New Thinking on How to Link Executive Pay with Performance Rappaport, Alfred Nodine, Thomas H. By: Jason Lueken & Jason Spears Jason Spears

A Step to Close Gaps Between Existing Compensation Practices  Replace stock options with options that are tied to a particular market.

Problems with Pay at the Top  Fixed-price options reward executives for any increase in share price, even if the increase is well below that realized by competitors or by the market as a whole.  Because the exercise prices remain fixed, premium-priced options hold no guarantee that the level of performance will be superior. During a period of rising markets, premium- priced options may still reward below-average performance. They also offer little or no reward to executives who outperform their competitors during times of modestly rising or declining markets.

The Advantages of Indexing  By tying a plan's exercise price to a selected index; boards can increase the pay of superior performers while appropriately penalizing poor ones  Indexed options do not reward underperforming executives simply because the market is rising. Nor do they penalize superior performers because the market is declining. They can keep executives motivated not only in the bull markets everyone has grown accustomed to but also in sustained bear markets.

The Front Line’s Contribution  Operating managers need to identify and focus on activities that maximize SVA and reduce costly investment in resources that contribute little to actual value.  Achieving superior returns is the ultimate goal for shareholders. It is, therefore, the only appropriate target for the CEO, the board, and corporate-level executives. Companies with superior performance standards in place at all levels send a powerful message to shareholders about their aspirations.

The Hierarchy of Performance Measure  PEOPLEMEASURELEVEL CEO and Total returnsExceed peer or corporate levelto shareholders market index executives Operating unitShareholderExceed investor executivesvalue added expectations executivesvalue added expectations Frontline employees Leading indicatorsSupport achievement Frontline employees Leading indicatorsSupport achievement and managers of value of superior share and managers of value of superior share holder value added holder value added

Key points  The concept of pay for performance is widely accepted, but the link between incentive pay and superior performance is still too weak.  Boards of directors need to push through changes in executive compensation practices, including their own pay schemes. And reforms must be adopted at all levels of the organization.  If indexed options are introduced for CEOs, then Shareholder Value Added (SVA) based measures should be introduced in business units.  Shareholders will applaud changes in pay schemes that motivate companies to deliver more value.