Pressure Prods Some Cos. to Revise Incentive Plans

Corporations are starting to go back to the drawing board to shape incentive plans and performance goals for executive compensation in 2010, thanks to economic uncertainty and populist pressure making it more difficult to get those tasks done.

A look at more than 200 early proxy filings reveals some changes to incentive plan practices, with some companies revising or increasing their performance metrics, others adjusting their performance goals, and still more setting new or longer holding periods, according to data compiled by executive compensation research firm Equilar.

One clear shift: Companies are putting more heft into their performance plans, rather than giving executives discretionary pay-outs, says Aaron Boyd, an Equilar research manager. “In the current climate, companies want to make sure their goals, metrics, and performance plans in general appropriately set and accurately reflect the success of the company,” he tells Compliance Week.

That’s not to say companies are overhauling compensation plans altogether. “We're not seeing wholesale revisions of plans, but companies are making some modifications, exchanging some metrics for others or tweaking their payout curve,” says Robert Newbury, head of compensation research at consulting firm Towers Watson.

Newbury says no single change has emerged as a dominant new trend; rather, “Companies are looking at their own program and seeing what bests fits for them,” he says. For example, some companies are moving toward incorporating business unit results for executives, while others are moving on the opposite direction.

Todd

Paula Todd, an executive compensation consultant also at Towers Watson, says some of the changes may be needed to “recalibrate” plans to ensure that they work as intended amid today’s economic turmoil. “Some companies may not have stress-tested their performance measures well enough to see how the different measures interact with each other [in a volatile market], or how sensitive they are on the upside or downside,” she says.

Matt Turner a managing director at compensation consulting firm Pearl Meyer & Partners, says compensation committees “are spending a lot more time and attention on performance measure selection and the goal-setting process.”

Boyd

The early proxy filings studied by Equilar included several examples of companies adding additional performance criteria to their plans. “Companies are recognizing that, in defining the success of an executive, they might not get the entire picture with just one metric,” Boyd says. “Diversifying their performance metrics allows companies in certain cases to take a broader measure of success.”

Data from Towers Watson bears that out. In a survey of 212 large North American companies conducted in late 2009, 89 percent reported using at least two performance measures in their annual incentive plans for top executives; two-thirds said they used at least three. Sales or revenue was the most common metric, followed by earnings per share or cash flow tied for second, and EBIT/EBITDA (earnings before interest, taxes, depreciation, and amortization) in third.

Turner

“It used to be that just looking at a company’s business strategy and peers would be good input for the measures in the performance plan,” Turner says. “Now companies are digging deeper to look at the link between performance measures and value creation.” One measure Turner says he’s seeing more often, perhaps due to market volatility, is relative total shareholder return compared against an external peer group or index.

Compensation committees “are spending a lot more time and attention on performance measure selection and the goal-setting process.”

—Matt Turner,

Managing Director,

Pearl Meyer & Partners

Heavy-equipment maker Ingersoll-Rand is one company that added more performance criteria to its plan last year. The company’s compensation committee expanded its metrics from two to three, adding available cash flow to its standard metrics of earnings per share and revenue growth; all three are weighted equally in the new plan. And Tenneco Corp. added EBITDA and free cash flow as performance metrics after previously focusing only on total shareholder return.

Other companies are creating incentive awards given only when the executive achieves multiple goals. Avid Technology, for example, recently modified the vesting periods of certain performance-based stock options previously given to some executive officers, so that the awards will only vest when the stock hits certain price targets and the company hits annual return-on-equity goals.

Some companies have implemented additional holding periods following the payout of performance incentives. For instance, TW Telecom decided to pay its 2009 bonuses two-thirds in cash and a third in restricted stock, with the equity portion subject to a four-year vesting period. Northrop Grumman now says half of performance-based stock awards must be held for at least three years. First Commonwealth Financial Corp. will pay awards in performance-restricted shares instead of cash, and those shares must be held for five years, with vesting also subject to the achievement of a target stock price for 30 days.

FINANCIAL PERFORMANCE MEASURES

The Chart below from Towers Watson compares what performance measures were being utilized in 2005 vs. 2010:

Towers Watson Incentive Survey (Feb. 25, 2010)

“It's less acceptable to shareholders to have short vesting and performance periods,” Turner says. “Even tech companies are challenging the idea that you can’t measure performance beyond a year.”

According to Equilar, several companies have changed their entire annual incentive plan from a cash to equity incentives. For example, CIGNA Corp. has adopted a stock payout plan to align management’s awards with shareholder interests. Beginning with the 2010 annual grant, the portion of an executive’s long-term incentive that was previously delivered in “strategic performance units” will now be delivered in “strategic performance shares.” While the SPU program was generally denominated in cash, the new SPS program will be denominated in CIGNA stock.

Numerous companies are tweaking their annual bonus plans to award a combination of cash and equity. Forestar Group will now pay bonuses one-third in cash and two-thirds in restricted stock that vests over three years. For 2010, GATX Corp. will pay annual incentive awards half in cash and half in restricted stock units subject to an additional two years of vesting. Others have moved to a more a performance-based compensation mix, to better align pay with performance. DiamondRock Hospitality redesigned its equity program for 2010 to include performance-based equity awards, instead of solely awarding time-based equity awards.

Jack Dolmat-Connell, president of compensation consulting firm DolmatConnell & Partners, says changes in the equity mix is one adjustment he now sees often. Several factors are driving that, such as the need to manage the burn rate and share pool, how much upside potential the company’s stock has, executive and key-employee retention concerns, and shareholder demand for performance-based equity, he says.

Still, Turner says, somewhat surprisingly, the use of discretion by boards in annual plans is alive and well. The vast majority of directors surveyed recently by Pearl Meyer & Partners and the National Association of Corporate Directors said they use at least some discretion in annual incentive determination, with the amount increasing among larger companies.

While it might have been expected to decline in the current climate, he says, “We found companies feel just as disposed to use discretion these days.”