Long-Term Incentive Design: How to Get It Right

CFOs are getting more involved in designing executive pay incentives these days, and it's not just because they have to sign off on the proxy's compensation discussion and analysis [MD&A] section, according to Myrna Hellerman, senior vice president and Midwest regional manager with strategic HR advisory firm Sibson Consulting. Hellerman talked with Business Finance about the increasing complexity of long-term incentives and how it's changing the finance/HR dynamic.

Business Finance: What's driving CFOs' increased involvement in executive incentive plan design?

Myrna Hellerman: It's related to the complexities of long-term incentive [LTI] design that have come into play in the last few years. In the past, the compensation person or the head of human resources would go and talk to the CFO -- maybe -- and ask, "How many options do we have left in our authorization?" The CFO would tell them, and they'd go back and look at current trend data about how much you should give to people at different levels. That's pretty much how the decision-making process worked; it was not a big deal.

But since FAS 123R, people have said "OK we now have this level playing field; there's no longer that 'free thing' of stock options. Is the wealth accumulation that comes from options really reflective of the efforts of the people who have been receiving them?" You could make an argument that if you're not the market darling, you can have the greatest operation going, but you'll never make any money on those options. People started thinking "How can we link LTI awards with performance using internal measures as well as external measures?"

It isn't just plain vanilla options any more; it isn't just restricted shares. Even for those two vehicles there are hundreds of variations around how you work with vesting and what kind of vesting you put in there. It's like giving a whole palette of color to an artist who's been working with black and white.

Both the finance side and the human resources side realize that in order to really maximize the opportunities for driving performance and retaining executives, neither of them can use the palette by themselves. They really do have to come together and look at how this all works.

BF: How is that changing the finance/HR dynamic?

MH: You have the evolution on the HR side of the house of the type of individual who may have an MBA or a quantitative undergraduate degree and who may be more attuned to the fact that there are financial implications around these opportunities that companies are trying to create through long-term incentives. They realize that they don't have all the data they need to think about maximizing the power of LTI. And they aren't as siloed in their thinking as maybe HR folks were traditionally thought to be.

The CFO may know all the rules, but may not know what kind of behavior the organization is trying to drive in making these kinds of grants.

The best place for them to meet is somewhere in the middle, each realizing that together they can come up with a great solution.

BF: What steps can finance executives take to enhance the collaboration?

MH: If they're a publicly traded company or one that tries to operate like a publicly traded company, one of the places to start is in the development of the compensation discussion and analysis [CD&A]. Form a team with HR and general counsel and maybe later the chair of the compensation committee and have a good conversation around the intent behind the programs that are in place. Look at how the programs and the strategy could impact the overall economics of the organization -- how they're being paid out, the cash flow implications, the equity utilization implications.

Sit down together and read six or eight CD&As of competitor companies and try to understand the designs and the intent behind them. It might be a really good idea to set up a lunch-and-learn proxy-reading club so you have that kind of dialog and everybody becomes educated.

One of the comments I hear from very seasoned human resources executives is that sometimes the finance area doesn't open up to a senior HR person; finance won't create that kind of linkage. Really, in these days, those old silos really can't exist when it comes to compensation programs any more. Being more open to discussion is key. A lot of it has to do with relationship-building between the two functions.