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Article | Executive Pay Memo Asia Pacific

"Guiding Principles": What captures the essence of executive compensation? In a word, “alignment.”

Executive Compensation

By Don Delves | May 23, 2018

If we were going to pick one principle, one concept, one word that best captures our job as executive compensation professionals, it would be alignment. The primary objective of all executive compensation programs should be to align the interests of management and owners. It should also motivate and reward excellent performance that advances the owners’ goals and objectives.

Compensation philosophy statements, proxy Compensation, Discussion and Analysis (CD&A) sections and consulting reports almost always say something about “fostering alignment with long-term shareholder interests.” These phrases are so ubiquitous, they may sometimes seem like a boilerplate mantra. But there is great thought and wisdom – and some controversy – behind these words. Back in the 1970s, a Harvard academic named Michael Jensen and others wrote a series of excellent papers on “Agency Theory,” which eloquently argued that corporate management (the hired “agent” of the owners), left to its own devices, would pursue its own interests (and pay itself accordingly) which are often at odds with shareholders’ long-term interests. The solution was to design and institute incentive programs that paid management for achieving desired shareholder goals and objectives. These objectives typically included growing the long-term value of the company, but also achieving a variety of financial and non-financial goals.

This may sound simple, but knowing, measuring and effectively motivating and rewarding management for achieving desired shareholder results is no easy task. Public companies are not all created equally, and shareholders invest in different companies for different reasons and with different expectations. Companies have to articulate what they offer, for instance, growth, return, dividends, risk, security and innovation. And they have to be able to deliver on what their investors expect. One of the best ways to assure this alignment between company performance and investor expectations is with effective incentive plans for executives and other employees.

In privately-owned companies, the owners are individuals, founders, family members or investors. The investor/owners may be private equity (PE) firms, venture capital investors, hedge funds, individual investors and others. Owners will have very specific preferences and objectives for risk level, growth rates, value creation, cash distribution versus reinvestment, ROI, time horizon and more. The owners may also have objectives around human capital, the company’s role in the community and environment, and philanthropic goals, among other ends. It is our job as executive compensation professionals to understand all of these preferences and goals, determine how to measure them and build them into effective incentive programs.

The viability and applicability of Agency Theory was tested and taken to the extreme in the 1990s. Jensen teamed up with another academic, Kevin Murphy in 1990 and published another persuasive paper, entitled CEO Incentives: It’s Not How Much You Pay but How. This paper argued, in essence, that if you really want to make managers think and act like owners, then they need to be owners – and perhaps significant owners. This coincided with – and may have helped justify – the beginning of the stock option explosion of the 1990s, during which annual option and stock grants to senior executives increased by 400% to 600% in about eight years. Typical overhang percentages reflecting the potential dilution shareholders could face from executive compensation awards, increased from about 5% in the early 1990s to 10% to 15% by the end of the decade. Grant levels peaked in about 2001 and came back down a bit, but have been at the higher level ever since. Subsequent papers by Murphy and others questioned the effectiveness of the virtually untethered granting of options during the 1990s.

So stock compensation and long-term incentive plans (LTIPs) in their many forms have become the major tools of alignment – along with the always powerful annual incentive. We have a lot more ammunition, and potential variation at our disposal today, than we did when Jensen first discussed Agency Theory. Alignment today is focused largely on stock price and stock performance. Relative total shareholder return (TSR) plans, fairly mechanical devices that assure a certain degree of alignment between managers and shareholders, are its most common manifestation. Over 50% of publicly-traded companies have some kind of relative TSR feature in their LTIP programs.

These plans align executive pay with shareholders, in that pay and stock performance move up and down in similar ways. However, one could argue that these plans are fairly passive, and not particularly motivational. They don’t actively motivate specific financial and non-financial actions and results that owners would like to see. So, while they align pay, they don’t necessarily foster, promote and reward specific actions and results.

Alignment also goes beyond the relationship between managers and owners. Compensation plans can and should foster alignment from the top to the bottom of an organization, as well as across geographies and divisions. Part of our job as executive compensation professionals is to determine how much alignment is desired between different levels in the organization as well as between different business units, divisions or geographies. This can be reflected in relative weightings on corporate versus business unit goals, and shared objectives that flow down from the top to lower levels, among other indicators.

So, in essence, alignment both syncs the interests of management and owners so that compensation reflects performance and also motivates particular behaviors across business lines and geographies at levels that drive business goals. It’s the job of executive compensation professionals to deliver solutions that find the right balance and capture the owners’ visions of how companies should perform and the directions they should head.

To learn more, view our video of Amanda Voegeli, director, executive compensation, as she explains how alignment gets to the heart of pay for performance.

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