New thinking on how to link executive pay with performance

As the stock market began its ascent in the mid-1990s, executive pay--always the subject of heated debate--mounted along with it. That's because among the largest U.S. companies, stock options now account for more than half of total CEO compensation and about 30% of senior operating managers' pay. One problem became particularly clear during the bull market's astonishing run: even below-average performers reap huge gains from stock options when the market is rising rapidly. The author proposes steps to close the gap between existing compensation practices and those needed to promote higher levels of achievement at all levels of the corporation. For top managers, he recommends replacing conventional stock options with options that are tied to a market or peer index. Below-average performers would not be rewarded under such plans; superior performers could, depending on the way plans were structured, receive even more. He notes that managers at the business unit level should not be judged on the company's stock price--over which they have little control--and advocates an approach that accurately measures the value added by each unit. Finally, he suggests how certain indicators of value can be used to measure the contribution of frontline managers and employees. The concept of pay for performance has gained wide acceptance, but the link between incentive pay and superior performance is still too weak. Reforms must be adopted at all levels of the organization. Shareholders will applaud changes in pay schemes that motivate companies to deliver more value.