The majority of the general public and mainstream media believe that CEOs control their boards allowing them to reap excessive pay packages that are not aligned with actual company performance. As a result of the perceived imbalance of power, critics of the executive compensation model have attacked one of its central foundations—the setting of challenging incentive performance goals—by perpetuating the following myths:
• Myth #1: Companies deliberately set low performance goals to make it easy for executives to receive higher bonuses.
• Myth #2: Companies set internal incentive goals below communicated guidance and analyst expectations, so they can be assured of large bonuses.
• Myth #3: Most companies long-term performance share plans pay out well above target and there is little correlation to stock price performance.
The authors’ research has shown that generally speaking these myths are false.
1. CEOs at high-performing companies that exceeded goals received above target bonuses, while underperformers received below target bonuses.
• Our historical research finds that 74 percent of S&P 200 companies (in 2007) met or exceeded their annual incentive plan target performance goals, which resulted in a median CEO annual incentive payout at 152 percent of target. By contrast, CEO payouts in companies that failed to meet their target goals were just 73 percent of target.
2. The setting of challenging goals leads to executives earning higher bonuses and delivers higher Total Shareholder Return (TSR).
• Companies with more difficult goals saw CEO short-term incentive payouts at 135 percent of target when these goals were achieved, while companies with low difficulty goals paid out 124 percent for achievement. Contrasted with myth #1 (that executives set easy goals to gain high bonuses), our research presents a counter argument, indicating that to earn a larger bonus than your counterparts, executive must set (and obtain) harder goals. Furthermore, S&P companies with high difficulty goals had a one-year TSR (2007) of approximately 10 percentage points higher than those with low difficulty goals.
3. Most companies set internal incentive goals above communicated guidance and analyst expectations.
• Our analysis of a random subset of the S&P companies shows that at least 90 percent of companies set internal compensation plan targets at or above Wall Street analyst annual earnings guidance. Myth #2 that a majority of companies set internal goals below analyst guidance is absolutely false.
4. Performance share plan payouts generally correlate with share price.
• While overall payouts are commensurate to target, payouts under CEO long-term plans at high-performing companies—those with higher TSR—significantly exceeded those at low-performing companies.
5. There are several practical tools for assessing the difficulty of goals. In addition to the standard internal budgeting process, most compensation committee members have indicated that they are looking for a broader perspective. A quantitative goal difficulty assessment provides financial facts using objective probabilities while providing much-needed external perspective. In reviewing the level of goal difficulty, we start by analyzing the following four perspectives:
1. Ten years of historical company performance
2. Ten years of historical peer company performance
3. Upcoming year analysts’ estimates for the company
4. Upcoming year analysts’ estimates for peer companies
Conclusion: Debunking the myth that companies deliberately set lower goals in order for executives to receive higher bonuses not only affirms a strong American work ethic at the top, it also paves the way for new executive compensation strategies that are good for leaders and shareholders alike. Indeed, the public scrutiny resulting from say on pay demands these approaches. Finally, boards of directors, the ultimate stewards of the future, can confidently insist that their CEOs earn every dime of their keep by delivering on the kind of challenging goals that drive growth, profitability and long-term share appreciation.
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