March 3, 2011
Performance Share Plans – The Best of Both Worlds
This article originally appeared on Robin A. Ferracone’s “Executive Pay Watch” blog on Forbes.com.
In a recent Compensation Committee meeting, one of the executives participating in the meeting asked whether or not I favor Total Shareholder Return (TSR) as a performance measure for performance share plans. This question was particularly apropos, as performance share plans are now prevalent among US companies, with approximately half of S&P 500 companies offering them, and with TSR as the most popular metric in these plans.
In addition, relative TSR is used by vast majority (80 percent) of FTSE 250 companies in the UK for their performance share plans, due largely to the fact that their version of Say on Pay was implemented back in 2006. So, the answer I gave the executive at the meeting flew in the face of conventional wisdom. I told him that relative TSR is not my first choice. Why? Because while TSR does a good job of measuring performance outcomes for shareholders, it does not do a good job of signaling to plan participants how to deliver those outcomes.
Now, don’t get me wrong. Anyone who has read my book, Fair Pay, Fair Play, can see that I am an ardent proponent of achieving alignment between executive pay and TSR. So, what could be better than forging a direct link to TSR itself in the incentive plan? The answer lies with financial measures, and in some cases strategic measures, that drive value.
Unlike TSR, good financial and strategic measures can communicate how to drive value, and therefore, can be infinitely more motivational than using value itself. The key in designing such a plan is to determine which financial (i.e., input) measures have the most significant influence on the stock price, i.e., the output measure.
Notwithstanding my preference for financial measures, relative TSR can be a reasonable default measure. After all, it does have some redeeming qualities. With relative TSR, companies can have confidence that the plan captures something that investors care about, and that the plan is likely to produce good pay and performance alignment. However, both relative TSR and relative financial measures can do an equally good job of stripping out the effect of external economic and industry factors, thus measuring management’s value added rather than economic conditions.
In either case, the key is to find the right relative benchmark. Unless the benchmark (i.e., using a peer group, industry, or index) is appropriately structured, the measure will do a better job of measuring the company’s volatility, rather than its performance.
For example, we worked with one high-tech company that was measuring TSR against a broad market index (i.e., the S&P 500). However, the tech cycles were much deeper than the general economic cycles, and as a result, the company was really measuring relative volatility, not performance.
In another example, we worked with a company that was measuring its performance against six peer companies. We showed them that if just one company got acquired, the awards would change considerably for no good reason. In this case, we moved the client from using a percentile ranking system to using a TSR range (e.g., +/ – 5 percent) around the median.
Another issue with relative plans is that the payouts may be high, even if the company performs poorly. This argues for having some type of failsafe mechanism in the plan.
In the end, I still prefer a performance share plan that is driven primarily by financial measures that drive value. This type of a plan offers motivational value to the executives as well as alignment to the shareholders. While no plan is perfect, it does seem to capture the best of both worlds.
Robin A. Ferracone is the Executive Chair of Farient Advisors LLC, an independent executive compensation and performance advisory firm that helps clients make performance-enhancing, defensible decisions that are in the best interests of their shareholders. Robin Ferracone is the author of a recently published book entitled Fair Pay, Fair Play: Aligning Executive Performance and Pay, which explores how companies can achieve better performance and pay alignment. Robin can be contacted at firstname.lastname@example.org.