Executive Compensation

Transcription

1 Executive Compensation Bulletin Enduring High-Performing Companies Take the Road Less Traveled in Executive Compensation Design Melissa Costa and Todd Lippincott, Towers Watson July 15, 2014 Companies are constantly faced with the challenge of designing executive compensation programs that are tailored to their business strategies and unique context, such as their life cycle, level of profitability and competition. At the same time, companies are faced with external pressures from regulators, proxy advisors, investors and others who have a view often quite narrow or rigid on what constitutes an appropriate executive compensation design. There s also significant pressure for companies and directors to conform to so-called market norms. To understand how top-performing companies address these challenges, Towers Watson recently completed an in-depth study of practices among what we ve defined as enduring high-performing companies. We wanted to understand if they approach executive compensation differently from other companies. The short answer is that they do, and sometimes in surprising ways. The results of our research confirm that there s no single lens for effectively evaluating executive compensation. Instead, we found that high-performing companies take a range of approaches and differentiate their executive compensation programs, sometimes in ways that many observers, including proxy advisory firms, would view unfavorably. Ultimately, this research is designed to support directors and management teams alike, and can provide a reference for enhanced pay design. Defining High-Performing Companies Companies and their management teams are regularly criticized for being overly focused on the short term, and executive compensation design is often viewed as a primary driver of this mindset. Our research focused on companies that had truly sustained above-average performance over the long term, which we defined as 15 years, to see if we could identify executive compensation practices that are aligned with greater sustainability of results. For the 15-year period ending in 2013, we identified 50 companies in the S&P 1500 with the most sustained outperformance in total shareholder return (TSR) versus the S&P 1500 overall. To avoid a bias in favor of companies that had spikes in TSR (e.g., at the end of the 15-year period), we did not simply measure TSR from the beginning to the end of the period. Instead, we analyzed TSR over rolling three- and five-year periods throughout the 15 years studied. To be included in our group of

2 sustained high performers, companies needed to have outperformed the S&P 1500 on a rolling basis 90% of the time (i.e., for at least 12 of the 13 overlapping three-year periods studied and at least 10 of the 11 overlapping five-year periods). Note that our sample of high-performing companies would have been too small for analysis if we considered only those companies that outperformed the market in all cycles. The resulting group of 50 companies covers 16 industry groups, with revenues ranging from $500 million to $150 billion. We also analyzed practices by company size in the following breakdowns: Revenue between $500 million and $2 billion Revenue between $2 billion and $5 billion Revenue greater than $5 billion Highlights of Our Findings While these high performers, like the broader market, used a wide array of compensation designs, there were a number of areas where their practices differed from market norms. The top six are highlighted below. 1. Compensation designs evolve as a company grows and matures. The study reinforced the importance of taking a company s stage of development into account when determining the appropriate executive compensation design. Notably, the high performers we identified did not take a one-size-fits-all approach. In many areas, their compensation design practices varied depending on the size of the company. For example, early in their life cycle, the high performers used fewer annual incentive plan metrics (often only one or two measures) and added metrics as they grew. The study reinforced the importance of taking a company s stage of development into account when determining the appropriate executive compensation design. In the broader market, by contrast, the number of annual incentive metrics used did not materially change based on company size, with many companies of all sizes, with revenue above $500 million, using four or more measures. In other words, smaller high-performing companies were more likely to zero in on a small number of highly critical performance measures, while the broader market tended to use a more diffuse set of metrics. Similarly, the high performers used fewer long-term incentive (LTI) vehicles earlier in their life cycles often only one, but sometimes two and added vehicles as they grew. This transition was not evident in the broader S&P Beyond design specifics, the implications of these findings are important at a more fundamental level. First, they reinforce the importance of considering company size when assessing the appropriateness of pay programs. (In contrast, some commentators and advisors apply the same standards around executive compensation regardless of company size.) Second, they suggest that high-performing companies with revenues in the $500 million to $2 billion range are more likely than their similarly sized competitors to retain the less complex incentive practices associated with smaller start-ups and early-stage companies. In short, they keep it simple and focus on a few key goals. 2. Despite consistently outperforming the market, high performers target market-median compensation. Our analysis revealed that target pay opportunities (i.e., target total direct compensation) were very similar between the high performers and the overall market median, adjusted for company size. Specifically, the target pay opportunities of high-performing company CEOs were 3% below the Enduring High-Performing Companies Take the Road Less Traveled in Executive Compensation Design I 2 Practices I 2

3 market median for the large companies and 1% above for the smaller companies. However, despite the median target positioning, their actual realizable pay exceeded market median levels, often significantly by 43% among large companies and 28% for small companies. Leverage in bonus and LTI create this upside. This finding supports the point that effective program design can ensure appropriate rewards for high performance. It also raises questions about the need for companies to adopt above-median target pay philosophies. 3. Stock options are an integral part of LTI program design. While there is a strong movement in the broader market to adopt long-term performance plans (e.g., full-value stock awards with vesting tied to TSR or other financial hurdles), high-performing companies place a greater emphasis on stock options, both in terms of prevalence and LTI mix. Among these companies, stock options represent about 50% more of the LTI mix than in the broader market. In addition, the high performers place less emphasis on long-term performance plans, again in both prevalence and mix. High-performing companies place a greater emphasis on stock options, both in terms of prevalence and LTI mix. This is one of the more surprising findings of the study. Stock options, in particular, are often singled out as a symbol of short-term management thinking. It s interesting that companies that have actually sustained above-average performance over time have embraced them. The prominence of stock options among this group, with their stronger share price performance, also explains why they are able to deliver higher actual (versus target) compensation than the market. 4. When long-term performance plans are used, return metrics are an important focal point. TSR was the most prevalent long-term performance plan measure among both the high performers and the S&P 1500 overall. However, beyond TSR, the high performers were more likely to use return metrics (e.g., return on invested capital, return on common equity) than the broader market, especially at the expense of measures such as revenue and operating income. For example, approximately a third of the high-performing companies in our sample used a return metric, compared to 20% of the broader market. Only about 10% of the high performers used operating income, versus 25% of the S&P The emphasis on return-based metrics among the high performers may indicate that they are more focused on using capital efficiently and ensuring that management is focused on the balance sheet as well as the income statement. 5. A longer-term orientation can be supported through small tweaks to design. High-performing companies generally have a stronger long-term pay orientation than the broader market, as demonstrated by longer option and restricted stock vesting schedules, as well as longer option terms. For example, a majority of the large high performers in our sample used an option vesting schedule of more than three years, while less than half of large companies in the broader market used this design. Similarly, two-thirds of large high performers cliff-vested their time-based restricted stock, while less than 40% of companies in the broader market did the same. Finally, while a 10-year option term remains the most common term among high performers and the broader market alike, companies in the broader market are over 50% more likely to use a shorter term. Enduring High-Performing Companies Take the Road Less Traveled in Executive Compensation Design I 3 Practices I 3

4 6. Executives of high-performing companies are a relative bargain. As noted above, while target pay opportunities were similar between high performers and the market on a size-adjusted basis, the CEOs of the high-performing companies have higher three-year actual realizable pay than CEOs in the broader market. However, when we analyzed annualized realizable CEO pay as a percentage of each company s market capitalization, this sharing rate was significantly lower among high-performing company CEOs than for broader-market CEOs. In short, high-performing companies are able to deliver high value to executives at a significantly lower relative cost to shareholders. Beyond reinforcing the notion that pay and performance appear to be well aligned in high-performing companies, our analysis reinforces the value of examining sharing rates. Today, many compensation analyses focus on absolute levels of pay and/or percentile rankings of pay and performance, which can provide helpful insights. However, sharing-rate analyses can provide a clearer picture of the return on a company s investment in executive compensation, especially when levels of performance vary significantly between companies. Key Takeaways Enduring high-performing companies often take the road less traveled, designing their executive compensation programs in ways that vary from market norms. Their compensation designs are tailored based on their size and unique business needs, and are longer-term and more returnfocused. While generally targeting the market median, these companies reward high performance through more leveraged incentive plan designs, including options, which actually translate to a high return on investment for shareholders. While generally targeting the market median, these companies reward high performance through more leveraged incentive plan designs, including options, which actually translate to a high return on investment for shareholders. Market norms remain an important reference point for all companies to consider in assessing and designing their compensation programs. At the same time, the results of our research on executive pay practices in high-performing companies reinforce the notion that companies should resist the pressure to conform to a one-size-fits-all design that may not be a best fit for each individual organization. For More Information To learn more about our analysis and understand how your company compares to the high performers in our sample, please contact Melissa Costa at melissa.costa@ or Todd Lippincott at todd.lippincott@. Enduring High-Performing Companies Take the Road Less Traveled in Executive Compensation Design I 4 Practices I 4

5 About Towers Watson Towers Watson is a leading global professional services company that helps organizations improve performance through effective people, risk and financial management. With more than 14,000 associates around the world, we offer consulting, technology and solutions in the areas of benefits, talent management, rewards, and risk and capital management. Information in this publication should not be used as a substitute for legal, accounting or other professional advice. Enduring High-Performing Companies Take the Road Less Traveled in Executive Compensation Design I 5 Practices I 5