The Art and Science of Measuring CEO Performance

In a further explanation of its thinking, the committee notes that, as part of its analysis, it looks at "how the financial goals were achieved, taking into account the quality of our earnings. The committee also considers objective data on the successful implementation of strategic initiatives that position us for future growth while also delivering positive total stockholder returns."

Tying compensation to performance can not only hold an executive's feet to the fire; it can also provide tax benefits to the corporation, according to Carter. Under an Internal Revenue Service rule designed to rein in executive pay, the maximum amount that a company can deduct annually for compensation is $1 million per executive. But any pay based on firm performance is excluded from this calculation.

"If you have elements of compensation tied to firm performance, you can deduct all of that as opposed to being limited to the $1 million," Carter says. "So sometimes you see companies saying that they have structured their pay to get maximum deductibility. But this requires that companies have objective ways of measuring performance against the targets they set, and they can't deviate from them over the course of the year. This exception to the rule is encouraging firms to base pay on performance and to not deviate from what they stated in the beginning as their performance measures."

Goals for Turnaround Specialists

Sometimes special situations call for special metrics. A troubled company, such as a money-losing auto manufacturer, for example, may not realistically be expected to increase earnings in a short time frame of a year or two. In such cases, the CEO's performance may be based on how well he or she stanches losses, halts a decline in market share or deals with labor unions. In worst-case scenarios, a board may hire a turnaround specialist to rescue the firm.

"Being a turnaround specialist means having a specific skill set; not everybody is equipped to do that," says Guay. "These individuals will want a big payoff if things work out well because they know there's a reasonable chance things won't work out well. They may have different structures for incentives. Maybe you're just trying to get the firm out of bankruptcy so it can once again be a publicly traded firm . So maybe you lever up the guy with stock for a long-term payoff, while also establishing some short-term goals for him, like achieving positive cash flow."

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