Pay for Performance: Paragon or Punchline?

The phrasing is so compelling: pay for performance! It sounds so just, so market-driven, so efficient, so fair, so sensible. And those beliefs have been essential to the concept's growth.

The reality is that it has been gamed, debased and undermined by a variety of strategems designed to assure that performance on the upside is amply rewarded while failures to meet the operational targets that trigger financial rewards are re-adjusted so that the executives in question get the rewards anyway.

Compliant boards and compensation consultants eager to earn further projects have been only too happy to define performance as it suited them, not as results dictated. A common excuse is that 'unforeseen' events  - like economic cycles (!) - should not 'unfairly' penalize management teams. The outcome has been contrary to that originally envisioned, a means of tying management's pay to shareholders' risk. If shareholders benefited, then so would the executive team, or so it was hoped. As the accompanying chart indicates, the percentage of corporations adopting pay for performance schemes grew apace. 

The problem has been that suddenly flexible vesting schedules, resets of stock option awards and bonuses, to say nothing of base pay, have demeaned and corrupted the system. This both contributed to the financialization of the economy and was a symptom on the underlying malaise. It helped spark the ensuing crisis by driving performance towards goals that rewarded short-term outcomes but degraded competitive capabilities in many organizations.

When the interests of the two competing interest groups - management teams and investors - became irreconcilable, changes finally began to appear. As the following article explains, shareholders, seeking greater returns from still-wounded markets, have begun to insist on the elimination of especially egregious practices that benefit managements at the expense of the investment community. This has little to do with morality or ethics. The two have traditionally been allies more often than not and probably will be again in the future. But when one believes itself to be disadvantaged by the practices of another - and financial returns are involved - money talks.

Pay for performance, on its face, makes economic sense. But unless the integrity of the relationship between the two is maintained and protected, it loses its purpose and its value. JL

Joann Lublin reports in the Wall Street Journal:

Though overall pay for chief executives keeps rising, changes pushed by activist investors are helping tie management compensation more closely to corporate performance, and eliminating several practices that critics have seen as excessive or unfair.
Companies such as Citigroup Inc., Abbott Laboratories and EOG Resources Inc. have done away with some controversial executive-pay practices ahead of this year's annual meetings, in a sign that shareholder pressure is squelching some long-cherished rewards.
At the top of the list are accelerated vesting of stock and stock options following a takeover, as well as bans on "gross-ups," where employers cover taxes owed by executives for certain benefits.
Activist investors at unions and public pension funds are pushing many of these changes, empowered by the federal requirement that U.S. companies give their shareholders an advisory vote on how they pay their executives.
Investors voted against pay policies at 58 companies last year, according to Institutional Shareholder Services, which advises big investors how to vote in corporate elections. Altogether, 325 companies won less than 80% of the vote. The symbolic say-on-pay votes don't require corrective steps by companies. But poor outcomes can embarrass board members and fuel wider shareholder discontent.
Citigroup, the third-biggest U.S. bank by assets, was the only major lender to lose its shareholder pay vote. The defeat in April 2012 reflected shareholder unhappiness over CEO Vikram Pandit's $14.9 million pay package for 2011 and metrics used in setting compensation targets for senior managers. The board forced out Mr. Pandit in October after a series of mishaps.
Chairman Michael E. O'Neill responded by conferring with investors over the summer and fall, meeting about 20 who together held nearly a third of the bank's outstanding shares. Early last month, the board's compensation committee, also led by Mr. O'Neill, set a new policy stipulating that executives wouldn't automatically be able to cash in unvested stock awards in the event of a takeover—even if they lose their jobs.
The odds of a Citigroup takeover are low, of course, but the move came as the AFL-CIO was pushing a shareholder resolution to end the practice.
The compensation committee's new policy "codifies its previously held view that the vesting of deferred equity awards to executive officers should not accelerate...as a result of a change of control of Citigroup,'' Citigroup spokeswoman Shannon Bell said. The labor federation dropped its proposal.
In late February, Citigroup unveiled a new compensation plan for the top brass, including new CEO Michael Corbat. The plan partly links rewards to stock performance and return on assets, a measure of the New York's company profitability relative to its size. With compensation "now tied directly to performance,'' the Citgroup board heeded shareholder complaints that "metrics lacked rigor,'' according to an unusual letter in the latest proxy statement, with all directors listed as signatories.
Investors including the AFL-CIO and International Union of Bricklayers met with Mr. O'Neill on Monday. The Citigroup chairman promised that the big bank will continue to disclose specific performance measures and monitor them so they remain appropriate, said Brandon Rees, acting head of the AFL-CIO's Office of Investment.
"Mr. O'Neill appreciates the input the Board has received from investors and looks forward to continued dialogue," Ms. Bell said Monday.
Pharmaceuticals maker Abbott Laboratories also has come under shareholder pressure over executive pay. The company lost 22% of the vote for say-on-pay in 2011, partly due to concerns over lofty pay for CEO Miles White, who received 2010 compensation valued at $25.6 million.
Proposals to ban gross-ups and to curb accelerated vesting of equity drew 38% of the vote last year, a high percentage for measures without management support.
Effective Jan. 1, Abbott eliminated gross-ups for officers. The company changed course "as part of its annual review process and in response to shareholder input,'' spokesman Scott Stoffel said. Mr. White's compensation reflected his experience and performance, Mr. Stoffel added.
Oil and gas producer EOG also narrowly won its shareholder vote on pay in 2011 and subsequently banned future gross-up payments to executives.
For last year's annual meeting, union-backed Amalgamated Bank submitted a resolution to limit accelerated vesting of equity that won 42.5% of the vote. Last October, EOG unveiled a performance-share plan without accelerated vesting upon a takeover. EOG didn't respond to requests for comment.
Technology company Hewlett-Packard Co. faced opposition to its pay practices this year from ISS. The proxy adviser had criticized H-P's board for not taking an $8.8 billion write-down related to the flawed acquisition of U.K. software firm Autonomy into account when determining executives' incentive awards and recommended that investors vote "no."
H-P modified its compensation scheme just days before its annual meeting Wednesday by restricting the maximum potential payout for top officers under a performance-linked plan, according to a regulatory filing.
ISS responded by dropping its negative recommendation. H-P said last week it believes its pay-for-performance program reflects the industry's best practices. H-P won approval of its pay practices with 75% of votes cast during Wednesday's meeting.
Some companies resist activist shareholders' protests over pay. Ventas Inc., which owns real estate used by health-care businesses such as hospitals and nursing homes, faces proposals this year to ban gross-ups, put limits on accelerated vesting and require executives to hold stock for longer periods of time.
Ventas won just 66.6% of the vote on its executive compensation policies last year. Still, the company will lobby major investors to oppose the latest resolutions. "It's in our shareholders' best interests to retain board flexibility,'' said Kristen Benson, Ventas's corporate secretary.