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Encana, TransAlta compensation plans need to be tweaked Add to ...

The days of massive pay packages that bear no relation to a company's success are fading, we are told. Any company that brings its executive compensation program to its shareholders in the spring without some sort of pay-for-performance plan risks rebuke for anachronistic, shareholder-unfriendly policies.

There are, however, approaches to compensation that are robust and provide rewards for exceptional performance - and then there are pay plans that could stand a tweak or two.

To get an idea of the latter, let's look at the pay at a couple of Alberta companies preparing for their shareholder gatherings later this month. At electric utility TransAlta , the company received a clear warning from its shareholders last year that its performance-share plan was not rigorous enough. But the company has returned in 2011 with the same weaknesses.

And natural gas explorer Encana has introduced new stock awards for its executives tied to its operational abilities. In doing so, however, it's removed the performance-based criteria from its option awards.

First, TransAlta. To its credit, while its shareholder-approved compensation plans allow it to issue stock options, the company hasn't given out any to its executives in years. TransAlta's board has a "long-held view," according to the company's proxy, that "time-vested stock option plans are not as effective a shareholder alignment mechanism as a performance-based equity plan."

Indeed. One of the primary criticisms of options is that a rising tide lifts all boats. When the broad market surges, stock options can provide millions of dollars to top executives even if the company failed to outperform its peers.

The TransAlta plan seeks to solve that by relying on grants of shares in the Performance Share Ownership Plan, or PSOP. The awards are directly correlated, the company says, to how TransAlta stock performs versus a peer group.

26th Percentile? Good Enough

The correlation may not be as beneficial to shareholders as you think, however. Executives get their target number of PSOP shares when TransAlta places at the 50th percentile of its peer group in total shareholder return (TSR) - smack dab in the middle. Hitting the 75th percentile - true outperformance - yields double the target.

And, most troublingly, PSOP awards still occur when TransAlta winds up between the 25th and 50th percentile in TSR. The company's shares must fall in the bottom quarter of its peers before the executives truly get punished with a zero return.

"I think you'll find - and we have certainly been advised," says TransAlta spokesman Bob Klager, that vesting when TSR is under the 50th percentile "is somewhat standard and a design very common in the marketplace."

Yet I'm not the only one taking shots at this plan. When TransAlta went before shareholders last year to make amendments to the plan, nearly 46 per cent of the votes were cast against the proposal. "These performance requirements allow bonuses to be awarded for mediocre and even poor performance," said the Shareholder Association for Research and Education, which included TransAlta in a roundup of significant governance-related votes last year.

At Encana, the problem is more subtle, but still troubling.

Heading into last year, Encana had a stock-compensation plan that deflected the common criticism of options. Just one-third of its annual option awards vested based simply on an executive's continued service, while two-thirds vested only if Encana met its targets for "recycle ratio." (This unusual-sounding metric is based on the company's ability to sell valuable energy products at an efficient cost of exploration and production.)

For most of the awards to have value, Encana had to make its operational goals and the share price had to rise to make the options useful. It's a tough, shareholder-friendly combination for an equity award.

It is also a philosophy Encana has now abandoned. The company introduced a new Performance Share Unit Plan in 2010. Under the plan, the awards of shares - not options - vest in chunks over three years based on the company making its recycle ratio targets.

At the same time, Encana has retained its stock option program, but now allows the entire grant to vest based on time, so executives can benefit from rising share prices, regardless of the company's operational performance. And with the new Performance Share Unit Plan, they can also benefit even if the share price declines. The company has taken one high hurdle and turned it into two lower hurdles.

Both TransAlta and Encana have a nonbinding "say on pay" vote at their shareholders meetings in this latter half of this month. Based on last year's unhappiness, there's an excellent chance TransAlta will get significant negative feedback. Encana's compensation issue is less obvious, so the company may get a higher level of approval. A look at the fine print, however, suggests the company's shareholders should send a similar message.

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