Should CEO Mojo Determine Pay?

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Regardless of what metrics are used, board directors should keep CEO pay plans focused on the big picture.

This would seem to be a simple thing for directors to know—whether their company is performing well. Profitable? Check. Stock rising? Check. Beating competitors on both? Check and check. Except this is 2019, and now even the standard measures for corporate performance—and how boards should reward CEOs for it—have hit a snag.

In a little-noticed but potentially game-changing move, the United States’ largest corporate-governance outfit is recommending that its institutional shareholders’ clients use a new metric to determine their company’s—and CEO’s—performance.­ In the new order, companies and CEOs with numbers that suggest they’re building up momentum for a strong future would be considered rising stars worthy of investor fuel and high salaries. But CEOs with great numbers might also see their big paydays fall if the metrics suggest a “falling star” scenario.

The idea comes from Institutional Shareholder Services (ISS), a corporate-governance firm that heavily influences the behavior of institutional investors and pension funds. And that, experts say, tends to affect what boards do. “This is one of the most difficult pay governance issues boards will be facing in the near future,” says Irv Becker, vice chairman of Korn Ferry’s Executive Pay and Governance practice.

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Called economic value added (EVA), the rarely used metric is now being aimed at helping investment firms decipher the true success of firms and whether CEOs are really delivering the goods to justify their pay packages. The metric is actually decades old but rarely used by companies. Last year, though, ISS bought the analytics firm EVA Dimensions, and it appears ready to put this acquisition to good use.

Backers of the metric say normal accounting systems can distort a firm’s true profitability because they don’t consider whether the CEO is producing more profit than the cost of capital and running the company. EVA seeks to remedy that omission by representing a firm’s sales, less all operational costs (including taxes) and deducting its cost of capital.

Looking at it this way, boards could conceivably reward CEOs who are losing money because their EVA suggests that they are turning things around. “The Momentum metrics, in short,” says an ISS white paper on the topic, “could provide investors with a justification for supporting competitive pay packages for the managers in turnaround companies even if the company’s overall performance is not yet fully competitive.”

But critics are quick to point out that determining EVA can be complex and open to a lot of interpretation and nuance. More importantly, experts say, the whole concept of adding or subtracting rewards at seemingly successful firms would open up a can of worms for compensation committees, not to mention the outside institutional investors who are analyzing the firms.

Some worry that a visionary CEO could be investing heavily in products of the future but producing negative EVA as they painfully drag the company to safety. “EVA has lots of flaws,” says Robin Ferracone, author of Fair Pay Fair Play and CEO of Farient Advisors. “If a company is investing heavily and building value through investments—in whatever, drug development or growing a subscriber base—that won’t show up in EVA. It actually makes you look worse. EVA has limited use.”

Still, most think the metric will gain more prominence as ISS promotes it. According to Becker, companies where there is a disconnect between EVA performance and traditional operating ­metrics will need to explain it in their compensation, discussion, and analysis statement, and boards may need to spend more time justifying rewards packages. “EVA just added another potential complexity to executive compensation,” he says.

EVA is in fact just part of a broader trend of compensation analysis becoming increasingly and excessively complicated as proxy advisory firms take a more active interest in how incentive plans are developed around “say on pay” disclosures. Hence, Korn Ferry’s recent guideline to help boards stay focused on the big picture: well-constructed compensation plans should result in CEOs outperforming their targets 20 percent of the time, missing them 20 percent of the time, and coming in close 60 percent of the time. “Plans that hit or miss targets too frequently should be reevaluated to ensure goal-setting is calibrated appropriately,” advises Becker.