Over the past 50 years, the share of income taken by the top 10 percent of earners in the U.S. has gone from 33.5 percent of all income to 47.9 percent, according to best-selling economist Thomas Piketty. Senior executive pay accounts for a large portion of that increase. Companies continue to pay their top executives more and more. Will the trend continue?
At an Enlightened Speakers Series discussion in Dallas, four experts on compensation discussed salary and performance metrics. They were John Casey, the founder of executive search firm John Casey & Associates; Charles Wheeler, director at Nexius, a technology company, who was formerly a compensation specialist at PWC; Susan Wetzel, Chair of the Executive Compensation Practice Group at the law firm Haynes & Boone; and Michael Halloran, Worldwide Partner at Mercer Consulting.
Keep it Simple & Transparent
Casey kicked off the presentation with the story of Pioneer Flour Mills, which was a $47 million business in 1988, and Casey was then CFO. Today, the company has gone global, with over $900 million in sales. Casey said a main driver of Pioneer’s growth was a shareholder value bonus plan started in 1994.
“The whole concept was based on three things,” Casey said. Growth of cash flow was the main component. If cash flow increased year over year, the bonus was paid. Second, the plan was simple. “Everyone in the plan could calculate their bonuses every day on the back of an envelope, and they did,” he said. And third, the company put in place information systems with the granularity needed for participants in the bonus plan to make decisions.
The success of the bonus plan showed how important it can be in driving business, said Casey.
Begin With the End in Mind
One particular challenge for private companies is long-term compensation, said Charles Wheeler, and retaining talented executives. “You have executives thinking about retirement and want to know how to get there, while you, the CEO, is thinking, ‘how do I keep you and how do we grow together?’” he said.
When building a plan, Wheeler advises companies to work backwards. “If you want to share a percentage of your increased cash flow with your key employees, set that as your objective and work backwards,” he said. “You’d be surprised at how many things you think might be frictions, now disappear.”
Wheeler told the story of an international manufacturing company in Fort Worth that started a long-term incentive plan to share the company’s increased value. After several years, three executives got checks totaling six million dollars. When asked how he felt about rewarding three employees with two million dollars each, the CEO said, “I feel great. You don’t realize it, but we’ve taken three percent of our increased cash flow and given it to these guys and we, the company, keep 97 percent of the remaining excess cash flow for us.” When the company shares its growth, but still gets to keep a disproportionate share of that growth, “It’s a good deal,” Wheeler said.
From Private to Public
Susan Wetzel addressed exit strategies for private companies. If the company plans to go public, employees are likely to fear the change. Creating a bonus plan will give them some peace of mind, Wetzel said. She recommends putting in a tail period. That way, if an employee is terminated prior to the IPO, they’d still get to share in the bonus. “We recommend a period of six months to a year after the transaction,” she said.
Another aspect of going public is to reevaluate compensation plans. “When you go public, all of these rules go into play that don’t apply to a private company,” she cautioned. “Gross ups are something public companies get dinged for. If you have a bunch of these in employment agreements, change them.” A gross up is the employer reimbursing a worker for the taxes paid on some portion of their income.
Companies going public have to take a look at the structure of their bonus plans, Wetzel said. In a public company, a performance-based compensation plan is an objective one, with metrics. “If you achieve those metrics, you’ll get paid this amount,” she said. “When you’re private, you don’t have to have that type of specificity.”
But, companies with discretionary bonus plans have a transition period of four years to grow into the new public company plan. Wetzel recommends using the transition period. “For some companies, it can be sticker shock to have no more discretion,” she said.
Paying for Performance
It can also be a shock to be in the public eye, said Mercer’s Mike Halloran. “The press loves executive compensation stories, and especially this time of year when public companies put out their proxies,” he said. As a result, most directors are concerned about making the right decisions on pay.
Pay for performance is in vogue right now, said Halloran. He said it’s not an excuse to reduce pay, it’s a way to get paid well for hitting a home run. And assuming the economy remains strong, executive pay will continue to go up. “All the action for public companies is in long-term incentives,” Halloran said. “The typical executive has 50-75 percent of their package in long-term incentives.”
A compensation report Mercer released last month said market-related metrics, such as total shareholder return and stock price appreciation, are common in long-term incentives. The report said long-term plans use fewer performance metrics than short-term plans, and incorporate fewer special conditions.
Halloran said most companies start to offer equity positions as part of a long-term package at the director level. “One notch below VPs at a salary between $100-$125,000 is the general rule,” he said. Vesting is often done over a three-year period, with one-third added each year.
Wetzel said clawbacks in pay are becoming popular, in both public and private companies. That allows companies to track performance over a longer period of time. “If somebody who gets big incentive pay has two really good years, they may not have the passion for the next year,” she said. “With a three-year payout, it keeps the game in play.”
The Mercer report last month also said income statement-related performance metrics, such as revenue and operating income, are typical of short-term incentives. Thirty-six percent of S&P 100 corporations use earnings per share, 49 percent use other profit measures, and 47 percent use revenues.
The Mercer report said short-term incentive (STI) and long-term incentive (LTI) programs need to complement each other. LTI programs should motivate executives to develop strategies and policies to achieve long-term growth and increase the value of the organization. Effective STI programs should motivate executives to execute on strategies and policies, and make good operating decisions to maximize performance over the course of a year.
But the practice of promoting from within can have the effect of holding down executive pay. “Someone coming up from the inside is not going to cost as much as bringing someone in from the outside,” said Halloran.
Macroeconomics is another factor affecting pay. The energy industry’s tough times will keep pay down in that sector, and companies that do a lot of their business overseas are being hurt by the strong dollar. “These macroeconomics issues have nothing to do with executive performance,” Halloran noted.
Increasingly, incentive plans are spreading throughout companies. “Each level is modified with a big one for the executives, another for the middle management, and another one for the remaining employees,” Wetzel said. Wheeler said if management really works with employees, they can get a plan done.
Halloran said a majority of companies today have incentive programs that go fairly deep into organizations. “The more successful companies go deep with plans that are tied to either company performance or to business unit performance,” he said.
What’s the most successful incentive program the panel has seen?
Wetzel told of an energy company that based its plan on well productivity over five years. “The plan was designed to increase production,” she said. “It was very transparent, and as a result everyone has performed well above expectation. The plan has paid out millions and millions of dollars.”
Halloran said a large retailer wanted to add gas stations to its store locations. The logistics are complex, but every year for five years, the company has met its goals.
Wheeler said a high-end steak house was losing its best chefs, because they were leaving to start knockoff restaurants. The incentive created gave a sense of ownership for the chefs. “Eventually, there was no reason to leave,” said Wheeler, “because that sense of ownership changed everything.”
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