How to boost pay for performance: companies could build better incentives in their executive compensation plans by adopting pay policies that tie compensation opportunity to performance, a consultant argues.

To understand executive incentives and executive pay, it is vital to: 1) look at wealth, not just annual pay; 2) measure the value of stock and options to executives who are largely undiversified; and 3) measure the sensitivity of executive wealth to controllable changes in shareholder wealth, such as shareholder return net of market and industry factors.

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When we do all these things, we find that there is a lot more pay for performance than conventional analysis suggests. However, most companies could provide significantly stronger incentives by adopting pay policies that tie compensation opportunity to performance. A "fixed share" stock grant policy--such as one providing an annual grant of a fixed number of shares--provides a higher grant value when the stock price increases and a lower grant value when the stock price declines and hence, ties compensation opportunity to stock price performance. A stronger incentive increases compensation risk and will be good for shareholders only if it is cost-efficient.

Employing a wealth leverage measure quantifies the strength of the incentive and provides the basis for determining the impact of stronger incentives on firm performance and assessing whether the increase in shareholder wealth from the stronger incentive is sufficient to offset the cost of the compensation premium needed to control retention risk.

Measuring Pay

The most common criticism of executive compensation is that there is a low correlation between the percentage change in top management compensation and the percentage change in the shareholders' wealth. The typical correlation analysis does not provide a meaningful picture of pay for performance because the pay measure used ignores the current year changes in the value of this year's stock and option grants, the value of prior years' stock and option grants and the present value of expected future compensation including future salary, bonus and stock adoption grants.

Using a pay measure ("realized pay") that includes the change in the value of all stock and option holdings and express realized pay as a percentage of the value of stock and option holdings at the beginning of the year, we find that 2002 shareholder return explains 62 percent of the variation in CFO pay vs. 3 percent for a conventional measure of current year grant date pay ("expected pay"). The sample used comprised 344 CFOs in the S & P Execucomp database.