How 'Competitive Pay' Undermines Pay for Performance (and What Companies Can Do to Avoid that)

15 Pages Posted: 13 Sep 2013

See all articles by Stephen F. O'Byrne

Stephen F. O'Byrne

Shareholder Value Advisors, Inc.

Mark Gressle

Gressle and McGinley

Date Written: Spring 2013

Abstract

Almost all proxy statements say that the company's pay programs are designed to achieve pay for performance and to provide competitive pay. While companies assume that these objectives are perfectly compatible, attempts to provide competitive pay often have the effect of undermining pay for performance. As currently practiced, competitive pay means that the company's target pay levels match the pay levels of its peer companies regardless of past performance. By targeting the dollar value of an equity award each year, competitive pay plans effectively reward poor performance in a given year by increasing equity grant shares in the following year — and, conversely, such plans penalize superior performance in one year by reducing the number of shares in the next. Likewise, the target share of the annual incentive award increases with poor performance and decreases with superior performance. In this fashion, the competitive pay approach distorts incentives and weakens the link between cumulative pay and cumulative performance. The authors show that the focus on competitive pay is a modern development that replaced the sharing formulas that governed executive pay in the first half of the twentieth century. Companies adopt the competitive pay model because they believe it does a better job of achieving the three main objectives of executive pay: strong incentives; retention; and limited shareholder cost. While competitive pay directly addresses retention risk, it can greatly weaken management incentives. Furthermore, boards tends to rely on competitive pay data to set target compensation because they have no meaningful measure of incentive strength and the actual cost to shareholders. Without quantitative measures of incentive strength and shareholder cost, boards run the risk of retaining poor performers and losing superior performers. Using a case study of Dow Chemical, the authors show how companies can measure the incentive strength of their executive pay plans, and how a simple pay plan using annual grants of performance shares can provide “perfect” pay for performance.

Suggested Citation

O'Byrne, Stephen F. and Gressle, Mark, How 'Competitive Pay' Undermines Pay for Performance (and What Companies Can Do to Avoid that) (Spring 2013). Journal of Applied Corporate Finance, Vol. 25, Issue 2, pp. 26-38, 2013. Available at SSRN: https://ssrn.com/abstract=2324595 or http://dx.doi.org/10.1111/jacf.12014

Stephen F. O'Byrne (Contact Author)

Shareholder Value Advisors, Inc. ( email )

1865 Palmer Avenue, Suite 210
Larchmont, NY 10538
United States
914-833-5891 (Phone)
914-833-5892 (Fax)

HOME PAGE: http://www.valueadvisors.com/Contact.htm

Mark Gressle

Gressle and McGinley ( email )

71 Pin Oak Ln
Wilton, CT 06897
United States

Register to save articles to
your library

Register

Paper statistics

Downloads
0
Abstract Views
706
PlumX Metrics