Exec Comp Flaws not Unique to Financial Sector

BCG’s analysis of changes in CEO compensation between 2007 and 2008 at 158 U.S. companies with more than $5 billion in revenues found a widespread disconnect between top executive pay and company performance. Nearly all the companies studied (94%) had negative total shareholder return (TSR) in 2008, and, for some, the average level of CEO pay declined from the previous year as expected.

However, about 40% of those companies with negative TSR actually paid their CEOs more in 2008 than they did in 2007, according to a press release.

BCG explained that since the late 1980s, the mix of the executive pay package has shifted decisively toward variable pay in general and long-term incentive compensation in the form of equity vehicles such as stock options and restricted stock grants in particular. The problem, according to the BCG white paper, “Fixing What’s Wrong with Executive Compensation,” is that these dominant forms of long-term incentive compensation are rarely linked to meaningful long-term performance metrics.

As a result, the vast majority of executives continue to focus on the annual cash bonus as the more meaningful and, therefore, more motivating component of variable pay. This trend has led to a narrow focus on maximizing short-term results and a willingness to take risks that boost near-term returns even if those returns prove unsustainable over the long term, BCG contends. Even worse, the firm says, the internal financial and operational metrics typically used to determine the annual bonus often do not really measure what creates value in the business.

“Too often, managers are rewarded for beating plan targets for, say, increasing sales, growing earnings per share, or improving their P&L statement,” said Frank Plaschke, a partner and managing director in BCG’s Munich office and a co-author of the study, in the press release. “But such metrics either reward growth irrespective of its impact on profitability or reward profitability but with no consideration of how much capital was invested to achieve that goal. They also encourage companies to retain earnings when, from a value-creation perspective, there might be better uses of that cash — for example, returning it to investors in the form of dividends.”

The white paper describes five principles that should inform any redesign of executive compensation systems:

• Emphasize the Long Term. Incentive compensation plans should have a bias toward the long term in the form of longer vesting periods and multi-year performance targets.
• Reward Relative Performance. Performance metrics for equity-based compensation should be based on relative, not absolute, performance by indexing a company's performance to that of a designated peer group.
• Measure Performance That Executives Can Directly Influence. In general, executives at the business unit level should be evaluated according to financial and operational performance metrics that are relevant to the units they head.
• Focus on Value Creation, Not Just Earnings or the P&L Statement. Internal performance metrics should take into account how executives use the capital entrusted to them by holding them accountable for the size and sustainability of the cash flows they generate after reinvestment.
• Minimize Asymmetries of Risk. In addition to allowing executives to enjoy the benefits of a potential upside, an effective incentive-compensation system must also ensure that they suffer the costs of potential downside by putting some portion of their own wealth at risk.

The paper also examines concrete mechanisms for applying these principles to the two dominant forms of variable pay: long-term incentive compensation in the form of stock options or grants, and short-term incentive compensation in the form of the annual cash bonus, according to a press release. BCG warns companies that designing an effective executive-compensation system is a complex challenge and requires careful coordination and alignment across multiple high-level units: the board's compensation committee, the senior team, corporate finance, investor relations, and HR.

To receive a copy of the report, contact Eric Gregoire at 617.850.3783 or gregoire.eric@bcg.com .