Performance-related pay works

Dec 14 2007 by Nic Paton Print This Article

Fat cats, snouts in the trough performance-related pay has always been controversial. But new research suggests it actually works, with the most highly paid and rewarded executives tending to be found at the highest performing companies.

The study by consultancy Watson Wyatt suggests that executives at high-performing companies generally receive greater compensation than their counterparts at underperforming companies.

This shows that corporate America's executive pay-for-performance model does work, the study argues.

Chief executives at high-performing companies earned significantly more "realisable" pay between 2004 and 2006, especially from long-term incentive (LTI) awards.

Realisable pay, it said, was the current value of outstanding LTI awards (typically in-the-money stock options, restricted stock and performance share payouts) granted over a specific time frame using the ending stock price.

Between 2004 and 2006, the median realisable LTI for CEOs at higher-performing companies was $5.2m, compared with just $1.7m for CEOs at lower-performing companies.

Separately, the study also found that a growing number of workers were forfeiting "in-the-money" stock options as companies continued to pull back on broad-based stock options.

"The evidence from this year's study clearly indicates that most boards of directors are linking executive pay to financial performance, when pay is measured by its realisable value," said Ira Kay, global director of compensation consulting at Watson Wyatt.

"Executives who deliver above-average performance are earning significantly more than those who don't deliver. And many executives are losing great amounts of wealth when their companies perform poorly. Both are shareholder-friendly outcomes," added Kay.

Yet the study also found a large reduction in the value of stock-based compensation programmes, as the estimated grant value per employee declined by roughly a third between 2004 and 2006.

Additionally, the rate by which workers forfeited stock options increased by nearly a fifth last year, from 4.7 per cent to 5.6 per cent, it found.

"While some options are forfeited because they expire with no value, an increase in forfeitures in a rising stock market suggests many employees are forgoing large amount of intrinsic option value to take jobs at other organisations," said Kay.

"Moreover, shutting out employees from stock options has the potential to create morale and productivity issues, particularly as executives continue to have higher realisable pay.

"Greater share ownership helps motivate executives and employees, while aligning executive pay with performance and shareholders' interests. Companies can make that happen by offering programs that encourage executives to increase their company stock ownership and including a broad-based group of employees in their stock option incentive programs," Kay concluded.

The finding comes just days after a British survey suggested that many UK companies are increasingly looking beyond purely financial measures to set pay for their top executives and leaders.

The study by PricewaterhouseCoopers concluded there had been a sharp increase in the use of non-financial measures, such as customer satisfaction, levels of health and safety and employee engagement, market share, environmental measures and corporate and social responsibility, in its annual report on UK pay trends.

Even at board level, fewer than a fifth of companies now relied solely on measures of financial performance in their annual bonus schemes.

And the use of non-financial measures had risen from 35 per cent of bonus schemes last year, to 57 per cent this year.