In this month's Financial Directions section, sponsored by Mercer Gray, we look at how a company's share price is a good indicator of its performance, but a "very imperfect" indicator of executive performance. For a PDF of the full section click here
A new Mercer HR white paper says that linking executive pay with company performance could divert executives from good leadership habits and make them drive up the company share price in deceitful and unsustainable ways.
The research covers FTSE-100 companies from 1999 to 2001, with a method referred to as performance sensitivity analysis, which measures the correlation of month-to-month movements in a company’s shareholder returns with those of indices of both industry and general market performance.
For example, it finds that the volatility of total shareholder return (TSR) at Reuters is greater than Reed over the period. However, it finds that the proportion of TSR specific to the company and driven by executive performance is 76% in Reed’s case, compared with just 36% for Reuters.
Mercer believes that with such high levels of industry risk at Reuters (accounting for 43% of the share price volatility), stock-based incentives for executives could prove “quite costly” to Reuters shareholders.
Mercer has devised what it claims is a consistent measure of relative shareholder return that takes into account external factors. Dubbed the ‘return-to-risk ratio’ (RTRR), it is calculated by dividing the company’s average total shareholder return by the proportion of share price volatility driven by market and industry factors.
ARM Holdings is ranked the top FTSE-100 company by total shareholder return in the period 1999 to 2001, but it would drop to 8th place when ranked by its RTRR.
Morrison rises from 25th to 10th when ranked by RTRR. MAN Group performs well on both measures, ranking second in total shareholder return and finishing top in RTRR.
Incentive pay represents a high proportion of CEO compensation for these high-performing companies, but it is often linked to share performance rather than the stewardship of the individuals concerned, Mercer argues.
The median long-term incentive pay as a percentage of salary jumped to about 90% in 2001, from 54% in 1999.
The top-10 companies based on TSR paid their CEO more than the bottom 10 on the same measure. However, CEOs of the top and bottom 10 companies measured on TSR received more compensation than the top 10 measured by RTRR. Mercer says that executives of companies that performed badly in terms of shareholder return, but performed well in terms of return-to-risk, were underpaid in relative terms.
Nevertheless, the top 10 companies by RTRR showed a huge increase in total direct compensation toward the end of the study, rewarding their CEOs with an 88% increase in 2001.
The study argues that there is scope to link performance and reward by developing “more accurate measures” that account for external factors and determine a more relative contribution from the executives.
Information on Linking executive pay with performance: a more robust approach, is available by sending an email to [email protected].
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