Keeping Creativity in Compensation
A consequence of say on pay is greater homogenization of pay programs.
by Robert A. Eckert and Robin A. Ferracone | September 25, 2014
Robert A. Eckert ran Mattel, the world’s largest toymaker, for 11 years until his retirement in 2011. Prior, he worked for 23 years at Kraft Foods, rising to the C-suite. He currently serves on the boards of Amgen; McDonald’s, where he chairs the compensation committee; and privately held Levi Strauss, where he chairs the human resources committee. Eckert first met compensation consultant Robin A. Ferracone in 2009 when she interviewed him for her book, Fair Pay, Fair Play: Aligning Executive Performance and Pay. The driven founder and CEO of Farient Advisors has been at the forefront of developing methodologies to better align compensation and performance. She co-founded and sold SCA Consulting to Mercer in 2001. After serving in a number of leadership roles there, and at its parent company, Marsh & McLennan, she became global head of human capital at Mercer. She resigned in 2007 and subsequently started Farient. NACD Directorship invited this experienced duo to compare notes on compensation issues. What follows is an edited transcript of their conversation, which begins with a look at the current environment.
Robin A. Ferracone: The economic environment is generally good, so we see companies doing a fairly good job on say on pay. Most of the upheaval that we have experienced since Dodd- Frank was enacted is now stabilizing. Companies are honing their pay-for-performance messaging, and they’re bringing in more long-term performance plans, like performance share plans. The danger is complacency, losing creativity, and not having plans that flex, to ensure that when performance falls off, pay falls off with it. Without these things, you’ve got a real problem.
Robert A. Eckert: We’ve enjoyed a couple of good years in the stock markets, yet at the same time it’s still tough for businesses to grow and perform well. That puts pressure on people: “Boy, the stock is doing well, but is the business doing that well?”
Ferracone: Performance as a basis for compensation—this is an art. Bob, where do you think companies can be doing better?
Eckert: In the spirit of continuous improvement, and with compensation in general, we’ve made really good strides in the last 10 or 20 years, but I don’t know that anybody declares victory because you’re always trying to improve business results, and if there’s an opportunity to improve business results, then there’s an opportunity to tie compensation to support that improvement.
Ferracone: Where we can do better is to provide more insight around how to link financial measures that drive value to compensation. Subsequent to that, goal setting around those measures needs more work. The danger is that if the stock price is good and financial performance is tough to come by, people default to stock price and total shareholder return (TSR) to measure performance, and I feel as though we shouldn’t let ourselves do that. The place to improve is figuring out what measures link to value and to set goals against those measures in the intermediate term, let’s say, in a three- to five-year time frame.
Eckert: Let me back up one step. You and I are very supportive of using some form of TSR in long-term compensation, and broadly speaking, industry has adopted that as well—that’s a really important point. But there are also ways to determine what drives TSR, and some companies I’ve been associated with have used analytical tools to help predict and model what would happen to shareholder returns against various internal performance scenarios. This allows management to take compensation to that next step—what are the two or three things we really want to drive? The result of which will be a good stock price. The senior executives of the kind of companies you and I support get up in the morning and are motivated to do a good job. Compensation can provide focus for them. We’ve both had some experience of shining some light on some portion of the bonus system or on some specific measure you want to improve, and then you see the results improve. What beyond just hitting the end number of TSR can we do to make sure we’re moving in the right direction?
Ferracone: It’s a question of your sight line—what’s going to be motivational and what’s going to give people the signals on what is going to drive value. If I say to an executive, “Well, drive shareholder value up,” then that takes a very strong management process internally to deliver the messages about what’s going to drive value. Not every company has that ability. If you can build some of that focus into the incentive plan as part of the messaging, it can also provide the motivational line of sight.
Eckert: One example from my days at Mattel was when we adopted a pretty strong focus on TSR by building a model of our own performance with the output being TSR. We realized that one of the big drivers of TSR for our company was gross margin, a measure against which we were struggling to consistently improve. While the share price had done well, gross margin started to slip. Then the share price slipped. Gross margin was the single biggest driver in predicting shareholder return. So we put an internal focus on gross margin. That is, we took a portion of our annual bonus and linked it to specific gross margin targets. And sure enough, the organization focused on gross margin, hit those targets, and, not surprisingly, TSR increased and everybody won. TSR is great, but now let’s take it one level or two levels below the surface and make sure we’re driving good performance inside the company.
Ferracone: You make an interesting point about how you had a situation where you needed to drive gross margin to higher levels and therefore drive value. And so my question is, once you get the gross margin to where you think it should be, or whatever the measure is, to what extent do you think measures then need to be changed? My observation is that there can be two extremes: either stick with the same measures and that’s the end of it, or every year there’s a new recipe. What’s your thought on that?
Eckert: I’d rather err on the side of sticking too long with measures I believe are appropriate. But when something changes, anything changes, that’s a great opportunity to say, “Are we still focused on the right things?” And, you know, every once in a while, we need to look at “Are we shining that light on the right thing?” and “What’s today’s issue? Does it require a change in our comp program?”
Ferracone: What is the time horizon over which you use the measure? Maybe that is an area for improvement, because companies might get too comfortable using a measure, or they might change it up every year. Keeping a measure for as long as it truly is useful and testing that and thinking ahead of it is often a good thing. And it’s something that companies could probably hone their processes around.
Eckert: I am concerned that we are taking some of the creativity out of executive compensation. One example is we’ve now put in place a process to deal with the outliers, which is the say-on-pay vote. We’ve got outside people who are influential—like the proxy advisors—scrutinizing compensation. We’ve got the appropriate or even beyond appropriate level of disclosure on compensation. And one result is that we’re seeing numbers that revert not toward the mean but toward the median. So everybody knows what the median is and everybody sets targets around the median, and we’ve largely adopted some form of TSR. It almost feels sometimes like we’re heading toward the NBA’s version of salary, where the very toptier players get a maximum contract. So, for example, LeBron James can make the same amount of money as Kobe Bryant. And there are probably a dozen or two dozen people who get that number one tier, and then you have a second tier and a third tier. My anxiety is that I don’t want to go there and slot leaders so that the CEO gets X million, the CFO gets Y million, and the number three person gets Z million. Some people really deserve a lot of money because they perform really well, and some people really don’t deserve a lot of money because they haven’t performed well. I don’t want to see everything averaged out and I don’t want to see everything slotted. There was a time when compensation was probably too creative and people abused it. That’s why we got to where we are. But my anxiety is that the pendulum might be swinging a bit too far on the other side and the median has become too important. I don’t want to diminish the opportunity to create really insightful tools that drive superior performance which results in executives being compensated well when their companies perform spectacularly well.
Ferracone: The median is just a guide. It’s an input. It doesn’t define what you’re going to do. Whenever we’re consulting with clients, we take a very definitive look at that company’s strategy. What, if anything, has changed? Does this pay program fit with the strategy? And then we also look at whether these programs comport with typical practice in the environment. That’s not the driver. It’s another input. I think creativity is great. The question really is whether our compensation system is attuned to what our business needs. Let me ask you this: how much of this constraint is attributable to proxy advisors, investors, or consultants to the compensation committees, or committees themselves? What’s driving the conversion?
Eckert: I suspect it’s a little bit of all of the above, but I see compensation committees that understand their role of listening to advisors and seeking input from owners and proxy advisors in making decisions. There are more inputs to the committee than there used to be, and I’m not sure that’s all bad. Certainly, the advantage of the current disclosure guidelines is just that: we are disclosing more than ever to interested parties. And if stakeholders have the opportunity to review those disclosures and pose questions, then we’ve achieved what we set out to accomplish. The fact that there are so many people looking at the data and there’s so much data to look at, it’s pretty easy to become too formulaic. I just don’t want to lose that opportunity to find breakthrough pay programs that support breakthrough performance. It’s easy to paint by numbers. It’s more challenging to take the blank sheet and draw. The way that you, Robin, approach this is to start with business strategy and align performance goals with the business strategy and the compensation program—and that’s how it can be done as opposed to slotting people in.
Ferracone: It gives you a different starting point, really. One of the issues that I run into is that certain high-performing firms want to target compensation at above median because they feel like they’ve got a winning management team that has demonstrated great performance. I am reluctant to go there because my concern is when the bloom is off the rose and performance is not so great, then the company is obligated to do the reverse, that is, set target pay at below median. At that point, the retention card gets played. I have a couple of clients that, if they pay above target for a well-performing team, there’s an explicit agreement that they’ll pay below target if times change and performance drops. Do you agree with that?
Eckert: I do agree and I see it. In every compensation program with which I’m involved, I’ve seen above-target performance and compensation, and in the same company, below-target performance and compensation. Here’s a simple statistic: in the 11 years I was CEO of Mattel, if you averaged the 11 years of our annual bonus, I believe the payout was 97 percent of target. The range of payouts was zero in one year to 150 percent, the plan’s maximum. I kept a running total of how we were doing against target. If you’re an easy grader, the company is above target every year, and that’s not right. At the same time, if you’re below target every year, that’s not motivating, so you should work really hard to get the target right. In the short term, it’s hard to do that well. Business results are not that predictable. The environment isn’t that predictable. Things happen, good and bad, and the actual payout should reflect that.
Ferracone: What I try to do is make sure actual pay flexes enough to take into account the ups and downs and rely on that a little bit more than target. I know it’s easier said than done, but that is one way to achieve alignment without getting the target system out of alignment. The target system is harder to adjust. Creativity within some bounds is good.
Eckert: You need to avoid one-size-fits-all and tailor the program for that company’s needs, obviously within bounds, tied to the owners of the company.
Ferracone: I’m feeling as though there’s an opportunity to link the work that the broader board or the governance committee is doing with the compensation committee as it pertains to developing succession candidates and long-term retention targets. How do we make sure that potential successors are locked in differently than those who are less proven? One argument is to give possible successors more equity or make sure that their work assignments reflect that they are aggressively managing their careers, maybe even tie CEO pay to having a good succession process in place. There’s another school of thought that you can’t know who those good succession candidates are and that’s just going to cause us to pay up and we probably shouldn’t go there. I’m leaning more toward thinking that those linkages should be made, and companies should have a deliberate strategy to link compensation to the succession process. Sometimes succession evaluation is owned by a committee other than the compensation committee, and the two don’t get as explicitly linked as they could.
Eckert: Who the CEO is and how much he or she is compensated is a full board responsibility. The discussion of who the candidates are doesn’t require improvement. The notion that we somehow do special things for the next generation of candidates or help the current-generation CEO develop the next generation of candidates, to me, those are all fair game. But, they’re situation dependent. I wouldn’t want to get into a position where it becomes standard practice to have two or three successor candidates internally and those two or three people get a special seven-year grant, for example. I have a point of view in general on retention—that retention is an excuse to do something special for somebody, and it rarely works. People are rarely retained just through compensation. It just drives the price up.
Ferracone: The retention card gets overplayed, and we have to be really careful about that, and I would suggest that compensation committees really kick the tires on it. What about showing the love? I’ll put it that way, where if you’re doing the right things for your people—they like where they work, the culture is positive, the career opportunities make sense and are aggressively managed—then compensation is just really one component of why somebody is there. You don’t want it to be the main component.
Eckert: Absolutely. I want someone who loves the company and wants to see the company do really well and have an “oh, by the way, isn’t it nice that I get to do well, too” attitude. I’ve been fortunate in my experience to work with a lot of really talented, good people who love what they do and where they work. The good news is there is more scrutiny, there is more disclosure, and there is more discussion. There is more thought, analysis, and consideration. Those are all good. We need to keep working to get better and to find the areas of opportunity where we can make a big difference by using compensation in some way. You know, you don’t want the tail to wag the dog here, but we can find opportunities to shine the right light on the right measures and improve performance, and then everybody wins.
Ferracone: That’s the standard to which most investors are holding issuers, not that one size fits all, but does the story hang together and make sense. That’s the job of the compensation committee along with their advisors and management—to have a culture and a program around getting that done.