Fixing the executive compensation system – Boston Consulting Group

The Boston Consulting Group has released a new white paper – "Fixing What's Wrong with Executive Compensation" – that puts a critical spotlight on the current executive compensation system.

Analysing changes in executive salaries between 2007 and 2008 at more than 150 U.S. companies with more than $5 billion in revenues, BCG analysts discovered a disconnect between the compensation of high ranking executives and their company's overall performance.

While 94 percent of the companies had negative total shareholder return (TSR) last year, about 40 percent of those companies paid their chief executive officers more than they did in 2007. The average CEO salary level dropped compared to the previous year.

BCG experts argue that it is no longer enough to reiterate the demands that businesses 'pay for performance.' The problem, they say, is that existing forms of long-term incentive compensation for executives are hardly ever linked to significant long-term performance metrics. They merely prompt most executives to focus on the annual cash bonus and, as a result, they narrow their focus on short-term results and near-term returns even if the latter are unsustainable in the long run.

Gerry Hansell, senior partner in BCG's Chicago office and co-author of the white paper, said: "The idea of paying for performance isn't new. The very compensation systems that many criticize today are the product of nearly two decades of efforts to achieve precisely that goal."

Frank Plaschke, a partner and managing director in BCG's Munich office, added: "Too often, managers are rewarded for beating plan targets for, say, increasing sales, growing earnings per share, or improving their P&L statement. But such metrics either reward growth irrespective of its impact on profitability or reward profitability but with no consideration of how much capital was invested to achieve that goal. They also encourage companies to retain earnings when, from a value-creation perspective, there might be better uses of that cash -- for example, returning it to investors in the form of dividends."

To solve the problem of executive compensation, BCG experts propose the following principles:

• Emphasize the long term
• Reward relative performance
• Measure performance that executives can directly influence
• Focus on value creation
• Minimize asymmetries of risk

"The 'rules of the game' are changing," Plaschke concluded. "Executive compensation has to change along with them."

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