In this issue, answers to:

• How can companies assess balance in their pay programs?

• What factors might signal incentive programs that encourage excessive risk-taking?

• How can companies maximize limited rewards resources?

In our Perspective, Weathering the storm - part 1: Equity compensation actions for 2009, we examined various strategies for dealing with one challenge that has arisen from the recent economic and market volatility: how to manage 2009 equity grants in light of depressed stock prices. Along with this challenge, companies face broader considerations with their executive pay programs. They want to ensure that their programs are effective during this time of uncertainty - equity markets are experiencing unprecedented volatility, and the performance outlook for many companies is unpredictable.

Some shortcomings in executive compensation programs have been exposed in this extreme time. With recent performance volatility, executive rewards that had been thought to reflect underlying performance are being questioned. For example, the leverage of stock option compensation has been dramatic - tremendous value has been created and lost very quickly, calling into question performance links. The connection of compensation actions to the risk of performance results is, in many cases, unclear. Performance has been rewarded, but is the performance sustainable? Shareholders facing large equity losses in the face of significant executive compensation payouts may call for changes to program design or pay mix. Intermediate-term performance plans continue to emerge as a core component of senior executive pay, but goal setting is a challenge. Finally, during the economic slowdown, companies will be pressed to examine their total rewards spend; thus, fundamental questions surface about whether the right people are getting the right rewards.

In this Perspective, we take a step back and consider how executive compensation programs should be designed to address these short-comings. What specific problems have been revealed by the current economic crisis, and what are the implications for executive compensation going forward?

As we look to the future of executive compensation, four key action steps emerge:

• We believe there will be a renewed call for balance in executive compensation delivery - including a more balanced focus on retention and reward, a more holistic approach to performance metric selection and target setting, and more evenhanded use of short- and long-term compensation elements.

• Companies will rethink the relationship between risk and reward and, in particular, look for ways to ensure that rewards reflect sustainable performance results so that excessive risk-taking is not encouraged.

• With resources available for rewards scarce, differentiation of key contributors through rewards and career opportunities will be even more critical.

• Companies will look for ways to apply the concept of segmentation to compensation actions and maximize the return on limited rewards dollars.

Following is a detailed exploration of each of these actions. We will identify the guiding principles and specific design elements that should be considered to support the development of fair, reasonable and effective executive pay programs. While the evolution most certainly will be a multi-year process, companies that embrace best-practice trends early will be in a better position to withstand shareholder scrutiny and proactively address the future challenges that might arise from a prolonged economic downturn.

A renewed call for balance

The most effective executive compensation programs are designed to meet a range of objectives. By "programs" we refer to all of the elements of pay - salary, short- and long-term incentives, and benefits. Compensation programs must be competitive enough to attract and retain the right talent, and incentive plans must motivate executives to achieve the most critical near-, intermediate- and long-term priorities of the business. Program payout levels should be reasonable in the context of performance delivered. The compensation programs also must be responsive to shareholder interests by providing a meaningful relationship between pay and shareholder value creation.

In our view, a balanced program will deliver balanced results, which means it will be much more effective at meeting the full range of the aforementioned objectives. A well-balanced executive compensation program helps mitigate the biases in any single compensation plan or measurement approach. For example, "all or nothing" plans that evaluate results using only one or two performance metrics or hold executives to rigid performance criteria year after year fail to recognize the context in which performance occurs. Unexpected profit windfalls or a bull market can lead to over-compensation, while an industry downturn can result in compensation outcomes that do not adequately recognize executive contributions. Additionally, a compensation program that over-emphasizes short-term performance over long-term performance may encourage inappropriate risk-taking or actions that compromise longer-term goal attainment. Finally, a compensation program that does not consider meaningful retention attributes may leave a company exposed to unanticipated executive turnover.

Companies should examine their programs to ensure that the balance is appropriate and that payouts delivered under a range of performance outcomes are reasonable and defensible. The concept of balance should be applied to many aspects of compensation program design:

• Performance metrics - Choose metrics that provide a balanced picture of performance results and capture the range of relevant dimensions of performance - growth, profitability, returns and shareholder experience - so that the program does not inappropriately emphasize performance along one metric that would have unintended consequences on the company's overall financial picture.

• Target setting - Incorporate a wide range of internal and external perspectives into the target-setting process - including the annual budget and management estimates, strategic priorities, performance forecasts from external analysts, historical industry performance and macroeconomic indicators - to ensure the objectives are meaningful and appropriate. Test the corresponding range of pay outcomes against the performance results to ensure they make sense.

• Measurement approach - Consider the appropriateness of a mix of absolute and relative performance measures. Absolute measures enable the executive team to unite behind shared goals, while relative measures allow for an alternative assessment of performance by recognizing external conditions impacting the industry. For example, relative total shareholder return programs should be evaluated to ensure that payouts are appropriate when, as we have recently seen, relative performance may be strong but absolute performance and the shareholder experience are very poor.

• Vehicle selection - Use a blend of cash and equity compensation, and consider a mix of vehicles when granting annual and long-term incentive awards. Different long-term incentive vehicles provide varying degrees of payout leverage, alignment with shareholders, rewards for achieving financial and operational results, and executive perceived value. For example, recent stock market fluctuations illustrate that the payout leverage of stock options can be very dramatic and potentially so volatile that they demotivate the executive when they are dramatically underwater. On the other hand, intermediate-term cash plans focus on key financial and operational goals but temper the connection with (and leverage of) share price volatility. There is no one-size-fits-all approach, but a range of arrangements should be considered based on the executive's impact on company results, the need to directly link to shareholder experience and the risk/reward profile of executives.

• Time horizon - Use a balance of short-term (one year), intermediate-term (two to four years) and long-term (five-plus years) compensation elements. In particular, companies should look for ways to promote sustained performance to ensure that short-term goal attainment is not over-emphasized. One option is to shift a portion of the compensation to a longer-term delivery option, such as career shares. Alternatively, companies can consider deferring a portion of the annual bonus award into stock, implementing mandatory share holding requirements or adopting executive ownership guidelines to align executive interests with long-term value creation.

Balance always should be a fundamental guiding principle when designing compensation plans, but in a volatile market it is crucial. The "best fit" for a company is critical to meet its needs - thus, appropriate consideration should be given to a company's particular business model, executive requirements, compensation practices and external environment.

Risky business

Companies should closely examine the risk profile of the compensation program. Although this issue has surfaced most notably at financial services firms - where incentives were largely tied to short-term profits - there are broader lessons for all companies.

The 2008 "bailout bill" (more formally known as the Troubled Asset Relief Program, or TARP) addressed this issue head on for financial services firms. The law requires participating financial institutions' compensation committees to meet with the institutions' senior risk officers to ensure that the incentive compensation arrangements do not encourage senior executive officers to take "unnecessary and excessive risks that threaten the value of the financial institution." Such cautions have been extended to companies outside of the financial services industry as well: John White, former director of the Securities and Exchange Commission's Division of Corporation Finance, urged all US companies to consider limiting compensation packages that reward excessive risk taking by executives. Examining the risk profile of the compensation program should be a top priority for all companies.

While the appropriate degree of risk orientation varies among companies based on a number of factors (such as the stage of business maturity, business sector and profit model), all companies should be on the lookout for the following risk factors:

• Too much emphasis on quarterly or annual performance - Too much focus on short-term results can encourage executives to take risks that pay off in the near-term with handsome rewards, without giving appropriate consideration to the long-term impact on the company. This most often can be addressed by providing a reasonable mix of short- and long-term incentives, with the mix weighted more toward the long term for more senior executives. However, the design of your long-term incentive programs should be examined as well to ensure the programs truly reward sustained "long-term" results. For example, intermediate-term performance shares that embed annual or bi-annual goals are becoming more common to address challenges with long-range forecasting; however, they should be balanced with equity vehicles and vesting parameters that have longer time horizons. Where performance programs use shorter time horizons, care should be taken to ensure that long-range, sustained performance incentives are maintained and that payouts follow suit. Additionally, clawbacks of compensation payments or deferrals that remain at risk for performance should be considered to mitigate the impact of spurious short-term results.

• Uncapped incentive plans - Incentive plans that are uncapped can inappropriately reward executives for windfalls or spikes in performance that are not sustainable. Similar problems can arise when short-term incentives are funded as a set percentage of annual revenues or profits, because such mechanics don't factor in how the results were generated. In situations where caps are not used or award maximums are relatively high, companies should consider adjusting the program to provide for caps on payouts to manage inappropriate risk. Alternatively, companies could consider deferring incentive amounts in excess of certain levels into stock or other forms of at-risk pay to ensure that the interests of executives are appropriately aligned with long-term, sustainable results.

• Over-reliance on highly leveraged equity vehicles - Highly leveraged equity vehicles, such as stock options, provide significant payouts under strong performance scenarios but result in zero payout if stock price appreciation is negative. This can encourage executives to take excessive risks with hopes of a large payoff, since the downside risk is fixed regardless of how poor results might be. By granting options in combination with other, less leveraged vehicles (such as performance shares or restricted stock), the equity program can achieve a more varied risk/reward profile and eliminate the singular motivation for executives to "go big or go home."

• One-dimensional performance measurement - In addition to providing a lack of balance as described previously, incentive programs that evaluate results based on only one or two metrics may over-simplify the assessment of performance and potentially encourage inappropriate risk taking. For example, a company that bases its annual bonus on profit growth might actually be rewarding the destruction of shareholder value if it fails to recognize the amount or cost of the capital invested to generate those profits. Some counterbalance to allow for an adjustment for risk would be appropriate. For example, by considering returns or economic measures that factor in the cost of capital (such as economic profit) in combination with growth and profitability metrics (whether in a single plan or across multiple short- and long-term plans), companies can mitigate the risk that executives will focus on performance in one area to the detriment of overall shareholder value objectives. Another perspective is considering the role of share price in the program. This metric shows up in two ways: as a direct performance measure for award vesting (relative shareholder return metrics) and in the form of vehicle (stock options, restricted shares). Since share price is influenced by a range of factors - current company performance, forward-looking company prospects and general economic indicators - it is not a "pure" indicator of company success. Care should be taken to balance share price driven objectives with other operational and financial results.

Optimizing limited rewards through differentiation

With little or no value of outstanding equity awards at many companies, the threat of key executive talent being recruited by competitors is very real. Even in today's volatile environment, top executive talent is always in demand. However, uncertainty about the future and shortages of cash are compelling many companies to scale back their expenditures, and compensation budgets are no exception.

Companies need to do more with less, which means they'll need to be scrupulous in how they allocate limited reward dollars and equity. Top performers will always have the greatest opportunities to leave, even in a declining economy. On the flip side, poor performers are less likely to leave voluntarily and may contribute the least to the company's financial results. Most companies aim to differentiate pay based on performance, but the end results don't always reflect the organization's intentions. In today's environment, companies should look for opportunities to differentiate performance by analyzing the relationship between pay and performance outcomes, including the distribution of performance ratings, salary increases, bonus payouts and equity awards. Further, career opportunities and other non-monetary attributes should be differentiated and directed to employees who are the strongest performers and have the greatest impact.

Maximizing ROI with segmentation

Using segmentation as a basis for making rewards decisions is another way to increase the return on your human capital investments. Using segmentation broadens the concept of differentiation to ensure that compensation programs are tailored to reward employee populations based on the impact of their businesses, geographies and functions on the enterprise. This macro approach allocates rewards opportunities, so that they are directed to those areas that will contribute the most to business success. Rewards for executives should be considered in this scheme as well. Some key questions to consider are:

• What talent is the most critical to the business? Not all employees contribute the same amount to value creation at your organization - even at the executive level. With limited rewards available, companies increasingly need to identify the types of jobs (and particular individuals) that contribute more to the company's success and then provide them with incentives to perform. This may take the form of differentiating the magnitude of pay (e.g., targeting the 50th percentile for some segments and the 75th percentile for others) or rebalancing the mix of pay to motivate and retain (e.g., orienting the mix of some employees to focus more on variable pay while others are oriented toward fixed pay). This examination is fluid - if you've been paying a particular group or level of the organization above market, make sure the premium is still warranted given your business strategy and the current market conditions. If not, there may be an opportunity to migrate to more competitive levels and redirect those savings to improve your return on investment in other ways. A related consideration is your succession plan. What are your talent needs today, and how do you expect them to change in time? If gaps in the leadership team are revealed, now is great time to fill them - if companies come out of 2009 with open requisitions in critical roles, they will have missed an opportunity to pick up top-notch talent at relatively low prices.

• How should reward strategies be tailored to each business? Each business in the portfolio likely has a different impact on enterprise success and different business economics and profit models. Those factors should be considered as rewards for each business (and the overall enterprise) are optimized. For example, some businesses early in their evolution may call for a rewards strategy that is oriented toward long-term growth - with a corresponding focus, perhaps, on more leveraged incentive programs, a mix weighted to focus more on long-term incentives and performance measures that reinforce the importance of growth. On the other hand, a mature "cash cow" business in the portfolio may call for a rewards strategy that underscores rewards for current profitability and returns, so that the incentive programs may be less leveraged, the mix may provide more of a weight toward annual incentives and the performance measures might focus on profitability and expense control.

• What do your executives value? The accounting costs of compensation are not always correlated with the perceived value to executives, and executive perceptions are not stagnant over time. Consider conducting a pulse survey that asks executives to assign relative values to alternative delivery vehicles. You may find that you can increase the perceived value delivered without increasing the accounting costs - for example, by alternating the mix of equity granted or using a differentiated approach across business units or geographies. Companies looking to take a more innovative approach might even consider giving executives some degree of choice in the form of long-term incentive awards - a "self-selected" form of segmentation.

Moving forward in tough times

The current economic environment and the extreme shift in company performance have exposed some shortcomings of current executive compensation programs. Companies should examine their programs in 2009 to verify that the outcomes are appropriate and effective in motivating and retaining talent. The principles outlined in this article - balance, risk management, differentiation and segmentation - should serve as guideposts as companies review their programs. Companies and their boards also should be mindful of external perspectives as they reformulate their plans, especially for named executive officer compensation programs. We expect that "Say on Pay" will be enacted by Congress, or at least become a prevalent "best practice" for 2010. Therefore, 2009 pay decisions that are disclosed in 2010 proxies likely will be open to scrutiny and a vote by shareholders. With that in mind, careful consideration of program refinements is even more critical.