Aligning Executive Pay With Corporate Strategy

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The Context

The global socio-economic and political climate has been undergoing tremendous changes. Organisations are trying their best to adjust strategies while leveraging opportunities and mitigating risks. Those who are at the helm, and are driving business strategies to success or failure are the CEOs, executive directors and key management personnel. Their selection, remuneration and job conditions have naturally come into focus. Most importantly, it has become increasingly critical to ensure that the public and elected officials can readily grasp the reasonableness of executive compensation plans—especially in public corporations. Over the past decade, executive compensation plans have therefore, come under significant regulatory and political attack.Regulators have also tried to build guidelines to manage executive pay to protect shareholder interest and pay-equity transparency.

“Based on research, it has been found that the total pay has increased for Global CEOs by over 70 per cent average, in the last three years and close to 50 per cent for executive directors. Although there is a positive relationship between increase in the executives’ pay and increase in revenue, the growth isn’t proportional”

Also, it varies across sectors. The pay for CEOs and executive directors in the private sector has far outstripped that of public sector and affiliated executives. A related issue is the sense of equity on how pay varies between and across levels in big organisations.

From an overall context, the issues are scarcity of talent at the C-Suite level and the risk of wrong selection at this level. There is a need for talent who can manage and consistently deliver shareholder value. Seemingly lavish executive compensation havegarnered high-voltage attention in print, TV and Internet media. The public very often, has not been able to understand that executive compensation is a matter of meeting, and beating, global competition to attract the best and brightest executive talent. 

At the same time, executive compensation plans have abused both public funds and the interests of private shareholders. Directors of corporations, C-suite executives, division managers and HR professionals have been struggling with how to design the right type of executive compensation plans to meet corporate goals, and still appear reasonable to a public that does not understand the complexities and market challenges of the assignment.

The Approach Today

Volatile performance, corporate governance issues, scarcity of top management talent, complex environments, have underlined the need for a robust compensation strategy for executives. Furthermore, given the legal, social and political environment as explained above, a straightforward and well-balanced assessment of key design issues has become critical for HR professionals to draw up the right kind of Executive compensation plans. A sound executive compensation program depends on good governance and well-established compensation philosophies, policies and practices that are closely aligned with the organization’s overall goals and objectives.

Expanding the executive compensation package beyond a base salary and an annual cash incentive plan involves a number of accounting, tax, regulatory, cost and documentation issues. When considering the range of alternatives, employers are now engaging the advice and counsel of knowledgeable legal, technical and consulting professionals to conclude the same.

Importance of Metrics

As with any effort to improve organizational performance, metrics are keys. Organizations today spend a lot of time on executive compensation plans, in which they make sure they are getting their money’s worth. In an effort to improve the quality of their compensation decisions, Corporates today have tested relatively basic compensation scorecards. The reasons to do so were to improve transparency, and make managers feel more responsible for how they spent the company’s money.There are three steps to creating a compensation scorecard: confirm the organization’s compensation strategy, review the key elements within the compensation strategy, and decide what measures to use.The metrics thereby chosen, establish a baseline of where the organization is before the changes are applied, and further measure the results with the same methodology at the end of a specific time period.

Plan Design

Designing an effective executive compensation plan requires organizations to balance shareholder alignment, performance-based pay, recruitment and retention, and the assessment of cost versus perceived value. A long-term compensation plan with performance-based incentive vehicles can help achieve that balance.

Executives are privy to a wide range of compensation arrangements. Executive compensation arrangements may include several employees, or they may consist of individual agreements between the organization and one executive. Executive pay arrangements typically consist of six distinct compensation components: salary, annual incentives, long-term incentives, benefits, perquisites and severance/change-in-control agreements.

The following are some of the latest trends in executive compensation:

  • A higher percentage of executive pay is now linked to performance, based on measures such as income, profit and cash flow.
  • Pay incentives are more focused on long-term results. Year 2013 marked the first time, when long-term incentives became the single heaviest component in CEO pay packages, according to Hay Group. Long-term incentives like stock options now make up about 61% of total direct compensation.
  • Companies have cut back on perquisites for executives, especially the types most likely to raise shareholder ire—such as cushy severance packages, tax gross-ups on golden parachutes, spousal travel, cars and security. Personal jets remain the most popular perk, though, and haven’t lost ground, Hay Group says.

When determining the appropriate compensation strategy, employers necessarily need to consider the following organizational factors:

  • Business philosophy, mission and vision.
  • Business plan or strategy.
  • Life cycle, organizational structure and business processes.
  • Workforce composition and demographics.
  • Tax and accounting regulations.
  • Industry and competition.

An organization’s business philosophy encompasses its basic values and beliefs and defines the environment in which a total compensation strategy is to be administered. Mission and vision statements normally set the employer’s culture and philosophy as well as its total compensation strategy. Similarly, the organization’s business plan outlines the executives’ key performance measures and total compensation plan.

Country Implications

In India, the Companies Act 2013 laid down some important guidelines for the appointment and remuneration of key managerial personnel. It linked whole-time directors’ pay with company operations, profit and size. It also talked about various disclosures a listed company had to provide on directors’ remuneration. Sebi subsequently has also issued guidelines around executive pay focusing on equity-based compensation. Mandatory disclosures call for more transparency.

Different countries are either thinking of or enacting laws to encourage disclosures of not only quantum but also pay devices, the rationale for pay decisions and pay ratios. In developed countries, regulations have brought the focus on transparency through corporate disclosures. In India, there were historically no mandatory requirements on pay ratios but companies have started providing these disclosures in their annual reports in line with Section 197 (12) recently inserted in the Companies Act.

Conclusion

Well-designed performance incentives including equity compensation can improve manager/shareholder alignment. Organisations are focusing on ‘pay for performance’ and equity compensation, ensuring executive and shareholder gains are aligned.

We are seeing a trend in companies working to personalise broad employee compensation plans by function, level, geography and increasingly individual. They are working to improve the communication and understanding of those plans — senior executives being included in those – which would be critical for the overall success of robust alignments, all across.

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