Fixing executive pay

Business Strategy Review, 2003, Volume 14 Issue 2, pp 69-71 Fixing executive pay
Orit Gadiesh, Marcia Blenko and Robin Buchanan
That is certainly the view of institutional investors.
Setting executive pay should reflect
The critical question they are asking about executive sustained and superior performance. For
compensation is not “how much are we paying?” but institutional investors the issue should not
be how much executives are paid but what
Interviews we conducted with more than 40 they are paid for.
institutional investors in the UK and US underscorethis point: more than 90 per cent oppose option re- Sidney Taurel, Eli Lilly’s chief executive officer, pricing; 82 per cent say they want to discontinue rich addressed the pharmaceutical company’s 41,000 severance packages; and 70 per cent are against employees via videoconference in October 2001 to awarding bonuses tied to acquisitions. Yet 63 per cent outline far-reaching cost reductions. Standing in the say they are willing to approve compensation plans cafeteria of Lilly’s Indianapolis headquarters, Taurel that give senior managers a larger share of the value added up the financial impact of losing patent they create for shareholders – as long as senior protection for Prozac, the blockbuster antidepressant managers also share in the downside.
that accounted for more than a third of Lilly’s $2.8bnprofit in 2000.
Indeed, when pay is the measure, most executives stilldon’t feel the same pain as their shareholders. In 2001, No one would receive pay increases in 2002, Taurel when stock prices of the S&P 500 fell 13 per cent and said, and managers would give up bonuses and corporate profits were down 35 per cent, median total stock grants. Then Taurel delivered a blockbuster compensation for CEOs rose in nearly all industries, message of his own: he had asked directors to slash ranging from an increase of 31.6 per cent in his 2002 salary to $1. Employees got to their feet construction to 0.3 per cent in financial services, according to the most current data on executivecompensation compiled by The Conference Board. The In an era of ambiguous compensation plans for top exceptions were retail and telecommunications, where managers, Taurel’s request to cut his own pay sends a CEO compensation was unchanged by Conference clear signal of accountability. But compensation plans Board calculations (which involve taking into account should not rely on individual acts of responsibility, annual salary and bonus, plus the value of long-term however admirable. Instead, such plans should grants and payments, including stock options and explicitly and systematically link executive pay and restricted stock grants, and long-term performance 70 Orit Gadiesh, Marcia Blenko and Robin Buchanan They are clear about what drives value in theirbusinesses; they communicate it widely – internallyand externally - and they measure what matters They tie compensation to the real value created –reflecting the performance of both share price andthe underlying business over time They recognise that the frontline drives the bottomline and cascade appropriate measures andincentives to key employees They build trust with compensation systems thatare simple and transparent to employees as wellas investors Be clear on measures that matterDell Computer has built a pay system that hits manyof these marks. Dell’s strategy of cost and customerleadership has not wavered in a decade. Costleadership, for example, hinges upon the company’sability to manage inventory levels, working capital,return on invested capital, and service support costs.
With a clear picture of what drives value, Dell’s paysystem starts with executives’ base salaries, which areaverage among high-tech companies. A biggerpotential slice of the pay package comes from long-term, equity-based compensation that helps motivatemanagers to increase shareholder value.
The reward for successful strategy execution is builtinto Dell’s annual bonus, which uses value driverssuch as operating profit margin and customersatisfaction metrics to set ambitious targets for executives. In 2001, for example, CEO Michael Dell received only 25 per cent of his possible bonus, Tying executive compensation to sustained value although the company performed well relative to creation won’t happen simply by linking compensation peers. The reason? The business fell short of hitting to stock price. Management could be focused on the wrong priorities but benefit from a rising market. Orit could be doing exactly the right things but still be penalised as a result of forces outside its control.
Consider also Reckitt Benckiser, the UK-based makerof household cleaning products. Senior managers’ base The best compensation systems pay out for successful salaries are well below competitors and long-term strategy execution while including an equity incentives do not pay out unless the company achieves component to align management and shareholders.
growth rates that are double the industry average. The Executives are pushed to outperform both ambitious system’s multi-year aspect focuses management on internal targets and their peers in the stock market.
sustainable, not short-term, growth.
The companies that appear to get real benefit To earn their bonuses, Reckitt Benckiser executives from linking pay and performance apply four must show measured progress towards the company’s strategic targets. Net revenue growth that exceeds the industry average is one such target; executives achieveit by investing in high-growth categories where thecompany has strong, market-leading positions.
The plan also ensures management feels the pain ifshareholders are suffering. Besides using stock-basedincentives, Reckitt Benckiser mandates minimumholdings of 200,000 shares for each senior executiveand 400,000 shares for the CEO. The plan prohibitsre-pricing options and requires that bonuses bewithheld when targets are not reached. “I want tomake people sweat,” says CEO Bart Becht.
Cascade incentivesSome companies do link executive compensation toboth shareholder value and strategic targets but failto focus the rest of the organisation on the same goals.
Online trading company eBay, for example, recognisesthat customer service employees on the frontlines arevital to profitability; they help build a loyal customerbase and encourage existing customers to explore newcategories. These key employees are paid based ondirect customer feedback and can access reports ontheir performance at any time.
In a similar fashion, Nucor, the US steel maker, haspushed production incentives out to its mill workers, who are key to determining productivity. The Dell: only 25 per cent of his bonus company pays hourly workers about half as much asthe competition, then adds weekly cash bonuses support once the performance requirements for the that can double or triple the hourly wage depending on the amount of quality steel handled by a workteam on its shifts. When the weekly bonuses are The debate on executive compensation is set to included, Nucor’s hourly workers, all non-union, are continue, particularly with company performance the highest-paid in the industry but the company is lagging and the stock markets feeling their way one of the most efficient in terms of labour costs per through uncertain economic times. But this debate will be more productive if companies and shareholdersfocus on the right question – not whether executive teams are overpaid but how compensation can be Once companies have linked compensation to what linked more effectively to sustained and superior drives value, they can explain compensation packages performance. Eli Lilly’s Taurel is an inspiration but it to employees and investors with credibility.
should not take an individual act of responsibility by Compensation has greater impact when everybody the CEO to align pay and performance.
knows what he is paid for. Indeed, shareholders whounderstand compensation packages are more likely to Orit Gadiesh is chairman of Bain & Company. accept them – 73 per cent of institutional investors are Marcia Blenko is a Bain vice-president in looking for more transparency, according to our survey.
London and Robin Buchanan is the seniorpartner in London. A version of this article When Reckitt Benckiser laid out its executive appeared in the World Economic Forum’s compensation plan for 2000, the media’s initial Global Agenda magazine in January 2003. reaction was hostile. But scepticism turned into broad

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