You are the Director of Compensation and Benefits for Lansing-Smith Corporation, a 6-month old sales and service organization that currently has a workforce of 150 employees. You recently joined the organization when the Vice President of Operations decided to move the Compensation and Benefits function out of the Accounting Department, into a separate function. From your own observations you have identified several areas in need of review, redesign or development, including projects such as an audit of current pay plans to ensure they are aligned with federal regulations, an analysis of various pay plans to assess which plans will provide maximum benefit for Lansing-Smith, extensive job analyses to ensure a solid understanding of each position, job evaluations to determine the worth of the positions, consideration of various incentive plan designs to identify a plan that effectively drives individual and group performance to achieve production goals and research, development, communication and management training for a company-wide performance appraisal process.
You are dedicated to developing compensation and benefit practices that are motivating and empowering for employees. You are confident that with well-developed programs and practices, employees will be motivated to perform at higher levels, thereby driving overall company performance.
Details: The VP of operations asks for you to prepare a report for her and upper level management as they consider shifting pay structure.
In your report, discuss various pay plan options- merit-based pay, pay-for-performance, merit plus incentive, and pay-for-knowledge plans.
Within your report you should discuss the advantages and disadvantages of each plan, the type of company or environment is each plan best suited for, and how each type of plan fits in with current philosophy on compensation design. Give your opinion, with solid reasons, as to which choice would be best for Lansing-Smith.
Here is an example organization's review of pay plans and their shift to variable pay:
ATcon: 7X7 ASM Pay Plan (http://www.atconsse.com/products/downloads/ATcon-7X7-ASM-Pay-Plan-SSE-Rev41404.pdf
Let us discuss each plan one by one:
Heneman (1992) defines merit awards as incentive pay that is based upon past performance and is designed to motivate future performance. Where individual employees are responsible for complete tasks with measurable effects on the total output of the firm, the links between rewards for past performance and future effort are strengthened; conversely, where teamwork is an important component of the production process, it is not only more difficult to evaluate individual performance, but financial rewards may not elicit the appropriate cooperative behaviour among employees. Moreover, financial rewards may diminish the intrinsic value individuals place upon their work; they may decrease the employees' self-esteem if they deem merit awards to be too infrequent or if they hold an inflated self-evaluation of their performance; or may generate the "Matthew effect" where the motivation of underperformers declines and overperformers experience a sense of guilt (Heneman 1992: 49-56).
Economists applying agency theory reach much the same conclusion. Lazear and Rosen (1981) characterize merit pay as a "rank-order tournament," where individuals compete for salary "prizes" on the basis of relative, rather than absolute, performance. Where it is difficult for firms to obtain an absolute measure of worker productivity, or where it is cheaper to obtain an relative measure, firms establish a competitive game among employees and reward the winners with a prize. They offer the example of a handful of junior executives vying for a senior executive position within a firm. Differences in performance may be marginal and the best that can be achieved is a ranking of individuals. By offering promotion and a raise to the most productive, an incentive is created for all competitors to increase their output. Although the winner's new salary may exceed his/her value to the firm, it is an efficient arrangement if the total increase in productivity of all contestants is sufficiently large to justify the winner's higher salary (Lazear and Rosen 1981). Similarly, merit pay schemes involve a zero-sum game relying upon a relative measure of output among contestants vying for a salary prize. A fixed pool of funds is distributed among employees exhibiting the greatest production over an interval of time with the "more exceptional" rewarded by transferring funds away from "less exceptional" performers.
If the salary prize induces enough greater effort, the value of the resulting increase in productivity exceeds the higher salary costs. Alternatively, if production relies upon a high degree of cooperation among employees - in the form of common tasks, or the transfer of knowledge through on-the-job training - merit pay may be inefficient. Rank-order tournaments based upon relative performance create an incentive to withhold cooperative effort. According to Lazear (1989: 578-9): ...
In your report, discuss various pay plan options- merit-based pay, pay-for-performance, merit plus incentive, and pay-for-knowledge plans.
Executive Pay and Benefits, Stock Options Use and Google
Case 1 (Questions 1-3)
No topic inflames the passions of business leaders and shareholders like executive pay. Companies and compensation consultants argue that, in a free market, they'd be foolish not to pay the going rate for top talent. Investors demand that compensation be tied to performance and complain loudly when pay rises while share prices don't.
The perennial battle is about to reach a new level of contentiousness. The proxy season, just getting started, will be the first under new Securities & Exchange Commission reporting rules that force companies to disclose more about executive pay than ever before--from the hundreds of millions some executives stand to gain in severance, pensions, and deferred pay, to any perk worth more than $10,000. Golden parachutes and sybaritic benefits such as club memberships and personal use of company jets won't score many points against a backdrop of the options-backdating scandal and increasingly empowered activist investors.
Thanks to recent blowups like that at Home Depot, shareholder-rights groups hold a distinct advantage in the public-relations war. Former Chief Executive Robert L. Nardelli walked away from Home Depot Inc. (HD ) in early January with a $210 million severance package, shocking shareholders unhappy with the company's flagging stock. And the timing couldn't have been worse for companies nervously preparing to reveal their own pay practices. "Home Depot is a preview of things to come," says Michael S. Melbinger, a compensation lawyer with Winston & Strawn in Chicago. "It's the perfect example of the rich payout that would have been buried before, but which everyone now must disclose."
Governance advocates and politicians gain even more public support when they point out that in 2005 the average CEO in the Standard & Poor's 500-stock index took home 369 times the pay of the average worker, up from 28 times the average in 1970. The counterargument, that the ratio is down from the 514 multiple in 2000, doesn't get much traction.
THE LITTLE THINGS
Some boards have been looking hard at executive contracts and even tried to renegotiate them. Such minor perks as the personal driver and financial planning services are often on the table. But most boards plan to do little more.
In many cases, they can't. Almost all CEOs have contracts guaranteeing their big payouts. And the fear of angering a CEO over a pay issue has made directors reluctant to push harder. "No one wants to be responsible for seeing the CEO walk," says Jannice L. Koors, a managing director of pay consultants Pearl Meyer & Partners. In a survey of 110 companies at yearend, Mercer Human Resource Consulting found that 70% planned only minimal changes to their executive compensation programs as a result of the new SEC rules; just 15% said the impact would be more substantial. Cutbacks in executives' packages are "just not terribly widespread," says Mark A. Borges, a former SEC official who is a principal at Mercer. Chicago lawyer Melbinger, who has sat in on recent board meetings, echoes Borges' view: "Yes, there's pressure to get rid of these deals, but I have not seen a single situation where an executive was willing to give one up."
To avoid provoking shareholders, companies are most commonly shifting pay out of categories that raise questions. Late last year aerospace giant Lockheed Martin Corp. (LMT ) said it would stop paying for a car and driver as well as club dues for CEO Robert J. Stevens. Instead, it hiked his $1.48 million salary $40,000. A spokesman says ending perks was in the company's best interests.
Some items, however, are too large to move or obscure. The biggest fights are likely to be over multimillion-dollar deferred pay and retirement accounts, as well as guaranteed payments for executives who are fired or who leave when the company is acquired. Such items have been focal points of recent firestorms, from the Nardelli flap to the $82 million pension Pfizer Inc. (PFE ) paid outgoing CEO Hank McKinnell last year.
The surprise this proxy season, predicts Shekhar Purohit, a principal of pay consultants James F. Reda & Associates, will be just how common, and lucrative, these severance packages are. Typically they include a payment of three times salary and bonus, immediate vesting of options and restricted stock awards, and, in many cases, payment of taxes owed. Purohit says dozens of executives could have payouts of $100 million or more.
Revelations of extra-sweet deferred-compensation deals are sure to raise eyebrows, too. Such plans usually allow executives to sock away money tax-free, often with a company match--much like 401(k) accounts, only with no limit on the contributions. And some companies guarantee better-than-market interest for executives. American Express Co. (AXP ) gave CEO Kenneth I. Chenault $1.1 million in above-market returns on his deferred compensation account in 2005. The company won't divulge the rate it gave that year, but in 2006 it paid 13% on executives' deferred balances. In late January, AmEx said it would continue to pay 13% to 16% on money they set aside between 1994 and 2004 if the company meets or beats financial targets, and will pay 9% to 11% on money deferred after 2005. A spokesman says the plan is consistent with industry practice.
Pension plans will likely draw attention, too. Whereas regular workers typically retire on one-half to two-thirds of their average salary in their last three to five years, some CEOs get far more. Pfizer's deal with McKinnell was unusually rich: In calculating his final pay, Pfizer counted not only salary and bonus, but stock awards that vested through 2004. That notched his annual pension up from roughly $3.5 million to $6.6 million. The company says it stopped including new stock awards in pension calculations in 2001, but earlier grants were grandfathered in. Huge bonuses issued just before retirement can also pump up pensions. "It's the gift that keeps on giving," says Kevin J. Murphy, a professor at the University of Southern California's Marshall School of Business.
Governance activists are already targeting such practices. The United Brotherhood of Carpenters has identified 14 companies, including AT&T (T ) and Johnson & Johnson (JNJ ), where it believes the inclusion of large incentive bonuses in pension calculations has led to excessive benefits. So far, the union can claim one small victory. In January, American Express also announced further limits on retirement benefits. Rather than basing them on total salary and bonus--which for Chenault were $1.1 million and $6 million, respectively, in 2005--earnings used in calculating retirement will be capped at twice the annual salary. The AmEx spokesman says the changes, long in the works, stem from the shift away from traditional defined benefit pensions to 401(k)-type defined contribution plans.
As for the smaller perks, companies maintain that some are born of legitimate need. For example, many argue that use of a company jet even for personal flights is a must in the post-9/11 era. Ditto home alarm systems and other security measures. The practice isn't universal. Intel Corp. (INTC ) and Goldman Sachs & Co. (GS ) both forbid personal use of company jets.
Even so, in a study of 2005 proxies filed by the 100 largest U.S. companies, compensation research firm Equilar Inc. found that the median value of personal travel on corporate jets rose 21.7%, to $109,000, while execs got roughly $37,000 to safeguard themselves, up 69%. The numbers for individuals can fly much higher. United Technologies Corp. (UTX ) chief George David ran up a $581,396 tab for "personal use of the corporate aircraft for security reasons," according to SEC filings. The company declined to comment. FedEx Corp. (FDX ) gave CEO Frederick W. Smith $833,000 in jet use and security services on top of his $1.3 million salary in fiscal 2006. FedEx, which requires the CEO to use the jet for all travel, says an independent security consultant determined the need for the benefits.
Still, jet travel irks some. Richard C. Breeden, a former SEC chairman who runs a hedge fund, criticized restaurant chain Applebee's International Inc. (APPB ) over the issue. He found that, over a 10-month period, Applebee's jet made 29 trips to Galveston, Tex., where Lloyd Hill, who stepped down as CEO in September but remains chairman, has a beach house. A spokeswoman for Applebee's, which said on Feb. 13 it will explore a sale, says its plane policy is disclosed.
One thing is clear: It is increasingly tough for boards to keep everyone happy. Retired General Hugh Shelton, the former chairman of the U.S. Joint Chiefs of Staff who heads the compensation committee of software maker Red Hat Inc. (RHT ), says boards are focused more on finding the right balance between shareholder demands to link pay to performance and the company's need to ensure good executives have the right incentives. "You try to be fair, and give appropriate rewards for performance," he says. But ultimately, "you compensate them so that they're not desperate to go to work for someone else."
Case 2 (Question 4)
Erik Lie loves academic life. The University of Iowa associate finance professor is free to research whatever topic intrigues him, and his $160,000-plus income goes a nice long way in Iowa City. Summers off mean that Lie (rhymes with "key"), his wife, and two kids can travel back to his parents' vacation home in Norway. During the rest of the year, he's free to take off after class for a run or some cross-country skiing. "Life as a professor is good," says the lanky 38-year-old.
It's particularly good now that Lie's research is having a major impact on Corporate America. His mid-2005 research first suggested that hundreds of companies may have routinely manipulated stock- option accounting rules to sweeten top executives' paydays. A later study done with his research partner, Indiana University associate professor Randall Heron, puts the number at 2,000, or 29% of all public corporations. Five executives face criminal indictments for such alleged backdating, more than 100 companies face civil charges and shareholder suits, and hundreds more are neck-deep in comprehensive investigations of their books to try to make sure the Feds don't add them to the list.
The scandal is creating a financial windfall for Lie. He and Heron have created a limited partnership now that the initial crush of calls from reporters has given way to people willing to actually pay for their insights. Lie says he has earned around $100,000 from hedge funds and other investors, who pay him to handicap whether a company's options irregularities are harmless paperwork errors or the kinds of fraud that lead to CEO ousters and big civil penalties. He'll probably draw $400 an hour or more doing consulting work for law firms, and still more as an expert witness. He's now a senior adviser at the Brattle Group, a consultancy in Washington. All told, Lie figures he could make $250,000 before the options scandal fades from memory.
Lie may be underestimating his prospects. An elite business prof can make tens of thousands for a one-day consulting gig. Notre Dame University professor Paul H. Schultz, who in the mid-1990s discovered that NASDAQ market makers were skimming pennies from investors on stock trades, says he earned $250,000 over three years, charging $250 an hour to work with plaintiffs' attorneys. "But Erik can do quite a bit better, if he wants to," Schultz says. "There are more lawsuits, and he should be charging a higher rate."
Rarely has an academic had such an outsize, real-time impact on the business world. Academics had long known that companies tended to grant options with remarkable acuity--just before big rises that gave those options immediate value, at least on paper. But Lie and Heron were first to suggest that this could only have happened with the help of hindsight. That's because those favorable trading patterns appeared only in cases where companies had delayed their options paperwork for months, giving them the ability to look back and cherry-pick the most lucrative grant dates. That's a violation of federal law--and of many corporate options plans--if not properly disclosed.
Lie helped make sure the scandal exploded, notifying the Securities & Exchange Commission of his work and showing The Wall Street Journal how to interpret a particular company's options records, although he insists he never I.D.'d companies himself. He's clearly proud of his work's resonance but insists the attendant financial opportunities are a low priority. He limits his consulting time, he says, to less than one day a week. "I did not start this line of research for the money, and I am still not in this for the money," Lie says.
Now he's turning away many opportunities, he says--particularly from plaintiffs' lawyers who would like to tailor his findings to suit their cases. But he is helping "less pushy" plaintiffs' attorneys prepare potential cases against three dozen companies, diving into details of specific transactions. Indeed, he says he'll probably take the stand as an expert witness in some high-profile cases. He won't name any names, in part because it's too early to know which companies will settle rather than make it into court, but does say that he "may become involved in litigations" against Apple Computer (AAPL ).
Lie is also open to working with defendants facing options-related allegations, although none have taken him up on the offer. "People tend to think I'm against all companies," he says, "but I think some of the companies identified in the media are innocent"--perhaps a dozen or so of the 200 companies that have announced options irregularities. He says some guiltless CEOs are likely to lose their jobs simply because they were at the helm when mistakes were made by others. Still, "it's one of those necessary evils; a small price to pay to get more transparency into the system. How much is good governance worth to the economy? I don't know, but it's billions and billions."
Lie grew up the son of left-leaning parents in southern Norway. His father, Rolf, a retired construction engineer, thinks Lie is imbued with the economic egalitarianism they taught him. "Erik doesn't like that people have gotten money they didn't deserve," says the elder Lie. The son briefly considered a career in law but later caught the academic bug while doing a finance research project at the University of Oregon.
When he began researching stock options as a young professor in 2002, it wasn't to find a scandal. "Shareholders were giving executives options so they'd work harder to change corporate behavior," he says. "I just wanted to see how it manifested itself"--say, by companies repurchasing more shares. Even after Lie began to suspect backdating, it took a while for anyone to listen. An initial paper in 2004 was slammed by a reviewer who said that Lie was "overreaching" and that his conclusions "made little economic sense." After Sarbanes-Oxley regulations were imposed, however, all option grants had to be reported to the SEC within two days. By comparing the new grants with pre-SarbOx grants, Lie and Heron were able to document a disappearance of the windfall obtained by execs at companies that had taken months to file in the past.
Defense lawyers dismiss Lie's analysis because it doesn't consider legitimate explanations for how options may have been granted at low stock prices. For example, CEOs during the boom routinely granted options on days when their stocks were down because of unfounded rumors. That way, they could provide some extra incentive to employees before cranking up their investor relations efforts to refute the rumor. "His analysis is simplistic," says Richard Marmaro of Skadden, Arps, Slate, Meagher & Flom, who is representing indicted former Brocade Communications Systems (BRCD ) CEO Greg Reyes. "There are people whose job it is to grant options, who are expert in understanding what they perceived to be low prices."
Lie says he's going into this next phase of the scandal with his eyes wide open, expecting to have his motives criticized, and ready for persuasive arguments about why a specific company, board, or executive did nothing wrong. He figures that the bulk of backdaters have yet to be identified, and that just 10% will ever be punished in any way. "I don't anticipate I'll be able to create something of this magnitude again," he says. "But it's not necessary for me that there is a consequence for every single firm. My research has already helped curb this behavior. That's the most important thing."
Case 3 (Question 5)
In a bid to breathe new life into scandal-tainted stock options, Google (GOOG) plans to give employees a novel method of cashing in their options starting next April. The search giant will let employees sell their vested stock options, which give the holder the right to reap the difference between the initial price and the current price, to selected financial institutions in an auction marketplace it's setting up with Morgan Stanley (MS).
The program is a unique stab at unlocking for employees the underlying value of these securities that have been a favored method of luring and keeping employees, particularly among technology companies. In the past year or so, as rules requiring the expensing of stock options kicked in, employers have been cutting back on the number of options they grant, or doling out new incentives such as restricted stock, in a bid to avoid a hit to reported profits.
That has some observers worrying about the possible demise of a classic performance incentive tool. While options continue to be granted by many companies, some 30% have cut back their options grants, and 25% of employees who once received options and other equity awards now do not, according to the National Center for Employee Ownership, a nonprofit research group in Oakland, Calif. And for those getting grants, the value of their options is about a third lower than it used to be.
How It Works Under Google's Transferable Stock Option program, employees could sell their stock options on the semi-private marketplace much the way public options are sold today. That would let employees potentially reap more than if they merely exercised and then sold the securities. Say an employee holds an option with a strike price of $400, meaning it can be purchased for $400 and then resold at a higher price. If Google's stock is trading at $500, an investor might pay $150 for that option, betting that the stock will rise well past $500 during the life of the option. The employee selling the option could net an immediate $150. An employee exercising and then selling the same option would net only $100, the difference between the strike price and the current price.
The impetus for the new approach is Google's volatile stock, which can change substantially in the space of a month or even days. Google's stock has been on a long if volatile rise since the company's initial public offering in 2004 at $85 a share. Just since Sept. 1, the shares have risen 27%, to $481.78 on Dec. 12, after rising above $500 in November.
As a result, many recent and incoming employees may feel the options don't have much value, given how high Google's stock already is. Moreover, an employee who joins one week ultimately may end up having very different compensation than another hired a few weeks later. That difference can raise pay equity issues and potentially reduce the incentive for employees to stick around. "This goes a long way toward solving recruiting and retention issues," says Dave Rolefson, Google's equity and executive compensation manager.
"Very Innovative" If Google's plan works ? an open question at this point ? other companies once again might find options an attractive offering for hiring and keeping talent. "I think it's a very good idea," says James Glassman, resident fellow at the American Enterprise Institute, who was briefed on the plan. "It achieves Google's goal of making the value of options more apparent to people who get them."
There could also be some unpredictable consequences to the plan. Investors buying these options no doubt will want to hedge their bets, possibly through a short sale ? a bet that Google's stock will fall. That's not usually something companies like to see. But Google believes the overall impact of the program on the company will be positive. Former Securities & Exchange Commission Chairman Arthur Levitt, now a senior advisor to the Carlyle Group, says he's not sure what all the implications will be. "But on balance, it's a very innovative program," he says.
The plan is only for employees, not executives, who Google says are already adequately compensated. So on its face the plan doesn't address some of the recent problems surrounding stock options, including manipulation of the date on which the securities are granted, so-called backdating, that have landed companies other than Google in legal hot water. But it does offer a different ? and possibly more accurate ? way to value stock options, an area of great debate even now, nearly a year after options were required to be logged as expenses on a company's books.
No Benefit to the Bottom Line Google's program isn't aimed at minimizing the impact to its bottom line, however. Indeed, the company expects to incur a larger expense on its books as the plan rolls out. That's because the fair market value of the options will be greater under the new plan than the current one. The reason: The options, which are estimated to have a four-year average life before employees exercise them, will convert to two-year options when they're sold to investors. So their expected life will be essentially extended by two years ? making them more valuable because investors will have two more years for Google's stock potentially to rise, and thus more of an impact on Google's bottom line.
If Google's stock doesn't rise, or even falls, the options may well still have value, because investors may assume that over a two-year period the stock has a good chance to rise again. So employees may be able to sell even underwater options ? those whose strike price is higher than the current stock price ? and reap gains. "Underwater options lose their value as retention tools," notes Levitt. Even under Google's new plan, however, if its stock price drops well below options' strike prices, investors may not want to pay for them, and the options will still be worthless.
Google said it's not implementing the new plan because it's having problems attracting and retaining employees ? at least not yet. "We're not having any problem recruiting people to work at Google," says Rolefson. "Attrition rates are very low." The idea, in an increasingly competitive business, is to keep it that way.
1. What has been the compensation of CEOs relative to their "line" workers the past few years?
2. Do you think it is deserved? Why?
3. Do executives and related compensation/ incentives appear key to effective implementation, or unrelated?
4. Regarding Case 2, does it seem reasonable for executives and employees to "backdate" stock option grants so that their grants are priced at the lowest daily stock price within a two -to four- month time period? Why?
5. Regarding Case 3, does it appear Google has found a way to add liquidity and simplicity to employee stock options designed to reward effective implementation and performance.