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Executive Compensation Arbitrage: Exploiting Preferences for
Competitive Advantage
ConsultingCompensation
1Executive Compensation Arbitrage: Exploiting Preferences for Competitive Advantage
One of the biggest criticisms hurled against executive compensation design is all the “trend chasing” that occurs: chasing the right peer groups, chasing the perfect surveys, chasing the proper award mix, and of course, chasing the wisdom of your board consultant. However, the response from those who develop incentive plans is that if an organization does not react to these trends, the company’s compensation may fall behind its competitors—resulting in poor executive retention or angry shareholders.
More so than ever, external pressures have focused long-term incentive (LTI) plan design on a myriad of new pay-for-performance trends and governance requirements. From heightened media scrutiny to legislators enacting oversight, the executive compensation atmosphere has steadily expanded to include more and more design perspectives—all vying to affect compensation trends. In response, companies are continuing to move in a direction to please proxy advisors and to ensure they are satisfying Dodd-Frank “Say on Pay.” As organizations are compelled into reacting to numerous pay trends, it creates unintended consequences that do not support the motivation, retention, and alignment of executive talent. These influences have undercut traditional incentive methods and dislodged the recipient from the design process.
With all the noise surrounding executive compensation design, it is clear that the voice of the executive has been crowded out. In effect, executive participants have no say on pay.
In a pulse survey of LTI design preferences, Aon Hewitt found that compensation decision-makers and executive participants hold dramatically different perspectives on the success of their respective programs. Among those LTI participants responding to the survey, only half reported high satisfaction with the incentives, while those who design the LTI programs were 30%–50% more likely to be satisfied with a plan’s features. As executive participants are less likely to be satisfied with LTI plans, they also attributed low levels of retentive value to them. The satisfaction and retention levels are even less for those executives who are at risk of leaving the company. Even those who would be considered modest retention risks tend to have low satisfaction and see even less retention value in their plans.
The survey feedback also underscored one clear example of the tension between LTI design practices and preferences: the diminished accessibility of “earned” equity awards. While the drive for higher shareholder alignment through equity-based incentives has been admirable, the ongoing trend to limit executives’ access to earned awards through increased ownership guidelines, regulatory waiting periods, and pressures for a “hold to retirement” culture has made many executives perceive their equity awards as less de-sirable as an incentive vehicle. As earned equity becomes less accessible to executives, preferences in turn tend to move toward performance-based cash awards. So executives who perceive access to equity as onerous would likely prefer the risks associated with performance-based cash, rather than receiving time-based stock options or restricted stock awards that are locked up after being earned.
The New World of Executive Compensation
LTI Perception Gap
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The consequence of these design trends is that many LTI features, increasingly influenced by externalities, have promoted a perception gap between many executives and their incentive programs. More importantly, this gap has clear attrition implications. While individuals may be at risk to leave an organization for multiple reasons (including the compensation plan itself), the data shows that many LTI programs do not provide a strong retentive counterbalance against those risks. Given that most organizations already find themselves struggling to balance opposing design considerations, some HR professionals may be unaware of (or constrained to address) the waning executive satisfaction. As economic conditions improve and hiring picks up, organizations with a strong grasp of executive preferences may be able to exploit these preference gaps as an arbitrage opportunity in their search for talent. Who will be the first organization to respond and more fully consider executive preferences in LTI? An executive’s current employer, or her next?
As mentioned above, Aon Hewitt’s survey found a sizable difference between the satisfaction of LTI participants and the satisfaction of those who design and manage those plans. Among those participants responding, only 54% are highly satisfied with their LTI program. Executives are further split on whether their program has the appropriate LTI mix (56%) or provides a significant performance motive (51%). Additionally, only 56% of executives thought their plan provided a considerable retention motive.
Low Executive Satisfaction with LTI
About the SurveyAon Hewitt’s Long-Term Incentive (LTI) Preference Survey was conducted online from November 1–December, 31, 2010. The survey separately asked 10 similar questions to two demographics: 1) LTI design professionals/HR heads; and 2) executive LTI participants. A total of 130 US-based organizations responded to either the questionnaire designed for HR professionals or the one designed for executive participants. The survey was intended to highlight recent LTI design features and how participants and HR professionals tend to separately value them. It asked only questions on LTI features and perceptions, not on the award amounts.
3Executive Compensation Arbitrage: Exploiting Preferences for Competitive Advantage
Figure 1. Executive Perception of LTI by Engagement Level
High Retention Risk (18%)
Modest Retention Risk (29%)
Low Retention Risk (53%)
27%
9%
21%
33%
80%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
79%
LTI Provides Strong Retention Motive High Satisfaction with LTI
Percent of Survey Population
While the executive responses illustrate some discontent toward LTI plans, the HR professionals responding to the survey are more satisfied with design and unlikely to be planning any significant modifications. Almost three-quarters (73%) of companies are satisfied with their LTI mix and 74% are comfortable with their plan’s performance orientation. Considering that the majority (70%) believe their compensation committee is satisfied with LTI design, many view their strategy as ultimately fulfilling its purpose.
When focusing on those executives who are at-risk of leaving, the likelihood of their satisfaction with LTI decreases significantly. As Figure 1 illustrates, satisfaction varies widely by an executive’s response to a standard engagement question (“How likely are you to think about leaving your current employer?”). Those executives who are at-risk to leave an organization are more likely to be dissatisfied than those who are at low risk. In fact, those who are at the lowest risk to leave are even more likely than HR professionals and compensation committees to be satisfied with LTI design. What is most striking to us is that even executives who consider themselves modest retention risks have low satisfaction levels. They are also the most likely group to have a low opinion of the retention value of their LTI programs. This is surprising because, for most companies, the modest risk executives are the ones to whom retention is the most critical.
Corporate cultures, shareholder activism, and government intervention have all contributed in making it difficult for executives to find an appropriate window to sell shares. The majority (71%) of executives responding to the survey are likely to believe that an organization’s culture and/or policy make selling shares of company stock difficult. This difficulty in selling awards is at odds with the flexibility formerly enjoyed by executives and has an impact on how executives view the value (and design) of their LTI awards. Again highlighting a difference of opinion, only 23% of compensation-decision makers consider it difficult to sell shares or exercise options from a design perspective, and a quarter of companies (25%) have recently increased or are considering increasing its stock ownership guidelines.
While driving long-term equity holding by LTI participants is a popular shareholder alignment tool, the perception of over-bearing guidelines is likely to drive executive preferences away from equity awards entirely, as Figure 2 shows.
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Inaccessible Equity Compensation
Figure 2. Percent of Executivesthat Prefer at Least 50% of Their
LTI in Cash
Onerous Just Right Lenient
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
78%
47%
33%
When Ownership Guidelines Are:
The harder a company makes it to access “earned” equity, the more likely an executive participant would rather have immediate access to a portion of the award through performance-based cash awards. So instead of equity optimally retaining talent (as intended), the effectiveness is reduced as participants have less access to the rewards. Accordingly, when executives have freer access to earned equity there is also less of a need for cash-based incentives.
5Executive Compensation Arbitrage: Exploiting Preferences for Competitive Advantage
With unprecedented demands placed on LTI design, the process of developing a program that adequately appeals to participants is more difficult than ever. Plan design has progressively become a matter of finding equilibrium between the traditional goals of aligning talent with accommodating the more recent demands of those lobbying for change. As many of these trends are influenced by those groups wishing to “reign-in” or “realign” compensation levels, it is to be expected that there would be some satisfaction disconnect between the designers (who are obliged to react to market trends) and participants (who may feel their pay targeted). While new LTI trends should certainly not be ignored, they should ultimately be placed in the context of what best aligns performance with shareholder interests, and considered with the recipient’s preferences in mind. Companies that fail to do so miss an opportunity to retain those executives who are already thinking about leaving the organization.
The research uncovered an LTI perception gap that shows the design pendulum has swung too far from what many executives think motivates them. Given that a program’s fundamental goal is to motivate, then organizations should be aware that sometimes the latest trendy plan features could have the opposite effect, particularly in terms of retention. While compensation decision makers would never blindly follow trends at the expense of engagement, being informed on exactly how an organization’s talent perceives certain practices (and their unintended consequences) could have a lasting effect on retention.
What Do Shareholders Think?Generally speaking, we found that shareholders are less beholden to specific design trends and tend to view compensation design as a unique process based on business strategy and market position. They do however have clear underlying preferences for LTI programs. As a group that is ultimately concerned with maximizing returns, shareholders demand a clearly demonstrated pay-for-performance link. As many investors want their executive populations to feel the effects of management’s performance on stock price, most prefer that companies maintain some level of stock ownership guidelines (while keeping in mind dilution concerns). However, irrespective of whether shareholders follow a proxy-advisory firm’s vote recommendations, they do not generally believe in a “one-size-fits-all” approach to the LTI design. Shareholders do not even necessarily prefer executive alignment in equity, if cash is less costly. Depending on the institutional investor make-up of a company, companies would benefit from assessing how their shareholders feel about strong ownerships guidelines when developing an LTI strategy. According to the survey, only 30% of public companies already seek input from their shareholders or their proxy advisors on design.
Implications and a “Moneyball” Moment
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What struck us as we were reviewing these findings were the potential similarities to Michael Lewis’ Moneyball. At a high level, the book describes a disconnect in baseball’s labor market where certain statistics (such as RBIs) were given a disproportionate amount of value in the recruitment process. As explained in the book, it was discovered through non-standard analysis that other statistics, widely considered less valuable in recruiting (such as slugging percentage), were surprisingly better indicators of a player’s long-term success. These findings cut against long-standing trends/beliefs, but paid off when applied to recruiting practices. The book highlighted how this uncommon insight could be successfully exploited by teams willing to go against “conventional wisdom” and reassess accepted practices.
As in baseball recruiting, there is a comparable disconnect in the executive compensation labor market. The various interests that influence the current “conventional wisdom” in LTI design are often disconnected from what the recipients value in terms of their own long-term performance. The open question is whether these differences in LTI satisfaction will be similarly exploited by companies that are willing to reassess their incentive programs. It is clear that the survey findings are counter to some of the current incentive trends: to provide more equity awards and then make them harder to get, and to develop a LTI strategy using lots of external input. But the executive preference is clearly an undervalued force in the LTI design process. Those organizations that place more emphasis on it will have the edge over those that are more intent on following the trends.
Companies should foster a constructive dialog between all those groups involved in LTI strategy. Management, the compensation committee, and shareholders should all have a seat at the table. While it is understood that each group comes with its own interests and not every demand will be met, developing a structured way to prioritize and balance opposing LTI design pressures will become increasingly important as the economy improves, and talent becomes more mobile.
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About Aon HewittAon Hewitt is the global leader in human capital consulting and outsourcing solutions. The company partners with organizations to solve their most complex benefits, talent and related financial challenges, and improve business performance. Aon Hewitt designs, implements, communicates and administers a wide range of human capital, retirement, investment management, health care, compensation and talent management strategies. With more than 29,000 professionals in 90 countries, Aon Hewitt makes the world a better place to work for clients and their employees. For more information on Aon Hewitt, please visit www.aonhewitt.com.
Contact InformationTodd [email protected]
Copyright Aon Hewitt 2011
