Decisions about executive pay can have an indelible impact on a company. When compensation is managed carefully, it aligns people’s behavior with the company’s strategy and generates better performance. When it’s managed poorly, the effects can be devastating: the loss of key talent, demotivation, misaligned objectives, and poor shareholder returns. Given the high stakes, it’s critical for boards and management teams to get compensation right.
Many struggle with this challenge. One problem is that only a few best practices work in all situations. So it’s imperative for companies to start with clear strategies and for their leaders to understand the basic elements of compensation and ways to link it to desired outcomes.
In this blog, we’ll describe how firms approach executive compensation and how some have used it to improve performance, sharing insights from our research and experiences. Two of us (Boris and Sarah) have studied compensation for over a decade. The other two (Mike and Metin) have more than 30 years of combined experience advising a broad range of companies on executive compensation.
How Boards Approach Executive Compensation
When making decisions about compensation, many directors look at the large amount of data available on executive pay. U.S. regulations require every publicly traded company to disclose the amount and type of compensation given to its CEO and CFO and other highly paid executives, as well as the criteria used in setting it.
Most companies try to keep up with what their peers are offering, but as one director told us, “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 commented, “You need to look at what other firms are doing with their incentive programs 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 echoed the belief that the market determines executive compensation levels.
However, directors also argued that there are complex nuances to setting compensation. They pointed to challenges in finding suitable companies to use as benchmarks and in ensuring that that selection isn’t manipulated to achieve a certain outcome. The obstacles are even greater for smaller private companies, for which data is less available. Some directors also felt that benchmarking had created a “race to the top.” One commented, “The problem is that everyone always says, ‘We want to be just above the midpoint in this.’ And when everyone does that, then the midpoint keeps moving, right?” Other board members explained that deviations from benchmarks are often necessary to align executives with unique corporate strategies and organizational cultures.
The Four Dimensions of Compensation Design
Modern compensation systems can generally be analyzed along four dimensions: fixed versus variable, short-term versus long-term, cash versus equity, and individual versus group. The factors that drive choices include the firm’s strategic objectives, ability to attract and retain talent, ownership structure, culture, corporate governance, and cash flow. Within the Russell 3000 Index, companies focus on aligning pay and company performance—something stakeholders expect. But particularly outside the United States, companies may have to take into account other factors, such as seniority.
Fixed Versus Variable
Total direct compensation is made up of a base salary (set in advance and paid in cash) and short-term and long-term incentives. Both kinds of incentives are variable or at-risk elements and may be contingent on the achievement of certain organizational or individual goals. Awards can be based on an established formula or at the discretion of management or the board’s compensation committee. Our analysis of the compensation of the five highest-paid executives at Russell 3000 companies shows that on average 82% of their compensation is variable; the rest is base salary.
Short Versus Long Term
A second dimension is an extent to which variable compensation is paid out in the year it is awarded or deferred and paid over some future period. This applies to awards where the amount (a specified cash payment or a fixed number of shares) is established up front and where it’s based on meeting specified future hurdles. Short-term variable compensation generally takes the form of cash; long-term generally is delivered in equity, through instruments such as stock options, restricted stock, and performance shares.
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Cash Versus Equity
Our analysis showed that on average 41% of senior executive compensation is paid in cash, and 59% in equity. The mix is often determined by business maturity. Young companies tend to rely a lot on equity to attract and retain key employees if cash is scarce. The percentage of equity compensation is notably higher for large-cap companies (63%) than for small-cap companies (48%), however. Technology, telecom, health care, and energy companies put the largest percentage of pay in the form of equity.
Individual Versus Group
On average 29% of comp is based on individual performance and 71% on the performance of the organization (such as a division) or company. A firm’s culture and values will have an impact on the amounts tied to the two kinds of performance. “I” companies—in which there’s a high degree of personal accountability and individuals have the ability to influence results—tend to link more compensation to individual accomplishments. Such companies tend to be human-capital-centric and highly competitive—think of consulting, law, investment banking, and asset management firms, where partners are often valued for bringing in business.