The Handbook of Board Governance, 2nd Edition

39Measuring and Improving Pay for Performance: Board Oversight of Executive Pay

Stephen F. O'Byrne

President, Shareholder Value Advisors Inc.

Executive pay in public and private for-profit companies has three basic objectives: provide strong incentives to increase shareholder value, retain key talent, and limit the cost of executive pay to levels that will maximize the wealth of existing shareholders. The key responsibility of the board is to ensure that the company's executive pay program achieves the three basic objectives of executive pay.

In this chapter, I will argue that:

• The board cannot effectively discharge its responsibility without meaningful measures of incentive strength, that is, pay sensitivity to performance, and the pay premium at peer group average performance, what we call performance-adjusted cost.
• The measures commonly used for board oversight of executive pay—percent of pay at risk and competitive position—are very poor proxies for incentive strength and performance-adjusted cost.
• There is a simple, but very informative, analysis that provides measures of incentive strength and performance-adjusted cost that can be used for benchmarking and, more importantly, to understand the pay-plan design needed to achieve perfect pay for performance.

The chapter is organized in the following sections:

• The three basic objectives of executive pay.
• A brief history of executive pay.
• Why percent of pay at risk is not a meaningful measure of incentive strength.
• Measuring ...