Problems With Executive Compensation Extend Beyond Financial Sector, According to Study by The Boston Consulting Group

BOSTON, MA--(Marketwire - July 14, 2009) - Furor over bankers' pay has once again put a critical spotlight on executive compensation, but the problems aren't limited to the financial sector, according to a recent study by The Boston Consulting Group (BCG).

BCG analysis of changes in CEO compensation between 2007 and 2008 at 158 U.S. companies with more than $5 billion in revenues found a widespread disconnect between top executive pay and company performance. Nearly all the companies studied (94 percent) had negative total shareholder return (TSR) in 2008, and, as one would expect, the average level of CEO pay declined from the previous year. About 40 percent of those companies with negative TSR, however, actually paid their CEOs more in 2008 than they did in 2007.

Systemic Flaws in Current Executive Compensation Systems

The BCG White Paper "Fixing What's Wrong with Executive Compensation" argues that in order to solve the problem, it's not enough simply to renew demands that companies "pay for performance."

"The idea of paying for performance isn't new," said Gerry Hansell, senior partner and managing director in BCG's Chicago office and a co-author of the report. "The very compensation systems that many criticize today are the product of nearly two decades of efforts to achieve precisely that goal."

Since the late 1980s, the mix of the executive pay package has shifted decisively toward variable pay in general and long-term incentive compensation in the form of equity vehicles such as stock options and restricted stock grants in particular. The problem, according to the BCG White Paper, is that these dominant forms of long-term incentive compensation are rarely linked to meaningful long-term performance metrics.

As a result, the vast majority of executives continue to focus on the annual cash bonus as the more meaningful and, therefore, more motivating component of variable pay. This trend has led, as in the banking industry, to a narrow focus on maximizing short-term results and a willingness to take risks that boost near-term returns even if those returns prove unsustainable over the long term.

Even worse, the internal financial and operational metrics typically used to determine the annual bonus often do not really measure what creates value in the business. "Too often, managers are rewarded for beating plan targets for, say, increasing sales, growing earnings per share, or improving their P&L statement," said Frank Plaschke, a partner and managing director in BCG's Munich office and a co-author of the study. "But such metrics either reward growth irrespective of its impact on profitability or reward profitability but with no consideration of how much capital was invested to achieve that goal. They also encourage companies to retain earnings when, from a value-creation perspective, there might be better uses of that cash -- for example, returning it to investors in the form of dividends."

Key Principles of Compensation Redesign

To address these shortcomings, the paper describes five principles that should inform any redesign of executive compensation systems:

-- Emphasize the Long Term. Incentive compensation plans should have a bias toward the long term in the form of longer vesting periods and multi-year performance targets.

-- Reward Relative Performance. Performance metrics for equity-based compensation should be based on relative, not absolute, performance by indexing a company's performance to that of a designated peer group.

-- Measure Performance That Executives Can Directly Influence. In general, executives at the business unit level should be evaluated according to financial and operational performance metrics that are relevant to the units they head.

-- Focus on Value Creation, Not Just Earnings or the P&L Statement. Internal performance metrics should take into account how executives use the capital entrusted to them by holding them accountable for the size and sustainability of the cash flows they generate after reinvestment.

-- Minimize Asymmetries of Risk. In addition to allowing executives to enjoy the benefits of a potential upside, an effective incentive-compensation system must also ensure that they suffer the costs of potential downside by putting some portion of their own wealth at risk.

The paper also examines concrete mechanisms for applying these principles to the two dominant forms of variable pay: long-term incentive compensation in the form of stock options or grants, and short-term incentive compensation in the form of the annual cash bonus.

A Complex Challenge

The BCG White Paper also warns companies that designing an effective executive-compensation system is a complex challenge and requires careful coordination and alignment across multiple high-level units: the board's compensation committee, the senior team, corporate finance, investor relations, and HR. "The precise combination of mechanisms appropriate for any individual company will depend on the complexity of its business, the specifics of its strategy, the key drivers of value creation in its industry, and the priorities of its investor base," said Lars-Uwe Luther, a senior partner and managing director in BCG's Berlin office and co-author of the study.

Given the many shortcomings of current practices, however, companies cannot really avoid the challenge. The economy is moving into a new period with major impacts on company strategy and investor expectations. "The 'rules of the game' are changing," said Plaschke. "Executive compensation has to change along with them."

To receive a copy of the report or arrange an interview with one of the authors, please contact Eric Gregoire at +1 617 850 3783 or gregoire.eric@bcg.com.

About The Boston Consulting Group

The Boston Consulting Group (BCG) is a global management consulting firm and the world's leading advisor on business strategy. We partner with clients in all sectors and regions to identify their highest-value opportunities, address their most critical challenges, and transform their businesses. Our customized approach combines deep insight into the dynamics of companies and markets with close collaboration at all levels of the client organization. This ensures that our clients achieve sustainable competitive advantage, build more capable organizations, and secure lasting results. Founded in 1963, BCG is a private company with 66 offices in 38 countries. For more information, please visit www.bcg.com.