Raising the pay bar: under intense pressure, boards are adopting creative measures to tie CEO pay to performance.

So long, rest and vest. Hello, pay for performance.

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It may come as no surprise that board compensation committees have been under increasing pressure to forge better links between CEO compensation and company performance. Stock options, although technically under the pay-for-performance rubric, have fallen decidedly out of favor both with CEOs, who've seen their options sink in the bear market, and investors, who've learned the hard way that share price is neither the only nor the best metric by which to gauge a CEO's performance. Thus, the pay-for-performance trend toward using more creative incentive tools, such as performance-based restricted stock, long-term bonuses and premium options.

Each of these tools holds the promise of more closely tying CEO pay to performance. Yet the changes being made to compensation packages raise their own questions: How can boards design effective plans? Will these plans help retain talented CEOs or drive them away? Will CEOs earn more or less? "This is a time of real flux," says Diane Doubleday, a principal at New York-based Mercer Human Resource Consulting. "Companies are rushing to institute these plans, but it's going to require fine-tuning if they're going to be effective."

Without question, the compensation strategy most likely to be widely adopted is performance-based restricted stock. It benefits from being a new twist on a familiar incentive, restricted stock. Under a traditional restricted-stock plan, CEOs receive blocks of shares that vest based on length of service, typically anywhere from three to five years. By contrast, performance-restricted stock vests based on achieving goals, such as growing return on invested capital.

Pearl Meyer & Partners, an executive compensation consultancy in New York, analyzed 50 early 2003 proxies and found eight companies with performance-restricted stock plans. Firms that recently have introduced such plans for their CEOs include Campbell Soup, GE and International Paper.

GE, for example, granted CEO Jeffrey Immelt 250,000 performance units in September 2003. (For tax reasons, many companies choose to issue units rather than outright shares.) As is typical, Immelt's units have a value that corresponds one-to-one to the value of a GE share. The units vest after five years based on two performance targets: GE must achieve average operating cash flow growth of 10 percent annually, and total shareholder return that meets or exceeds the S & P 500.

The payout, in this case, is all, half or nothing. If GE hits both targets, Immelt will receive the full grant of 250,000 units. Currently, the block of units has a value of roughly $7.5 million, slightly more than his 2003 base salary plus annual bonus. If GE hits only one target, Immelt gets half of the pie. Should the company miss both performance targets, he gets nothing.

Performance-restricted stock offers the advantage of versatility. A company can tie vesting to an array of metrics, everything from return on assets to top-line growth. Companies can also define performance relative to peer groups. On this score, GE cast a wide net--with the goal of beating the S & P 500--but a company can also choose to go very narrow and aim to outperform its two nearest competitors, for example.

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But the same versatility that makes performance-restricted stock so attractive is also its downside. Compensation experts point out that such plans have the potential to utterly befuddle boards. What are the right metrics? Once metrics are chosen, what is a reasonable rate of growth--5 percent, 10 percent or more? Who is the proper peer group to benchmark against? "This is going to be a real challenge for boards," says Joseph Sorrentino, a partner at Pearl Meyer. "Picking the right targets will require a lot of time, effort, study and thought."

Lucent Takes a Balanced Approach

Long-term bonuses are another arrow in the pay-for-performance quiver. The name is somewhat confusing, though. Generally, long-term bonuses are not meant to replace annual bonuses. More often, they replace a portion of some other long-term incentive such as options or stock grants. Rather than handing out 100,000 options, a company might hand out 50,000 and introduce a long-term bonus plan. Payout for such plans, once again, is based on meeting various performance objectives.

In 2003, Lucent initiated a long-term bonus plan for CEO Pat Russo. It's based on hitting various operating income targets. (Lucent declines to disclose exact details.) At the end of three years, Russo is due to receive a $4 million bonus. But she stands to get anywhere from 0 to 200 percent of that amount, depending on Lucent's performance. Truly stellar operating income results, then, could earn Russo $8 million at the end of three years, four times her 2003 annual bonus.

The major advantage of long-term bonuses is that they allow a company to achieve a better-balanced compensation mix. Many companies feel their CEOs have too large of an equity stake. Long-term bonuses provide a countervailing cash incentive. Such plans also present an opportunity for companies to balance short-and long-term goals. Say a CEO's annual bonus is tied to an earnings-per-share goal. It might make sense to tie the long-term bonus to some other measure, such as return on invested capital. "These plans can make CEOs think more like complete managers," says Dan Ryterband, managing director at Frederic W. Cook & Co., an executive compensation consultancy based in New York.

IBM: Motivate Without Demoralizing 

Of course, long-term bonuses face the same challenge as performance-restricted stock, namely that choosing metrics can be a brainteaser for boards. Options, by contrast, have an elegant simplicity: As stock price goes up, the value of the options goes up. Thus, one of the more intriguing new pay ideas is the inclusion of premium options, also known as underwater options. Basically, these are options with an exercise price somewhere north of the market price at the date of grant.

So far only one company has instituted a premium-option plan. But it's a biggie: IBM. In February, the company granted CEO Sam Palmisano a block of 250,000 premium options. At the time, IBM was trading at roughly $96 per share. In order for Palmisano to exercise any options, the share price first has to rise 10 percent, to roughly $105. "We liked the simplicity. Plus, we weren't ready to abandon stock appreciation [as a metric]," says Steven Hindin, director of executive compensation at IBM. "But we saw this as a way of setting a higher performance hurdle."

Premium options could work at IBM. It's worth noting, though, that lately the company has been trading at around $90, even further underwater. And therein lies the challenge. Along with scandals and accounting changes, there's another big reason companies are moving away from options: They've lost their motivational oomph during the sluggish economy of recent years. So many of Microsoft's 1.6 billion outstanding options are underwater that the company recently switched to other compensation tools. In such an environment, granting options that actually start underwater is likely to work only for unabashedly high-growth companies, or turnaround situations where the CEO sees plenty of growth potential. Otherwise, premium options run the risk of demoralizing rather than motivating the top executive.

One final way to tie pay to performance: simply require CEOs to hold more stock for longer periods. An increasing number of companies are either adding share-ownership guidelines or adjusting their existing requirements upward. For example, Procter & Gamble just upped the guideline, requiring its CEO, A.G. Lafley, to hold stock equal to six rather than five times his base salary. Because Lafley is paid $1.6 million a year, he must now hold a minimum of $9.6 million in P & G stock.

This is an attractive idea, in theory. After all, it ties a CEO's interests more closely to his or her company's long-term performance. Then again, P & G instituted its new guideline at a time when Lafley held 200,000 shares, worth $18 million. His stake is already more than 11 times his annual salary. In such cases, critics point out, share-ownership guidelines are mere window dressing. They're meant to mollify institutional critics but are hardly a substitute for more vigorous compensation reform.

But it's possible to design more effective share-ownership guidelines. Citigroup, for example, doesn't require CEO Charles Prince to hold any particular salary multiple. But any time he exercises a block of options, 75 percent of the value must be maintained in stock until he leaves the company. That partly explains why Sandy Weill, Citigroup's chairman and former CEO, holds 16.8 million shares, worth more than $800 million. "When guidelines are structured right, the CEO's ultimate payday and the company's long-term performance are better intertwined," says Gary Locke, a principal of the executive compensation practice at Stamford, Conn.-based Towers Perrin.

Now for the $64 million question. Will CEOs make more or less money under these new types of plans? The answer is, it depends. CEOs in fast-growth industries who have grown used to ample option grants may balk at an alternative model. As a rule, companies tend to grant three options for every share of restricted stock. Because options are riskier, the thinking goes, it makes sense to grant more of them. If a company's stock appreciates roughly 10 percent annually, options usually provide the heftier compensation bang over time.

CEOs of struggling companies, however, may welcome a change. They may have lost interest in options that are languishing on the ocean floor. For them, it may be appealing to rejigger their long-term incentives so there's a chance to make some money, even if it's less money than their options might have delivered. "In companies or industries where the prospects are poor, CEOs may appreciate a more reliable incentive," notes Blair Jones, a senior vice president at Sibson Consulting, a human resources firm in New York.

The bottom line is that performance pay has the potential to deliver everything you'd want from a compensation plan. It can motivate, retain and better align the CEO with various constituencies. But it's going to require some real head scratching. Setting performance hurdles too low or picking the wrong metrics will open companies up to the very criticism they've been trying to avoid. It's also worth stressing that performance pay is not a substitute for existing compensation tools. It simply becomes part of the overall menu, alongside salary, annual bonus and options, which will continue to have a role. As Randy Jayne, a senior partner with the Chicago executive search firm Heidrick & Struggles, puts it: "The real issue is striking the right balance."

GETTING CREATIVE WITH CEO PAY

Alternative Compensation            Advantages

Performance-based restricted        Awards can be tied to measures
shares--Blocks of shares that vest  other than strict stock price, such
due to meeting performance goals    as revenues or return on equity.
rather than length of service
Long-term bonuses--Bonus plans      Encourages CEOs to take the long
that pay out over several years     view far more than the classic
                                    annual bonus
Premium-priced options--Options     Option grants have the advantage
with an exercise price that's       of being an easy-to-understand
higher than the grant price         performance driver. This is simply
                                    a new twist.
Retention levels--Rules that        It's axiomatic: CEOs who hold
require CEOs to hold certain        more stock for longer are better
amounts of a company's stock for    aligned with shareholders.
prescribed amounts of time

Alternative Compensation            Disadvantages

Performance-based restricted        It can be challenging for boards
shares--Blocks of shares that vest  to select the proper metrics and
due to meeting performance goals    performance thresholds.
rather than length of service
Long-term bonuses--Bonus plans      Smaller public firms, in particular,
that pay out over several years     may lack the ready cash to provide
                                    a big award at the end of three or
                                    five years.
Premium-priced options--Options     Because these option grants start
with an exercise price that's       underwater, they can lose their
higher than the grant price         incentivizing power.
Retention levels--Rules that        This is a compensation plan
require CEOs to hold certain        tweak at most and can't be
amounts of a company's stock for    expected to have a major impact
prescribed amounts of time          on performance.

Alternative Compensation            Companies with these plans

Performance-based restricted        GE, Kodak, International Paper
shares--Blocks of shares that vest
due to meeting performance goals
rather than length of service
Long-term bonuses--Bonus plans      FedEx, Lucent Technologies,
that pay out over several years     Nextel
Premium-priced options--Options     IBM
with an exercise price that's
higher than the grant price
Retention levels--Rules that        Procter & Gamble, Sun Trust
require CEOs to hold certain
amounts of a company's stock for
prescribed amounts of time