VIEWPOINT | ALIGNING COMPANY PERFORMANCE AND EXECUTIVE PAY

Publicly traded companies in the U.S. are preparing for their third year of federally mandated "Say on Pay" voting that allows shareholders to cast a non-binding vote "for" or "against" a company's executive compensation program. The goal of the mandate is to more closely align pay with performance.

Towers Watson's 2012 Automotive Industry Executive Compensation and Equity Study finds that, while many companies say their compensation pays for performance, fewer than one in three is effectively showing evidence of the alignment. Executive Compensation Consultant Michael Horne details the study's findings.

What group does the 2012 study cover?

We analyzed the year-over-year compensation level change for 60 publicly traded automotive suppliers, some of which are aftermarket retail parts companies. These organizations range in size from $250 million to $60 billion in revenue. As in our previous studies, original equipment manufacturers were not included.

Where do you see improved alignment between pay and performance?

The strongest evidence is the increased use of multiple long-term incentive awards among supplier companies, specifically those that require achievement of a performance goal in order to earn a payout. Historically, stock options have been the award of choice in the auto industry. In fact, four out of five companies still use them today, compared with 50%-55% for other industries.

However, this year we found that 77% of auto industry companies were using performance-based awards. This is a dramatic increase from the 20%-25% historical prevalence rate from a few studies back and is evidence of the drive toward pay for performance.

There's also evidence of better alignment when we reviewed the relationship between actual and target bonus payouts. The industry's performance has improved, but the performance of some companies fell from 2010 to 2011. As such, commensurate with company performance, actual bonus payouts at the median dropped to 140% of target from 162% of target in 2011. And 12% of CEOs received no bonus last year. Bonuses were still well above target opportunity, which might suggest that management and compensation committees are still developing the measure, selection and goal-setting process.

How well do companies show that compensation is aligned with performance?

Many say their executive programs pay for performance. But when we analyzed the 40 largest companies in this year's study, we found that only 30% provided clear evidence of alignment between pay and performance in the Compensation Discussion and Analysis section of their proxies.

Interestingly, when we applied Towers Watson's methodology for assessing pay for performance, about 60% of their CEOs showed fairly good alignment with total shareholder return over the past three years. So organizations may be doing a better job than they describe.

The question for many companies today is: How do you show alignment? Lots of organizations think they know the answer. They have an incentive payout formula, but they increasingly realize they don't have a clear approach to indicate that the pay an executive earned is an accurate reflection of the company's performance.

Why is that important?

The U.S. Securities and Exchange Commission announced pay-for-performance disclosure requirements for the CEO and the other named executive officers a few years ago but has not yet issued a specific time frame for defining how pay or performance will be measured and over what time period.

Also, investors now have a clear expectation that companies will align executive pay and company performance. The alignment of pay and performance (or lack thereof) has become the single largest factor in the Say on Pay voting results. As a result, companies are compelled to analyze, describe and defend their compensation programs from this perspective.

As we have discussed, achieving alignment is challenging. Towers Watson believes companies must be able to answer these questions when addressing the alignment between pay and performance: Do you have a quantitative process? Do you measure performance over an appropriate time period? Do you have the right measures? How does the company's alignment compare with that of other peer companies? We have developed an assessment tool and process to help companies find answers and improve alignment.

Will companies eventually settle on a common set of measures?

Probably not. Companies are driven by different measures for success that depend on their industry, "life-cycle" and long-term business strategy. For some it may be total shareholder return. For others, return on invested capital or same-store sales is the key performance measure. In the case of the auto industry, our study found that EBITDA (earnings before interest, tax and depreciation) was the most prevalent metric in long-term incentive plans.

Organizations should be set up for long-term growth and value creation. But there's a lot of short-term focus too. If the last quarterly results were bad, should the CEO's pay be immediately reduced accordingly? Many organizations are struggling with this balance. They want accountability, but they also want management to take a long-term view and be rewarded for achieving those goals. There is no single answer.

For more information about Towers Watson's pay-for-performance assessment tool and copy of this year's compensation study, contact Michael Horne at (248) 936-7516 or michael.horne@towerswatson.com.