NEW YORK--(BUSINESS WIRE)--For the vast majority of S&P 1500 companies, there is a major disconnect between corporate operating performance, shareholder value and incentive plans for executives. New research details an over-reliance on accounting metrics that do not measure capital efficiency, and how total shareholder return obscures a line of sight to the underlying drivers of economic performance. Economic performance explains only 12% of variance in chief executive officer (CEO) compensation.
The Alignment Gap Between Creating Value, Performance Measurement, and Long-Term Incentive Design, authored by Organizational Capital Partners and commissioned by the Investor Responsibility Research Center Institute (IRRCi), finds that:
- Economic performance explains only 12% of variance in CEO pay. More than 60% is explained by company size, industry, and existing company pay policy. None of those are performance driven.
- Some 75% of companies have no balance sheet or capital efficiency metrics in their disclosed performance measurement and long-term incentive plan design.
- Only 17% of companies specifically disclose return on invested capital or economic profit as a long-term performance measure for long-term executive compensation.
- Some 47% of S&P 1500 companies over the last five years (2008 – 2012) did not generate a positive cumulative economic profit or return on invested capital greater than their cost of capital.
- More than 85% of the S&P 1500 have no disclosed line of sight process metrics aligned to future value such as innovation and growth drivers.
- Only 10% of all long-term incentives have a disclosed longest performance period for named officers of greater than three years.
- Nearly 25% of companies have no long-term performance based awards at all, relying instead stock options and time-based restricted stock in their long-term compensation plans.
“Too often, the wrong performance measures and wrong incentives are used over too short a performance period,” said Jon Lukomnik, IRRCi executive director. “Investors, directors and corporate executive management all want companies to create value. But this report tells us that most companies are not measuring the fundamental drivers of economic performance such as earning a return more than the cost of capital. To compound the problem, companies largely have their longest accountable performance period for named officers at three years or less. Moreover, only a few CEOs are measured and compensated for strengthening the building blocks of long-term value creation such as innovation, research and development, and new product or market development,” he said.
“These findings indicate there is a critical need for a fundamental re-examination of measurement and executive compensation so as to incent sustained corporate economic performance.” Lukomnik added. “This means reducing the overwhelming dependence of large U.S. companies on total shareholder return (TSR) as a dominant performance and incentive compensation metric. TSR is not a direct measure of operating performance. It is a post hoc measure of alignment with short-term stock market price movements. Top management has limited decision authority over too much of what drives TSR, which can be as varied as Federal Reserve policy, the flow of funds into the stock market and specific industry dynamics as varied as commodity prices or changes in regulation. Disrupting the status quo of performance measurement won’t be easy, but the analysis reveals that too many companies are off course,” he said.
The study also indicates that:
- TSR is, by far, the most dominant performance metric in long-term incentive plans, present in more than 50% of all plans despite the fact that executives do not have line of sight accountability for key drivers that impact TSR outcomes.
- Nearly 60% of companies changed performance metrics for CEO compensation in 2013, and one-third of companies changed at least 25% of the peer group used for performance benchmarking. That lack of stability of performance metrics can suggest a short-term focus despite the fact that the incentive plans are supposed to be long-term focused.
“Future value is a key input for value creating TSR along with current operating performance” said Mark Van Clieaf, report co-author and partner with Organizational Capital Partners. “A critical role of executive management is to lead the investments that create innovation from new products, new markets, and new business models that drive future revenue growth and positive returns on capital. Yet, the analysis finds that few named corporate officer roles are directly measured and rewarded for the innovation that creates positive economic value over a three to five year or longer innovation cycle,” Van Clieaf said.
The study suggests that the majority of companies could enhance long-term value creation and long-term incentive plan design by:
- Applying value-based performance metrics such as return on invested capital (ROIC) and/or economic profit in performance measurement design while migrating away from the dominant use of total shareholder return or earnings per share;
- Adding future value improvement drivers (i.e. innovation, customer loyalty) to the performance metrics mix and long-term incentive plan design;
- Extending the longest accountable performance-period for named executive officers to a period longer than three years;
- Stabilizing the performance metrics and peer groups used in long-term incentive design to the extent possible; and
- Creating coherent and coordinated reporting on business performance, executive rewards, and disclosures for investors based on this framework.
Download the research here.
A webinar is to review the findings and respond to questions is scheduled for 11:00 AM ET on Monday, November 24, 2014. Register for the webinar here.
The Investor Responsibility Research Center Institute is a nonprofit research organization that funds academic and practitioner research that enables investors, policymakers, and other stakeholders to make data-driven decisions. IRRCi research covers a wide range of topics of interest to investors, is objective, unbiased, and disseminated widely. More information is available at www.irrcinstitute.org.
Organizational Capital Partners is a global strategy consulting firm that delivers client impact through aligning shareholder value with, innovation, structure, and incentive design to implement value creating business strategy. More information is available at http://www.orgcapitalpartners.com/.