Complex nuances that need to be studied

BY Jayashantha Jayawardhana

Decisions concerning executive pay can have a telling impact on a business. When compensation is managed well, it aligns the behaviour of executives with the company’s strategy and generates better performance. If it’s managed poorly however, the effects can be devastating: the loss of talent, demotivation, misaligned objectives and dismal shareholder returns.

Considering the high stakes, it’s critical for boards and management teams to get it right.

Many boards, even those comprising seasoned business leaders, tend to buckle under the weight of this challenge. One problem they encounter is that only a handful of best practices work in all situations. So it’s important for companies to begin with clear strategies, and for their leaders to understand the basic elements of compensation and how to link it to desired outcomes.

In an article titled ‘Compensation Packages That Actually Drive Performance’ – published in the Harvard Business Review (HBR) – Boris Groysberg, Sarah Abbott, Michael Marino and Metin Aksoy describe how firms approach executive compensation, and how some have used it to improve performance.

Their research draws on FW Cook’s analysis of executive compensation in companies in the Russell 3000 Index – Harvard Business School’s extensive research on boards of directors including quantitative data from a survey of over 5,000 global board members – and also in-depth interviews they conducted with more than 100 directors of public and private companies in more than 12 countries.

Most corporations try to match what their peers are offering. But one director asserts that “obviously, there is some balancing. If you want your CEO to stay, you’ll probably err on the side of paying more. But in a public company, we can’t go wildly off the rails because there’s enough data out there.”

Another director comments: “You need to look at what other firms are doing with their incentive programmes because that will set the expectations of your people. And if your people are being poached, you need to know what they’re being approached with.”

Many others echo the belief that the market determines executive compensation levels.

However, directors also argue that there are complex nuances to setting compensation levels. They point to the challenges of finding suitable companies to use as benchmarks and ensuring that such selections aren’t manipulated to achieve a certain outcome.

On the issue of benchmarking, one director quips: “The problem is that everyone always wants to be just above the midpoint in this. And when everyone does that, then the midpoint keeps moving.”

In general, modern compensation systems can be analysed along four dimensions: fixed vs variable; short term vs long term; cash vs equity; and individual vs group.

The factors that drive choices encompass the company’s strategic objectives, ability to attract and retain talent, ownership structure, culture, corporate governance and cash flow.

In the case of variable vs fixed, the total compensation is made up of a base salary (set in advance and paid in cash), and long and short-term incentives that are contingent upon achieving certain performance goals.

Both incentives are variable or at risk elements. Awards can be based on an established formula or at the discretion of management or the board’s compensation committee.

Short term vs long term incentives may be paid in the year the goals are achieved or they can be deferred and paid over several years. According to the findings of this study, on average 28 percent of senior executives’ variable compensation is paid in the year it’s awarded (or immediately thereafter) and 72 percent is paid later.

Companies that seek rapid growth or change favour short-term rewards. Short-term variable compensation generally takes the form of cash while long-term compensation is usually delivered in equity through instruments such as stock options, and restricted stock and performance shares.

In the case of equity vs cash, stock options usually represent a larger share of compensation than cash. On average, 41 percent of senior executive compensation is paid in cash and 59 percent in equity. The mix is often determined by business maturity.

Young companies that are short on cash tend to bank heavily on equity to attract and retain top talent. Equity compensation encourages executives to think like owners. But equity and share options are typically at the mercy of stock markets.

And with regard to individual vs group, on average 29 percent of compensation is based on individual performance and 71 percent on the performance of a division of the business or the company as a whole.

A firm’s culture and values will have an impact on the amounts tied to the two types of performance.