Article

Manager's Journal: Executive Pay: The Same Old Saw?

Executive pay should not become the trigger for executive succession. Nor should matching compensation to results rely on individual acts of responsibility.

Par Orit Gadiesh and Marcia Blenko

First published on avril 29, 2003
min


The resignation of AMR Corp.'s Donald J. Carty on Friday, over union criticism of executive benefits at American Airlines, is the latest gust in a storm gathering force around executive compensation. Some leaders of companies fallen on tough times, like Agilent and Charles Schwab, are willingly giving up bonuses and returning stock-option grants. Others, like former chief executive Mr. Carty, are giving up their jobs. But executive pay should not become the trigger for executive succession. Nor should matching compensation to results rely on individual acts of responsibility. Corporate boards should make the link between executive pay and shareholder value explicit and systematic. The poster child for this philosophy is Michael Dell, who received only 25% of his possible bonus for 2001 even though Dell Computer Corp. far outperformed its peers on stock price. The company hadn't met other important internal targets, including operating-profit margin and customer-satisfaction metrics—so Mr. Dell took a hit, thanks to his firm's pay system. Shareholders find real merit in tying pay to delivering real value. Nearly 100% of institutional investors, for example, oppose option repricing, according to a recent survey our firm conducted with 42 institutional investors in the U.K. and U.S. Eighty-two percent say they want to discontinue rich severance packages; and 70% are against awarding bonuses tied to acquisitions. Yet a strong majority, 63%, say they are willing to approve compensation plans that give senior managers a larger share of the value they create for shareholders—as long as executives also share in the downside. Tying executive rewards to sustained value creation won't happen simply by linking compensation to shareholder returns. Management could be focused on the wrong priorities but benefit from a rising market, or vice versa. The best compensation should also reward successful strategy execution to push executives to outperform both ambitious internal targets and their peers in the stock market. The companies like Dell that appear to get real benefit from linking pay and performance are clear about what drives value in their businesses, they communicate it widely—internally and externally—and they measure what matters. Performance improves when companies understand the potential of their businesses over the medium term—say, the next three to five years—and then focus on the most critical levers for achieving that value. For Mr. Carty's successor, Gerard J. Arpe, as for executives at all carriers, it will be more critical than ever to link executive compensation to cash flow, successful balance sheet restructuring, and some measure of employee unity. Even with the right measures in place, unless the incentives to perform are palpable, compensation becomes a blunt tool or, worse, a scheme that rewards mediocrity. At Reckitt Benckiser, the Anglo-Dutch maker of household cleaning products, senior managers' base salaries are well below competitors', and long-term incentives don't pay out unless the company achieves growth rates that are double the industry average. To earn their bonuses, executives must show measured progress toward the company's strategic targets. The company also mandates minimum inside shareholdings for senior executives, making the downside of mediocre performance real and immediate. The best programs cascade benefits to key employees. Nucor, the U.S. steelmaker, has pushed production incentives out to its millworkers, who are key to determining productivity. Hourly workers earn about half as much as the competition, but are eligible for weekly cash bonuses that can double or treble the hourly wage. Including bonuses, Nucor's workers net out as the highest-paid in the industry—and the company has among the lowest labor costs in its business. Nucor's pay system works because it is easy to understand. And if ordinary people can understand a compensation plan, then pay can reinforce the behaviors that create value. The debate on executive compensation is set to run. But this debate will be more productive if companies and shareholders focus on the right question—not whether executive teams are overpaid, but how compensation can be linked more effectively to sustained and superior performance. And the answer, as AMR learned the hard way, has to make sense to all stakeholders. Ms. Gadiesh is chairman of Bain & Co. Ms. Blenko is a Bain vice president in London.

The resignation of AMR Corp.'s Donald J. Carty on Friday, over union criticism of executive benefits at American Airlines, is the latest gust in a storm gathering force around executive compensation. Some leaders of companies fallen on tough times, like Agilent and Charles Schwab, are willingly giving up bonuses and returning stock-option grants. Others, like former chief executive Mr. Carty, are giving up their jobs.

But executive pay should not become the trigger for executive succession. Nor should matching compensation to results rely on individual acts of responsibility. Corporate boards should make the link between executive pay and shareholder value explicit and systematic.

The poster child for this philosophy is Michael Dell, who received only 25% of his possible bonus for 2001 even though Dell Computer Corp. far outperformed its peers on stock price. The company hadn't met other important internal targets, including operating-profit margin and customer-satisfaction metrics—so Mr. Dell took a hit, thanks to his firm's pay system.

Shareholders find real merit in tying pay to delivering real value. Nearly 100% of institutional investors, for example, oppose option repricing, according to a recent survey our firm conducted with 42 institutional investors in the U.K. and U.S. Eighty-two percent say they want to discontinue rich severance packages; and 70% are against awarding bonuses tied to acquisitions. Yet a strong majority, 63%, say they are willing to approve compensation plans that give senior managers a larger share of the value they create for shareholders—as long as executives also share in the downside.

Tying executive rewards to sustained value creation won't happen simply by linking compensation to shareholder returns. Management could be focused on the wrong priorities but benefit from a rising market, or vice versa. The best compensation should also reward successful strategy execution to push executives to outperform both ambitious internal targets and their peers in the stock market.

The companies like Dell that appear to get real benefit from linking pay and performance are clear about what drives value in their businesses, they communicate it widely—internally and externally—and they measure what matters.

Performance improves when companies understand the potential of their businesses over the medium term—say, the next three to five years—and then focus on the most critical levers for achieving that value. For Mr. Carty's successor, Gerard J. Arpe, as for executives at all carriers, it will be more critical than ever to link executive compensation to cash flow, successful balance sheet restructuring, and some measure of employee unity.

Even with the right measures in place, unless the incentives to perform are palpable, compensation becomes a blunt tool or, worse, a scheme that rewards mediocrity. At Reckitt Benckiser, the Anglo-Dutch maker of household cleaning products, senior managers' base salaries are well below competitors', and long-term incentives don't pay out unless the company achieves growth rates that are double the industry average. To earn their bonuses, executives must show measured progress toward the company's strategic targets.

The company also mandates minimum inside shareholdings for senior executives, making the downside of mediocre performance real and immediate.

The best programs cascade benefits to key employees. Nucor, the U.S. steelmaker, has pushed production incentives out to its millworkers, who are key to determining productivity. Hourly workers earn about half as much as the competition, but are eligible for weekly cash bonuses that can double or treble the hourly wage. Including bonuses, Nucor's workers net out as the highest-paid in the industry—and the company has among the lowest labor costs in its business.

Nucor's pay system works because it is easy to understand. And if ordinary people can understand a compensation plan, then pay can reinforce the behaviors that create value.

The debate on executive compensation is set to run. But this debate will be more productive if companies and shareholders focus on the right question—not whether executive teams are overpaid, but how compensation can be linked more effectively to sustained and superior performance. And the answer, as AMR learned the hard way, has to make sense to all stakeholders.

Ms. Gadiesh is chairman of Bain & Co. Ms. Blenko is a Bain vice president in London.