Executive Comp: Managing Through Uncertainty

"Executive compensation has long been a stormy topic among shareholders and the public, but never more so than now with the economy reeling, unemployment rising, sales and profits falling and companies looking to cut costs at every possible juncture. 

With 2008 compensation programs behind them and plans for 2009 beginning to take shape, boards find themselves grappling with compensation issues to an unprecedented degree, against the backdrop of deep economic uncertainty—and in a politically charged atmosphere, where shareholders and the public are angry not just at Wall Street bank executives but towards big business in general. And in their effort to avoid criticism on this sensitive issue, boards may be doing a disservice to the companies and shareholders they serve. Specifically, companies are wrestling what to do about salaries, bonuses, long-term incentives and underwater options. 

Historically, companies have increased salaries between three and four percent. Should that level be maintained, reduced, or frozen? In 2008, most bonuses did not pay out or else paid out below target: should bonus formulas be maintained or are they too aggressive? Long-term incentives (LTIs) pose a similar problem: how should they be set to meet the objectives of the company and attract and retain talent? Finally, what should companies do about worthless underwater options: should they be allowed to continue to sit there, accruing an expense against earnings having a dilutive effect, or be reset? 

According to research conducted by Korn/Ferry earlier this year, a number of trends are emerging in these areas. While some companies have maintained three to four percent salary increases, others are pulling back to the two to three percent range; still others have chosen to delay increases. Some, including Yahoo and Hewlett-Packard, have announced salary freezes for 2009 and at the most extreme, companies like FedEx are cutting some wages. 

This past year, most companies chose to stick with their bonus formulas, resulting in reduced or zero payouts, and did not supplement bonuses with cash. But given lower expectations for 2009, should the bonus targets be adjusted too? In the area of LTIs, companies like Liz Claiborne are shifting from three-year goals to a one-year time frame or are adopting relative performance goals. 

Finally, most companies are taking a wait-and-see approach about resetting underwater options, preferring to see what others do. But even here, there are exceptions: Google is repricing its underwater options, while Starbucks is offering a one-for-three swap. Boards understandably feel themselves under a microscope in setting executive compensation. But in talking with clients, we have emphasized the importance of taking an integrated approach, rather than making decisions in an isolated fashion. 

Companies need to ask what message is being sent by the compensation structures they adopt. In freezing salaries, not paying out bonuses, doing nothing about underwater options, and setting higher hurdles for LTIs, are we sending out a negative message to executives and shareholders alike? In focusing on the past, are we ignoring the future? Similarly, in the effort to align ourselves with shareholders, do we place too great an emphasis on what shareholders have experienced to date or do we try to align with shareholders from this point forward and to drive value up? 

Salaries, bonuses, LTIs and underwater options are serious issues but are not the fundamental question that companies face in the current crisis. The deeper question is how to reward, retain and incentivize executives, while delivering shareholder value. That question can only be answered by companies that address compensation in a thoughtful, holistic and forward-looking manner.