It's an age-old question for those working in executive compensation: how do we align the interests of executives with those of the shareholders?
The "tried-and-true" answer is to link executive compensation to organizational performance using performance pay. In theory, it's a simple answer. But in reality, it's more complex than you might think. We have to decide what measures of performance we are going to use and how we combine them. The right combination of chosen individual metrics, corporate financial performance metrics, behavioral and ethics measures, and corporate social responsibility metrics is critical to creating a performance pay package that reinforces organizational goals and truly aligns the interests of executives and shareholders.
When choosing this mix of performance metrics, more and more organizations are choosing to incorporate some measure of Total Shareholder Return (TSR). Tying executive compensation to TSR-based performance metrics has been described as a "simple and direct" tool to align the interests of executives with those of the shareholders. Including TSR-based performance metrics into compensation packages for executives has increased across all sectors of the economy from approximately 16% in 2004 to more than 48% in 2013 (see article referenced below).
But it turns out things are not as simple as they seem... New research examining a sample S&P 500 companies has found no statistical evidence of the anticipated positive impact of executive compensation plans including TSR-based performance metrics on the performance of the organization (see Enayati, Hallock and Barrington, "TSR, Executive Compensation and Firm Performance", Institute for Compensation Studies, ILR School, Cornell University, 2015). In fact, the effect of these TSR-linked compensation plans on one-year, three-year and five-year TSR measures are only occasionally statistically significant, and are often negative!
What this research did find was a consistent pattern of the negative relationship between executive compensation plans including TSR-based performance metrics and total revenue growth of the organization. They note that this is largely driven by the effect of last year's compensation plan on current year revenue growth. These patterns were present even after controlling for influential factors such as firm size, economic sectors, whether a change in CEO leadership occurred during the relevant time period, changes in the economic climate over time, and firm-specific fixed effects.
What does all of this mean? First of all, it's important to keep in mind that this analysis is looking only at the correlative relationships between variables, not causal relationships. We can't say that having an executive compensation plan that includes TSR-based performance metrics causes lower growth in total revenue. Second, studies of the relationship between TSR-based performance metrics and actual firm performance is limited. As the authors note, more empirical research on this question needs to be done, and these findings should be considered a first, not final, step in looking at this important question.
From my perspective, the upshot is that executive compensation - and pay for performance in general - is a hard issue to tackle. "Simple and direct" is a great place to start, but it often turns out that seems to be simple and direct is complex and convoluted.
Stephanie Thomas, Ph.D., is a Lecturer in the Department of Economics at Cornell University and the Program Director for the Institute for Compensation Studies (ICS) at Cornell’s School of Industrial and Labor Relations. Throughout her career, Stephanie has completed research on a variety of topics including wage determination, pay gaps and inequality, and performance-based compensation systems. She frequently provides expert commentary in a media outlets such as The New York Times, CBC, and NPR, and has published papers in a variety of journals.
Thanks Stephanie,
Companies have to look at how their performance correlates to TSR before using it. Some companies are market leaders and influence the TSR of others in their industry and others don't correlate as well. TSR seems like a great metric on the surface but may not be the right metric for every company when you dig deeper.
Posted by: Trevor | 03/22/2016 at 10:30 AM
You are certainly correct on your observations. Executive compensation and measuring executive performance in a constructive way is a 'slippery slope' at best.
Perhaps the folks who 'discovered' the 'sticks' that were used to find water underground in the 1700s could be recruited to address executive compensation. Or how about the people who read fortunes by feeling the bumps on your head?
Posted by: Jay Schuster | 03/22/2016 at 10:58 PM
Good parallels here with other pseudosciences. Some farmers still use dowsers. Phrenology had adherents until the last century, too, despite the failure of either approach to meet scientific standards of accuracy. Same applies to many of the arcane rituals performed in board rooms today, I suspect ... even though they may share similar traits. Much is claimed but little is proven. Basic research like this is vital.
Posted by: E. James (Jim) Brennan | 03/23/2016 at 01:50 AM
TSR...
First, the SEC has jumped on the TSR bandwagon fairly aggressively. https://www.sec.gov/news/pressrelease/2015-78.html. Companies will need to communicate the link between TSR and executive compensation even if they don't use it as a measurement for executive compensation.
More importantly TSR is a great metric for nearly every publicly traded company, but that does not mean is converts well into a goal for executive compensation. I wrote a bit about that issue here: http://www.compensationcafe.com/2014/06/relative-tsr-is-a-bit-like-cough-medicine.html
The research cited shows that the companies using TSR tended to be larger and less profitable. This does not surprise me. Those types of companies have: 1) the scrutiny from investors, 2) the budget required for this often expensive plan design process, 3) the need to justify leveraged payouts, when earnings may not explicitly support them.
The lack of correlation between the plans and performance has been shown in academic papers and consultancy whitepapers in the UK and elsewhere for at least 10 years. In looking at this prior research one clear issue came to the forefront. These plans, for relatively equal companies, are not designed equally.
Peer groups (size, adjustments etc.) used are fairly imcomparable from company to company.
The percentile targeted for 100% achievement ranges widely.
The amount of leverage for over and underperformance does not track well from company to company.
Those three factors alone would lead to a wide range of potential payouts for very similar companies. Throw in volatile stock prices and the other list of variables and features for this kind of compensation and consistency goes out the window.
I agree with Stephanie that "executive pay for performance is hard to tackle" an that "simple and direct". Big companies are complex. The stock markets are complex. Measuring performance is complex. Equity compensation is complex. While simplicity may be a goal, it should override effectiveness.
Posted by: Dan Walter | 03/24/2016 at 03:37 PM