In the latest of our Q&A interviews with governance and compliance executives, we talk to Paul Kirincic, head of human resources at $88 billion McKesson Corp., about reforming equity-based compensation. An index of previous conversations is available here.

McKesson made some pretty dramatic changes to its compensation program recently. Tell us about how you revamped the way you pay your employees.

We made changes over the course of the last two years in our long-term compensation programs. As we looked at the future with FAS 123, we knew the way we were distributing options would have to change. We began to take a hard look at who we were giving options to, and we realized that we couldn’t continue to afford to give options to that many people. It seemed unfair to just eliminate options altogether for certain levels in the organization. If you needed to cut your participants back 50 percent, the easy way to do that would’ve been just to draw a new line and not grant options to anybody below that line, but we didn’t think that was fair. The other change we made in our program was the realization two years ago—and we believe it’s still true today—that people value full-value shares as opposed to options.

So we thought, if we’re going to continue with a long-term program, rather than eliminate a whole pay rate or classification of employees, why don’t we grant options in more process-focused, formal way to the better performers—to create a program that says, you have an opportunity, based on your performance, to get a restricted stock award. So we may only give options to 50 percent of the people at a certain level. The question was, how do we determine which 50 percent to give it to? We decided the fair way to do it was based on individual contribution to the company’s success. We go through a process where we identify those top performers and grant them an award. Just because you get an award one year doesn’t mean you’ll get an award next year. We put in place a discipline to allow us to do that, then we set a target.

And the details?

In June, we’ll go to our employees and say, for your performance in the past year, we’ve selected you for target award of, for example, 1,000 shares. That award has the ability to have a 200 percent upside. Based on individual performance over the next year and the company’s performance, it could grow to 2,000 shares. Conversely, if you don’t do very well and the company doesn’t do well, it might be less than 1,000 shares. A year from now we’ll make the determination of the final award and grant an award of [restricted stock units] that will vest over the next three years. So, we’ve taken a long-term stock option program that was a pretty much a program of entitlement, and put a performance aspect into it.

You mentioned changing the number of employees who receive options. How dramatically did that change?

The number of people receiving equity awards will probably be reduced from historical levels by about 40 to 50 percent, but the pool of people who can get those awards remains the same. We haven’t drawn that line in the sand that says if you’re below the line, you’re never going to get options or equity grants again. We’ve said, based on performance, we’ll continue to make awards.

How did you craft this plan? Did you look at industry benchmarks or work with a consultant?

It was a joint effort. At the end of 2003, we brought together a group of our most senior business unit leaders and said, “Here’s the coming problem, or the coming opportunity, however you chose to look at it, that 123(R) was going to create.” We asked them, “How do you feel about this? You’ve got to manage the cost aspects of your businesses while continuing to reward your employees.” We listened to them tell us what their business needed.

At the same time, we also listened to what our major shareholders were saying about the need for performance-based, long-term equity programs. Then it was a joint effort between myself and my group in corporate compensation, continuing feedback from our business leaders, and external support from [consultant] Compensation Strategies.

FAS 123(R) mandates that stock options be expensed. How much was that a factor in all this?

FAS 123 got us thinking. Number two was this idea of driving a performance factor in our equity programs. I’d say those were two of the main forces.

How long did it take to put the new compensation structure in place?

We started in earnest collecting ideas towards the end of 2003. We’re in the implementation stage now. We settled on this design about six to 12 months ago. The delays in implementing FAS 123 gave us time to refine the plan and make sure we had all the elements in place. We used that time to refine the design and begin the communication process. As we got to the implementation stage, which began after the first of this year, we were in good shape with our managers understanding the program, the criteria, how it fit with our other compensation, and to do the appropriate amount of employee communication.

Did you hit any speed bumps along the way?

We’re always hitting speed bumps along the way. Some of the decisions we had to make along the way included how much our business and our industry could afford, so the size and breadth of the awards were always something we were looking at. We had some discussion around the time to vest. We selected a three-year vesting. You might say that’s a speed bump. I’d say that was a decision point on that structure that we made sure made sense for our people. The whole impact on whether this program is variable accounting—we hit that speed bump a couple of times. And, what kinds of performance measures to use from the company aspect of performance. We had to look at what are we going to measure? Enterprise performance? Business unit performance for that employee? What does that measurement look like? We had some back and forth on those types of design elements.

How did you communicate all of the changes to your employees?

We’ve used every method known to man. We’ve talked about it in print, used our employee portal, held meetings, Webcasts. We’ve also tried to keep the supervisor or the person making the decision about who gets the awards as a knowledgeable source of information. This isn’t impacting all 26,000 employees; it’s those who receive equity, which is a smaller subset. We’ve used the appropriate methods to talk to our top 2,500 people.

How have employees reacted to all of these changes? What kind of feedback have you gotten?

What our employee survey information has always told us is, our employees want to be recognized and rewarded for their performance. So our employees are excited about it from that standpoint. They realize this is another differentiator for working here and that their individual performance is going to be recognized and rewarded. That said, there’s always that, “So how am I doing? How fairly is the program going to be administered?” We’ve put in place the tools to allow that to happen and we’re confident it’s going to be managed appropriately.

We’re getting ready to communicate those first awards, so we’re at that point where we’re ready to launch. Six months from now, I’ll have a better answer to your question, but I believe we’ve done everything we can at this point to be fair with the program.

How will you measure the results and that you achieve what you want?

We are very strong believers in feedback. We’ll measure the program as we go forward in terms of whether it’s delivering what we anticipated and from a perception standpoint. We’ll use a variety of tools with our supervisory group and the employees impacted to get feedback on how it’s working, is it a fair program, and how we can improve it going forward. We’ll put in a formal structure to allow us to gather the appropriate data to drive further decisions.

Thanks, Paul.