The hidden risk of “at-risk” pay

Posted by Marc Hodak on May 30, 2014 under Executive compensation, Governance |

On Monday, Staples, Inc will try to win its “Say-on-Pay” vote with ISS recommending against approval the executive compensation plan.  ISS made its recommendation based on its usual arbitrary, micro-managing concerns which are not the subject of this post.  Here, I want to highlight the problem Staples created for itself, without anyone’s help, and unintentionally revealed in this pair of sentences:

The [Compensation] Committee … recognized the need to address retention of key talent and to continue to motivate associates in light of the fact that we did not pay any bonus under the Executive Officer Incentive Plan or Key Management Bonus Plan in 2013 and 2012.

As a result of the changes to the compensation program in 2013, an average of 84% of total target compensation (excluding the Reinvention Cash Award) for the NEOs was “at risk” based on performance results, and 100% of long term incentive compensation was contingent on results.

Anyone reading Staple’s proxy could be forgiven for thinking that these two sentences have nothing to do with each other, notwithstanding that they appear consecutively in this proxy.  It’s clear that neither the authors of this disclosure nor the board that approved it saw the connection, either.  But look carefully at what they are saying.

The first sentence says that a lack of bonuses has created a retention risk with regards to key employees.  The second sentence basically says that the company has affirmed a compensation structure that insures that future performance setbacks will re-create this retention risk.  Not to pick on Staples, you will find a similar compensation structure at most public U.S. corporations.

Among public companies, having 80% to 90% of target total executive pay derived from “at-risk” compensation, i.e., variable pay such as bonuses, has become the norm.  Thus, even if the bonus plan is perfectly designed to pay for performance, or, I should say, especially if it is so designed, a company is guaranteed to eventually encounter management retention problems.  After a couple years of poor performance–which can happen despite good management–key employees will be getting only a fraction of what they can earn elsewhere, and will get restless.  In fact, the only way to avoid retention problems with such a skewed compensation structure is to fudge on “performance-based” awards when things are bad.  That is what got Staples (and many other companies) into trouble.

Of course, paying people when performance is bad when you say you won’t is, as ISS might say, problematic.  It undermines the integrity of your incentive plan, creates cynicism among employees who don’t benefit from such forgiveness when the company is going through tough times, and causes external constituencies to look askance at your governance.  ISS, according to its myopic focus on compensation costs, simply blames the board for awarding bonuses that were not deserved.  They ignore the underlying cause, which is an unsustainably risky compensation structure.  In other words, too much target compensation is “at-risk.”

In fairness, this root cause is invisible to virtually every other corporate critic, investor, board member, and compensation consultant.  In fact, this ridiculous skew toward performance-based pay is one of the few things that all of these constituencies buy into.  But whenever the problem with this structure is made clear to institutional investors, so they can see the downside of paying senior executives like car salesmen getting lottery tickets in lieu of cash commissions, you can see the light go off over their heads. “Oh, yeah.  Why do boards do that?”

The proximate reason is:  That is how everyone else is doing it.  In our era of mindless benchmarking, if all of your peer companies have 90 percent of target compensation “at-risk,” you don’t dare go 50-50.  Peel back the onion one layer, and you see a faux-macho “pay-for-performance” ethos whereby boards can tout how much of their executives’ pay is tied to performance, oblivious to the retention issues that policy will likely create.  In other words, we have gotten to the 90 percent norm via a kind of perverse competition among image-conscious directors egged on by their peer-obsessed consultants

Peel back one more layer, and you see a government policy–S162m of the tax code, to be precise–that literally penalizes companies (and, by extension, their shareholders) for creating a more rational compensation structure, whereby any fixed pay above ten to twenty percent of a typical CEO’s target compensation will result in a punitive tax to their firm.

All of this comes together in a perfect recipe for distorted compensation structures, followed by reasonable measures taken by boards to overcome the inevitable problems created by these structures, followed by the cynicism those measures inevitably breed.

The solution is straightforward:  Bring the target compensation structure of senior executives back into the realm of reasonableness.  In other words, guarantee executives a fixed level of compensation that will be competitive when times are bad, and dial back the target bonus correspondingly so that the incentive plan can be both competitive and truly, sustainably, performance-based.  Executives may not get as much upside when things are good, but neither will they get frustrated to the point of wanting to leave when times are bad (and when they are still wanted by the board).  And, yes, shareholders will have to pay the tax associated with such a pay structure, but that is better than the “tax” they are now paying for boards that, in difficult years, must choose between losing key managers versus undermining the integrity of their incentive plans.

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