Can your company’s pay program withstand the intense scrutiny of regulators and shareholders and deliver appropriate rewards in return for the performance achieved?  It all comes down to ensuring sound pay/performance relationships. Three tests can assess the strength of that relationship:

Test #1: Pay/Performance Correlation. Does your executive pay correlate highly with company performance? This test examines how pay and performance move together. Ideally, the more performance increases, the more pay should increase (and vice versa). The correlation can be tested by comparing the relationship between changes in total cash compensation (TCC) and company financial results, such as earnings and cash flow over time. In addition, changes in the gains on long-term incentives (LTI) and in total direct compensation (TDC) over time should correlate with changes in total return to shareholders (TRS). Analyses show that correlations well in excess of 0.9 can be achieved by well-designed executive pay programs.

Test #2: Value Sharing. Does your company share an appropriate amount of the value created with senior executives? Value sharing focuses on the split between executives and shareholders. It should be evaluated from three perspectives:
1. percentage of total value (i.e., earnings and shareholder return) created for shareholders that will be allocated to the top five executives;
2. changes to that percentage given time and circumstances; and
3. a comparison of the value percentage across companies to confirm the sharing relationship is appropriate.
The test examines TCC as a percent of both earnings and cash flow, and computes LTI and TDC as a percent of TRS.

Test #3: Peer Alignment. Do relative pay and relative performance align when compared to a peer group? This test determines whether the relative positioning of pay levels for the CEO and other top five executives corresponds to the relative performance positioning when compared to the company’s peer group. Alignment means that pay at the median should be backed up by company performance at the median, and pay at the 75th percentile should require performance at the 75th percentile.

The three tests provide clues as to how well your executive compensation program is designed. Failing one or more of the tests indicates that re-evaluation is needed to determine whether pay is distributed according to strategic impact and whether the incentive design meets your company’s unique business situation. We find that the companies with the best results on these tests realize better financial results. The average TRS for companies with pay/performance correlations (Test #1) in the top third of the S&P 500 is 13.5%; the middle third, 5.4%, and the lower third, 2.3%.

For more information on this topic, refer to “Structuring ’Unassailable‘ Executive Compensation Programs.”