How to Tie Pay to Goals, Instead of the Stock Price
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September 8, 2002

How to Tie Pay to Goals, Instead of the Stock Price

By DANIEL ALTMAN

In a short memoir of his time at Yale University, James Tobin, the late Nobel-winning economist, separated professors there into two camps: the institutional types and the free agents. The institutional types were committed to building Yale's economics department and stayed loyal to the university. The free agents looked for better job offers and moved often.

The free agents might have been brilliant scholars, but the institutional types, Professor Tobin observed, were more valuable to Yale.

There may well be a parallel in corporate America.

In recent years, fatter and fatter pay packages, laden with stock options and other rewards like low-interest loans, have helped turn many executives into free agents.

Yet because it was the way to sure gains, the free agents often played to Wall Street and turned their stock and options into quick, easy money rather than ensuring their companies' long-term prospects.

Finding and retaining executives who are committed to helping a company grow over the long run might stop the cycle of skyrocketing pay and dwindling tenure. It might also help to curb the anything-goes ethics that led to the type of excesses seen at companies like Enron and WorldCom.

The question is this: How can companies reward executives in a way that provides proper incentives for good performance and encourages high-performance institutional types?

While corporate boards struggle to answer that question, professional experts on executive pay, as well as academics who study incentives, offer some guidance. Many recommend granting stock, especially with restrictions on its future sale, instead of granting options. Some suggest promoting loyalty and performance by tailoring executives' packages to their personal tastes — within reason. Virtually all the experts recommend an emphasis on long-term rewards for long-term success.

Pay packages "will be more goal-oriented than purely market-oriented," said Steven E. Gross, who leads the United States employment compensation practice at Mercer Human Resource Consulting. Rather than depending on stock prices alone, rewards could include grants of cash or stock for concrete achievements over a period of years, he said.

The trend that culminated last year, when executives of failing companies cashed in huge stock grants and options, actually began two decades ago, during the leveraged-buyout wave of the 1980's. Firms like Kohlberg Kravis Roberts, as buyers of undervalued businesses, looked for ways to link the outsiders they installed as executives to their new companies' futures, according to a recent paper by Brian J. Hall, a professor at Harvard Business School. Institutional investors also pushed executives to take ownership stakes, thinking that the executives would work to increase the return on their investments, Professor Hall wrote. As an added incentive, the tax and accounting treatment of stock options made them cheaper to dole out than cash or stock.

But such pay plans, Mr. Gross said, have little downside for executives. "I'm encouraging you to take risks to raise the stock price," he said, taking the role of a corporate board. "What happens if you fail? Nothing."

 
In the 1990's, the trend gathered speed. Pay packages became sweeter as the market for executive talent became tighter. The success of outsider chief executives led companies to realize that they might achieve impressive results by bypassing their internal talent pools, said Robert H. Frank, a professor of economics and management at Cornell University.

By 1993, top executives were moving among the country's biggest companies with increasing regularity. In that year, Eastman Kodak, I.B.M., Metro-Goldwyn-Mayer, Sunbeam-Oster and Westinghouse Electric all found new chiefs from outside their own executive suites.

Professor Frank compared the budding market for executives to the advent of free agency in baseball in the 1970's. Once teams could compete to lure talent, some players' salaries broke through the traditionally flat pay scale.

"It just became a free-agent market once there was this seismic shift to the view that people outside your company might be able to help your company," Professor Frank said.

Equity-based pay may have begun as a way to align the interests of executives with those of shareholders. But with more competition for talent, favorable tax treatment and a rising stock market, it often became little more than a cheap solution for attracting top executives. By 1999, some 60 percent of chief executives' annual pay came from stock and options, according to Professor Hall's calculations. Many companies, concerned about meeting quarterly earnings projections, also began to orient their pay packages toward short-term rewards.

Evidence of that shift still pervades pay packages at big companies. "They're not thinking about long-term incentives," said Clair Brown, who heads the Center for Work, Technology and Society at the University of California at Berkeley. "Their long-term outlook is about a year."

In a perverse way, shortsightedness might make sense, given the labor market for executives. A worldwide study of midsized companies released in June by DBM, a human resources consulting firm, found that chief executives in 2001 had been in office an average of three years. Companies that had three or more chief executives in the last decade included especially troubled ones like Kmart and Waste Management, but also others like Apple Computer, Blockbuster and the Ford Motor Company.

Yet it takes about 18 months for a chief executive to feel at home, said Denis St. Amour, president of DBM's Center for Executive Options. "That, in effect, gives you approximately a year, after you've gone through the learning curve and the acclimatization curve, to do your thing."

Executives planning to stay only a few years might have done a good job of massaging numbers for quarterly earnings reports, when that practice was more in vogue. But taking time to think about creative, long-term projects could have been contrary to their best interests. Investing in such projects could hurt earnings in the short term, and executives could not necessarily count on being in office long enough to reap the rewards of the projects.

"How many quarters does a chief executive have before people are going to start grumbling?" Mr. Gross asked. "You force people to be courageous."

Executives had a stronger incentive to engineer quick jumps in stock prices. Having stock options that could be exercised at will only enhanced that incentive. "The idea that you could cash them in at any time did really give a huge payout to anybody who could jack the price up in a hurry," Professor Frank said.

If the share price did not rise, options offered little incentive for an executive to stay, said J. Mark Poerio, a lawyer specializing in executive compensation issues at Paul, Hastings, Janofsky & Walker in Washington. If a shock to the market sent the stock tumbling, the executive might have considered the options worthless for the near future. "The stock options created an incentive to stick around and get rich," Mr. Poerio said, "but at the same time, if it didn't happen fast, it didn't give you the retention incentive."

During the recent boom, boards often found themselves looking for a hot new chief executive to slake Wall Street's thirst for shareholder value. A popular strategy, Mr. Poerio said, was to look for top talent holding apparently worthless options and to offer new grants at attractive prices.

Of course, companies trying to hold on to executives can also grant new options, or simply change the prices at which old options can be exercised. And many did.

In addition to encouraging decision-making horizons too short to guarantee long-term growth, the use of options might have made pay packages too mechanical. Job performance came down to a numerical formula involving stock prices and option values, both of which the executive could influence. "If I have a very complex performance package, I'm going to be spending all my time thinking, `How do I game this system?' " said W. Bentley MacLeod, director of the Center for Law, Economics and Organization at the University of Southern California.

The system may well turn institutional types into free agents. "You've maybe taken a chief executive and you've turned that individual around to do things in a way that will only get short-term results," Mr. St. Amour said.

Even executives who are loyal to a company increasingly feel the lure of swimming with the sharks to become richer. "The stayers definitely are getting left behind," Professor Brown said.

The cycle that caused pay packets to bulge while companies sought out free agents may soon slow. Whether or not options work for setting incentives, the spreading practice of accounting for them as expenses — and the wide perception of their misuse by executives — is likely to limit their popularity.

Professor Frank said easy-money deals would fade. "We'll definitely see many fewer of these short-term options packages," he said. "No one had worked out what the possible implications of those packages were."

The diminished attractiveness of stock and options could make more room for traditional compensation, like cash, bonuses and benefits, or for new strategies.

"Some of this less-expensive compensation is not going to be there," Mr. Gross said. "Now, all of a sudden, the rules change."

Mr. St. Amour said companies could strengthen relationships with executives by tailoring pay packages to a particular person's aspirations. "You need to try and address what's important to the individual," he said. "For some people, maybe it's a secure retirement. For other people, maybe it is a plane, a car or a boat. For other people, maybe it's the opportunity to do something in the organization in a leadership-coaching role."

Mr. Gross said he favored indexing pay to a company's earnings relative to the market. "If the stock goes down, it doesn't mean you're a loser," he said, if other stocks are falling as well. Though the notion of using relative, or indexed, returns "hasn't been real popular," Mr. Gross said, more companies are beginning to consider it seriously.

A trend is already emerging toward restricted and deferred stock grants, Mr. Poerio said. These can cut down on poaching of executives by other companies, he said, because they are worth something even if a company's share price falls. Grants might be made on condition that certain goals are met or only after an executive has stayed several years; executives might also be barred from selling stock for long periods.

"You get rich if the company performs well long term," Mr. Poerio said. "That really better aligns the executive's interest with stockholders.' "

Experts offered some suggestions for deciding how and when to grant stock.

"What a chief executive really needs is a short-, medium- and long-term plan that's tied into compensation options," Mr. St. Amour said. "They need to have milestones for that. You can actually build in the safeguards that will prevent someone from doing something in the short term that will give a negative impact in the medium or long term."

Mr. St. Amour suggested that companies invest part of their executives' short-term compensation in an "internal banking system" from which it could be withdrawn at later dates, based on continued success. He also recommended giving a bonus at the end of a longer period, like 5 or 10 years, for consistency in meeting milestones.

Milestones should not be based solely on profits and revenue, he said. "To use and measure against them alone is to disregard the fundamental things that keep an organization strong," he said. Initiating projects for growth and building relationships with clients should also be rewarded.

A milestone plan would have to rely on regular, subjective evaluations — a common feature elsewhere in the American workplace. "One of the big benefits of good management and subjective evaluation is that it allows the worker to be creative, do good things for the firm and be rewarded after that," Professor MacLeod said.

Such plans rely on implicit contracts — unwritten agreements between executives and boards that long-term performance will be rewarded. Executives might commit to forward-looking investments, and directors would wait for long-term growth rather than fixating on quarterly numbers.

Professor Frank predicted that the stock market, having recoiled somewhat from the culture of quarterly earnings manipulation, might welcome this type of a model as long as chief executives communicate their plans clearly.

Such a trend could benefit the longest-serving chief executives, who are often founders or scions of founding families. In the 1980's, several such executives found themselves supplanted by professional managers installed by impatient boards or leveraged-buyout firms. Those who remained usually had an implicit contract with their boards by dint of their deep personal stakes in their companies.

After the market bubble burst, companies did look more toward longtime employees for leadership. The DBM study revealed that in 2001, the number of chief executives hired from outside dropped by half from the previous year.

But Professor Brown said the job market for executive talent could still obstruct a return to old-fashioned relationships built on patience and trust. "I don't think you can restore the implicit contract," she said. "We're in a new situation. Workers are going to continue to maximize their career possibilities, and companies are going to hire as they see fit. Everybody's given up on long-term loyalty." 


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