 percent of total cash compensation in both 1974 and 1979, although the annualized value of the long-term incentive involved almost doubled. With all the increased compensation opportunities inherent in current annual and long-term incentive programs, shouldn t executives be putting more at risk? Shouldn t there be some deemphasis on the salary portion of the executive compensation package? While salary used to be an executive s total compensation package, now it s frequently only the base level, and this role requires mastering the basics of competitive levels, sound administration, and good communication. 23

9 An obvious problem with revising the salary portion of the executive s compensation package is that most of the other compensation elements, including bonus, long-term capital accumulation targets, insurance, and retirement income, are set as a function of base salary so base salary determines the value of much of the total compensation package. Therefore, significant changes would have to be made in the way these other elements are determined before any significant deemphasis on the executive s base salary could take place. Parh~oExecMftue Path to Executive But given a desire to pay for performance, we believe there should 1.~1. be a significant..f I element t of ~ - ~ risk versus reward j-in a com- Pay for Performance pany s executive compensation program, and that base salaries of executives who participate in the various incentive programs should grow at a more modest rate than the salaries of other employees. This might be accomplished by discounting the salary structure for incentive-plan participants, basing the merit increase guidelines on performance and position in the discounted salary range, and extending the timing between salary actions consistent with range penetration. Another approach might be to provide a single annual increase for this incentive group based on the percentage movement of their salary structure and then tie performance aspects to demanding short- and long-term goals with truly significant bonus and capital accumulation opportunities paid from these plans. Each aspect of the program - base salary, bonus, and long-term incentive - is interrelated and cannot be managed in isolation. While there is no single right way of managing compensation, the process of analyzing needs, setting objectives, and structuring total programs to meet them is a strategic approach that could improve most organizations return on their compensation investment. 24