Why companies are favoring formulaic metrics over discretion for determining CEO success
By Aaron C. Boyd
How do you know if someone performs well? This seems like a basic question. One that company boards are asked throughout the year, but especially at the end of the fiscal year when bonuses are determined. Yet it seems like each year, it becomes harder and harder to state with certainty and reward accordingly. What happened, and what can boards do about it?
The majority of pay for an executive now typically comes from equity awards, while yearly discretionary bonuses have been replaced by annual incentive plan payouts. Incentive plan bonuses serve the same function as the traditional year-end bonus. They differ, however, because instead of the compensation committee determining the appropriate level of pay at the end of the year while factoring in all the circumstances, the typical plan requires metrics and goals to be chosen at the beginning of the year. A payout is made at the end based on achievement measured against a formula. These incentive plans typically offer little in the way of flexibility and place a big emphasis on getting the metrics and goals right at the beginning of the year. The important difference is that performance is now determined based on outcomes, not behavior.
Brief History of CEO Bonuses
Bonuses for executives go back much further, but in 1993, section 162(m) of the United States Internal Revenue Service (IRS) was made law. That section eliminated the tax-deductibility of pay above $1 million unless the compensation was performance-based. The original purpose was to prevent oversized executive compensation packages. To the dismay of the proponents of the IRS law, the opposite effect occurred. Executive pay grew at an even faster rate. Fast-forward 15 years to the financial crisis, and many people had the same expectation about pending legislation to curb executive pay. Admittedly, many of the current rules passed have been successful at curbing pay only at Wall Street financial institutions, or at least successful in lowering it from the highs in 2006. However, CEO pay has continued to grow, and the median pay for CEOs is at an all-time, non-inflation-adjusted high.
Companies spend considerable amounts of time studying indicators to determine which provide an accurate reflection of how well the company has performed or how successful it will be in the future. Hundreds of leading and lagging indicators are used by outside investors to accurately predict where the company’s stock price is moving. Quarterly earnings statements are dissected, presentations are made, analysis is given, and investor reports are created—all for the purpose of assessing the state of the firm. All of that noise makes it hard to boil down the numbers to form an opinion, which is why only a handful of metrics are viewed as critical
The most popular metric used is total shareholder return (TSR). Since the goal of companies is to bring returns for investors, growing the value of the company is an end goal. While TSR is great from an investor’s standpoint to assess a firm’s performance relative to other possible investment decisions, it carries with it a lot of other factors. Macroeconomic financial situations, such as increasing interest rates, play a huge role in certain companies’ stock prices, while others are impacted by commodity prices, for example, for oil or precious metals. TSR over a one-year period can often provide unreliable results reflective of more outside circumstance than internal achievement.
Net income and earnings per share (EPS) are other highly popular metrics used to determine the health and outlook for a company. Referred to as the bottom line, these metrics illustrate whether a company is profitable, which is the ultimate test of a company’s viability. These measures do have their detractors who claim these numbers can be more a reflection of a company’s financial and accounting creativity than true performance. They also may not provide a good view of how the company will do in the future.
Companies may also be able to determine success using measurements not found on the operating statement. New stores opened, factories built, and product quality, to name a few, are all other metrics to be successful that also have implications for the future. Many companies are moving to a more diverse set of metrics recognizing that no one number can accurately demonstrate all the facets of what a company has done throughout the year. Boards have the challenge of determining the right mixture of financial and non-financial goals. The next challenge is figuring out who is actually responsible for those goals.
"CEOs are held responsible for success and failure, their companies become bigger, requiring more people to be successful while also creating more places for things to go wrong. "
President Harry Truman was famous for the sign on his desk that read, “The Buck Stops Here.” President Truman understood that, no matter what part he actually played in the outcome of something, as a leader, it was his responsibility to be accountable. This sentiment often rings true when it comes to company leaders. Leniency is not usually given to the top executives when results do not meet expectations. Quarterly earnings are missed. Revenue targets are too high. Growing expenses are hung around the neck of the CEO, regardless of circumstance.
It is the double-edged sword of being a leader. Success is attributed when things go well. Blame is assigned when things go poorly. The irony is that as CEOs are held responsible for success and failure, their companies become bigger, requiring more people to be successful while also creating more places for things to go wrong.
If we learned anything from the bear market of 2008 and 2009, it’s that factors beyond one person’s, or even one company’s, control can significantly impact how an organization succeeds. Certainly, some companies deserved blame for their role in the market downturn, but many more were put in unfortunate situations that required layoffs and cutbacks because credit dried up, the economy was suffering, and people cut back on spending.
As was mentioned earlier, performance is now often assessed based on results and not behavior. A CEO may execute to the plan perfectly, but commodity costs, disruptive technologies, new competitors, or macroeconomic financial hardship may cause targets to be missed. This has led to an increase in the use of relative metrics that compare results against those of other companies—measures done to account for factors affecting similar companies, but is still based on a formulaic approach.
The shift to a formula-based bonus has precipitated the decline of the use of discretion for year-end payouts. Not only does the use of discretion threaten tax-exempt status, but it is viewed unfavorably by outsiders. These aspects build to make a case for the near extinction of positive discretion, the upward adjustment of bonuses, while very little wiggle room exists for payouts to be adjusted after the fact.
In order for a bonus plan to qualify for the 162(m) IRS provision, positive discretion must be excluded from the terms of the incentive plan. Negative discretion is allowed, giving compensation committees the flexibility to reduce or eliminate a payout, but not increase it. If a company wants to ensure an executive is not prevented from receiving a bonus due to external factors, the compensation committee is actually incentivized to design the bonus plan in a way that makes positive discretion unnecessary.
Another big factor in the decline of discretion is the disapproval of those outside the boardroom. Many institutional investors have a negative take on positive discretion. BlackRock states in its voting guidelines that “overreliance on discretion or extraordinary pay decisions to reward executives, without clearly demonstrating how these decisions are aligned with shareholders’ interests” will likely result in a negative Say on Pay vote.
There is also a perception that the proxy advisory firms, namely ISS and Glass Lewis, will give a negative recommendation if the positive discretion exists in the plan. Glass Lewis recently clarified its voting guidelines to state that it is not unequivocally against use of discretion, but does require clear disclosure explaining the reason for the decision and how it fits into a pay for performance model. In addition, ISS lists the use of discretionary pay components as a problematic pay design issue in its most recent compensation policy. Glass Lewis states that the awarding of a discretionary bonus as a replacement for failing to achieve an incentive plan payout is a cause for it to issue a negative recommendation.
The media and watchdog groups also typically disapprove of the use of positive discretion. They may not have direct influence through the use of an actual vote, but they often have the biggest megaphone and will highlight companies that use these types of adjustment.
So where do we go from here? Will positive discretion reach ultimate extinction as I referred to earlier? Will boards ever be able to reclaim the use of their best business judgment to determine how much a CEO receives without fear of reprisal from the media or shareholders?
The short answer is probably ‘No.’ But there is a silver lining to the recent decline. Over the last few years, as companies have moved even further away from the use of discretion, it has exposed the limitations of the formulaic incentive plans. A company cannot predict everything, and choosing metrics and goals at the beginning of the year doesn’t do away with the need for a holistic review at the end of the year. With disclosure around compensation growing every year, companies have a greater platform with which to explain the reasoning behind their actions, thereby bringing outsiders into the minds of the compensation committee. Shareholder engagement has grown over the last few years, which is resulting in a greater understanding between stock owner and the company. This is leading to more trust, which, in turn, is providing greater freedom to the compensation committee to use its judgment as long as they provide an explanation.
Board members must be careful about exercising discretion, though. Thoughtfulness is the name of the game for compensation committees as they discuss the best way to approach altering an incentive payout. Disclosure is great, but no matter how good the relationship with investors, there needs to be a compelling reason for the use of discretion and a clear benefit to using it. More information is available every day to properly assess performance from a million different angles, but there also appears to be a growing number of voices willing to share their opinion on a company’s decision to use its best judgment.
Discretion may never regain its lofty place in the pay package of a CEO, but it appears that its use does not garner as negative a reaction as it once did. Should companies be allowed to use more discretion? I’ll leave that up to you.