10 Steps to Simplify Executive Compensation Design and Administration
The following observations are intended to serve as the basis for the design and administration of compensation arrangements for senior management in most businesses. They are in no particular order in terms of importance, but taken as a whole they represent key points of view on how pay should be structured and delivered in any well-run organization. The Rule of Thumb that follows each comment is based on many years of experience as an outside compensation adviser.
- Simplicity and comprehension – the entire package of pay, benefits, employment contracts, change in control benefits and the like should be kept as simple as possible. While there are numerous regulations and practices that are important (tax, accounting, SEC, equity valuation), there should be no part of executive compensation that cannot be clearly explained to any employee in the company, ideally on one sheet of paper.
Rule of Thumb 1: if it takes more than 15 minutes or one page of paper to explain the pay program of any executive, it is too complex and needs to be simplified. - Be reasonable and responsible – the final observation is all too obvious but often ignored. Compensation for executives should be viewed as reasonable, supportable and logical, given all the usual factors such as performance of the company and its executives, the state of the industry, the state of the economy, and anything else that may cause critics to question how pay was determined. Perks with high value or high visibility should be minimized or eliminated entirely for executives; benefits that are reserved only for a selected few should be dropped.
Rule of Thumb 2: if it smells bad, it is likely rotten and should be discarded. If a plan generates any level of discomfort at the board level or is likely to do so among other professional staff, it needs to be redone. - Market pay levels and peer groups – market compensation for executive talent is generally developed through several means: compensation surveys, proxy statements of peers and other sources of talent, and the history of each company engaged in hiring, selection and promotion of management.
Use survey data as a guideline for determining pay levels and practices, not as a statistically perfect blueprint.
Proxy statements should be used for details on pay plans as well as the history of the top five executives. As noted above, data from the proxy should not be used as the sole determinant of pay levels or plan design; it is simply another source.
Existing and historical internal pay levels and practices typically have more impact on future pay than any of the items noted earlier. For this reason, any significant departure from historical trends should be fully justified and explained.
Rule of Thumb 3: always be skeptical of market pay levels, no matter the source. Pay should be managed in a range of at least +/- 10% to 20% of indicated market. - Internal equity – the distribution of total compensation among the senior executives in any company says a lot about how the company is run, how it is viewed by other staff and by the general business community. This is true for companies that publish a proxy as well as privately-held businesses where pay is informally (but usually correctly) communicated. While it would be rare to find a CEO paid substantially less than his or her direct reports, such a model would clearly signal a certain approach, as would a spread of compensation substantially more or less compressed when compared to the market. All pay decisions should be made in the context of internal equity and external competitiveness.
Rule of Thumb 4: keep the spread in total pay among the top handful of executives to a minimum, and pay close attention to ongoing pay equity for all officers. - Performance of company and executive – pay for performance is certainly essential, and be sure to measure the performance of both the company overall as well as each executive, including the CEO. Maintain a reasonable degree of discretion in determination of variable pay to fully reflect individual performance, industry trends, windfall gains or losses and similar items that may be just as important as the outcome of a formula or payout matrix.
Rule of Thumb 5: funding for incentives may be formula-based but actual payouts should include the best judgment of the Board, the Compensation Committee and the chairman, as well as the operation of any distribution model. An external focus is essential when it comes to the final determination of incentives of any kind. - Predictability and control – the outcome of a well-designed pay package should have a high degree of predictability in terms of total value. While incentives cannot be precisely controlled, there should be no actual awards that fall well outside a range of expected outcomes. This is a critical flaw of many incentive designs and can lead to payouts (either cash or stock values) that are embarrassing to the company.
Rule of Thumb 6: design pay plans that contain adequate safeguards so that compensation at any point in time can be estimated with a high degree of accuracy. This ability should include potential payments from benefits, deferred pay plans, change in control awards and any other significant amounts. - Pay is only one part of the deal – and should be a relatively small one except for the Compensation Committee and the internal HR function. Clearly, running the company is the primary function of the management team and that would include all of the typical functional areas in any complex organization. Pay is always a hot topic and can create huge issues internally, but it should never dominate the primary goal of the business. If pay practices and levels are causing angst among more than a handful of staff, the pay plans likely need to be trashed and redone.
Rule of Thumb 7: where the typical CEO might work 3,000 hours each year, with perhaps 10% of this time devoted to HR-related initiatives (hiring, development, succession, compensation, benefits, communications), no more than 30 to 40 hours per year should be consumed by executive compensation discussions and decisions. - Disclosure –when a company is public, disclosure is mandated in terms of details, amounts, contingencies and the like, but only for a few executives. In an open environment, the company should be willing to fully disclose all variable pay plans, all benefit plans, equity awards, executive perks and anything else of value, with both fairness and accuracy.
Rule of Thumb 8: the more the better in terms of disclosure. Be sure that pay plans are not going to cause embarrassment when described in the Sunday business section. - The compensation committee – this committee should review and approve pay proposals initiated by the company and take an active role in developing and promoting a philosophy that is compatible with other goals and objectives of the organization. The committee should push for simplicity, internal equity, ease in communications and guarantee a direct link to measureable outcomes. It should resist its own designs and rely on professional internal staff and outside advisers to facilitate design and delivery.
Rule of Thumb 9: committee members should ask dozens of questions if necessary so that they fully understand all aspects of company or consultant reports. But keep In mind that the technical issues (statistics, valuation, tax, accounting, SEC) are secondary to the design and execution of the compensation strategy. - Be aware of conflicts with attorneys, consultants, and other outside advisors – all parties at the compensation table should disclose upfront any conflicts, affiliations or history that might interfere with the decision process, much as board members must disclose relationships in the proxy.
Rule of Thumb 10: in addition to being qualified and experienced, all company and committee advisers must disclose all relationships upfront and resign if necessary based on these relationships – no exceptions.