By Jairus Ashworth, Head of Rewards, Australia and New Zealand, Aon Hewitt

Challenges to Executive Pay

There is a widespread perception that executive pay is excessive, that it is only weakly related to performance, and that the details are obscure so that disclosure is not transparent. This view persists despite extensive regulatory change and greater intervention from shareholders in recent years.

Executives themselves find aspects of their pay deals perplexing and disconnected to their contribution to underlying performance, especially with regard to long-term incentives. This is supported by numerous research studies that show that frequently there is not a strong correlation between executive pay and company performance.

It is therefore not surprising that many companies are looking for better ways to link pay and performance, especially in countries where shareholders can vote against directors’ proposals on executive pay.

An Alternative, Holistic Model

Aon Hewitt has developed an alternative model for executive pay structures that addresses both the shareholders' and regulators' concerns, and more closely links an executive's reward to company performance. A key aspect of this model is a more holistic approach to total reward. At present, executive pay decisions are made largely in a fragmented way:

• fixed pay increases generally have limited connection to recent company performance (except in extreme circumstances such as during the global financial crisis);
• short-term incentive arrangements are often complex and their link to performance is often unclear;
• the value of long-term incentives is typically set at a notional grant date and has little to do with prior performance or subsequent vested values;
• total reward is thus a somewhat meaningless composite of actual and theoretical values with different past and future timeframes.

A more meaningful framework involves measuring total reward in the year received or vested, instead of the year in which each component is awarded. This measure then reflects actual pay received, not a hypothetical future value (such as grant date "fair" value).

Using a Single Scorecard

We recommend using a single performance scorecard to determine total reward, including fixed pay, and combining short-term and long-term incentives into the one plan.

Currently, incentive payments are usually split between short-term and long-term plans with different performance measures for each. A single balanced scorecard with a blend of one-year and multi-year performance measures can be used to reward in a more integrated and transparent way, sustained performance that has already been delivered. Part of the incentive reward may be paid soon after the financial year end (non-deferred incentive), with the balance deferred over several years and contingent upon the executive's continued service.
 
Note that the current year's award of a deferred incentive is not included as part of this year's total reward value. It will be counted in a future year's total reward at its vested value in the year in which it vests.

Within this framework, the non-deferred incentive component can be used as a balancing item. That is, it can be adjusted so that the actual total reward paid for the year is in line with the target total reward and performance as measured against the scorecard. This is because fixed pay and previously awarded incentives that vested during the year are now known quantities. Therefore, the non-deferred incentive determined at the end of the year can be used as a balancing element to deliver the desired total reward.

This approach is particularly useful when fixed pay increases are out of step with performance or when vested past deferrals differ substantially from their projected value. The latter often occurs when long-term incentive plans are based on performance hurdles that are poorly aligned to the company's overall performance.

Constructing the Performance Scorecard

This model simplifies and streamlines the relationship between performance and pay. However, its effectiveness depends on how well the performance scorecard is constructed and how well the reward payment schedule is calibrated. 
An effective scorecard has an appropriate blend of performance measures including:

• performance relative to expected or target performance for the year;
• performance relative to previous performance (i.e., measures of growth, preferably measured over several years);
• total shareholder return (using a more graduated scale than the "all-or-nothing" hurdles currently used for many long-term incentives);
• company and individual performance, so that each executive's scorecard reflects both group and individual contributions.

Including company growth as one of the measures in the scorecard is especially important in aligning a company's rate of growth in executive pay with its rate of growth as determined by key financial measures. Currently, many short-term incentive plans have no way of linking increases in executive remuneration to company growth. The financial measures used can also take into account the company's performance relative to prior market expectations, as appropriate.

Transitioning to the New Model

This new executive pay model is a substantial change from current models and applies some very different principles and measures. Its unfamiliarity may therefore result in some resistance until the fundamental concepts are proven. In shifting to this model, there are important transitional issues to consider, including communication to key stakeholders and the timeframe over which this change is implemented. Full migration from the traditional pay structure to this new model may take several years, especially when new performance measures with a multi-year retrospective element are included.

Some leaders may prefer to continue tweaking traditional pay plans, seeing this as a safer option. However, having done this for many years already, has failed to satisfy the expectations of shareholders, regulators and, in many cases, the participating executives. Those leaders who recognize the failure of the current executive pay model and migrate toward this new model will be able to demonstrate a clear link between total reward and performance. For many companies, this will be the first time there has been such a strong and transparent link.

Contact us

Jairus Ashworth is the Head of Rewards, Australia and New Zealand, at Aon Hewitt. Jairus is based in Sydney and can be reached at jairus.ashworth@aonhewitt.com.

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