Author: James Reda
Companies long have used well-thought-out compensation philosophies as part of their talent management programs. In today's global workforce, a compensation philosophy must be competitive across borders to attract and retain top talent.
Employers of choice need key leaders who will drive not only profitability, but who also will engage the organization's workforce. A less than compelling and market-competitive compensation philosophy may negatively affect a company's ability to attract, retain, motivate and develop key talent.
A global and fluid talent pool
Today, key talent is moving between public and private organizations without regard to size. Remote work has shattered geographical barriers, enabling businesses to tap into top talent from virtually anywhere in the world. Some key executive positions can move fluidly between industries, adding another layer to the raging competition for talent.
Companies in different industries and at varying stages of development may use differing compensation philosophies. Further, companies that operate in multiple countries must ensure fairness among leaders based in different geographies, but who work in similar roles with a similar level of experience. Organizations also need to ensure compliance across all geographies.
As a result, companies must understand the compensation philosophy "norm" among both direct competitors and the general industry to ensure that their plans and programs are competitive. Boards of directors should consider five key factors when developing an effective compensation philosophy:
- "Cultural fit" of the organization and key talent. Address prevailing attitudes, opinions and levels of commitment, as well as emerging geosocial-political practices such as environment, social and governance (ESG), diversity, equity and inclusion (DEI), and pay equity.
- Internal vs. external pay equity. How much weight should the company place on the internal relationships among positions vs. the external market? How should the company evaluate and compare related positions in different countries?
- Peer group comparisons. With which organizations should the company compare itself for salary as well as short- and long-term incentives?
- Pay positioning strategy. How should the company pay employees in relation to market levels (e.g., at the market median or an alternative percentile)?
- Performance alignment with the business plan. Specifically, how is the business plan aligned with the compensation system?
Ensuring cultural fit
Progressive employers are reassessing their reward and benefit offerings through the lens of ESG and DEI, ensuring their programs are equitable and inclusive of the diverse needs of all employees. Many organizations compensate employees serving similar job functions with comparably equal pay, regardless of gender, race, ethnicity, location or other status.
Ensuring that your approach is aligned with company goals, values and key business objectives will enhance the overall effectiveness of your total rewards offering. Supporting your benefits strategy with effective communications will further increase employee engagement.
Considering internal vs. external pay equity
At some companies, employees care more about how their pay stacks up against that of others within the organization. At other companies, however, people may care more about how pay compares with that of other organizations. In general, a company shouldn't rely primarily on peer group comparisons in setting pay.
In a trending approach, many organizations design pay programs for multinational executives using a group of "global executives." These executives typically report to a named executive officer and implement key strategic business initiatives while supervising a multinational workforce.
This compensation package design places pay and incentives within a single band. Base salary isn't tied to global locale, but instead to "global executive" peers. Annual incentive metrics align with the central goals of the company but maintain regional influence. Long-term incentives also align with headquartered company goals determined or influenced by the board of directors.
These global executives play key a role in company earnings and future growth. The company will expect them to relocate several times during their careers and lead regional operations across the globe before returning to headquarters. As companies seek growth and supply chains across continents, we expect this band of single-tier executives to expand.
Constructing peer groups
Of the five components that make up a compensation philosophy, establishing the compensation peer group can be the most difficult. Organizations use peer groups first to set the base salary, annual bonus, long-term incentive and other compensation and benefits such as health and welfare plans. Second, companies may measure financial success against the peer group to measure financial success compared.
To determine competitive compensation levels, carefully select a compensation peer group of at least 15 but no more than 20 companies. Selection considerations in order of importance include those companies that:
- Compete directly in the marketplace for your product.
- Earn comparable revenues in the same industry. Select companies that may not compete directly but pursue similar profit and growth opportunities.
- Enjoy stellar corporate performance or shareholder return. Some analysts consider including such companies in a compensation peer group as controversial because executives are less likely to jump industries.
- Your company gained executives from or lost executives to in the past 18 months.
- Operate in the same business sector.
- Operate in the same business location.
Among the considerations for a performance peer group, industry selection is the most important criteria. Expect your performance peer group to include more companies than your compensation peer group.
Compensation and performance peer group development may represent a particular challenge for companies with:
- Multinational operations and leaders
- Competitors based outside the US and/or that are privately held
- A unique mix of industry segments
- Revenue or assets significantly below or above industry competitors
Selecting appropriate peer groups is key to a compensation philosophy. In some cases, compensation committees will select a specific peer group for their chief executive officer and a different peer group for less senior employees. As rationale, companies will conduct national or sometimes internation searches for senior executives, while the focus shifts to regional or local for lower-level leadership positions. At Gallagher, we recommend you review both peer groups annually to ensure continued relevance.
Developing a pay positioning strategy
If your company plans aggressive corporate goals, target compensation levels accordingly. As with other parts of the compensation philosophy, set the pay positioning strategy at the beginning of the year to include:
Percentile ranking of pay components vs. market. Set levels for each of the following: Salary, bonus, long-term incentives, pension, health and wellness benefits, perquisites and severance practices. Most companies target the median (50th percentile) for setting total compensation, with variations for each element.
Pay mix: This mix consists of salary, short-term incentive (STI) compensation and long-term incentive (LTI) compensation. Consider the following factors:
- Mix of salary, STI and LTI
- The STI/LTI ratio
- Performance measure comparisons between STI and LTI
- The LTI mix:
- Restricted stock
- Stock options
- Performance shares
Pay for performance curve. This piece consists of threshold, target and maximum payout. The threshold varies by relative or absolute, the target pays out at 100%, with the maximum for 75th percentile performance.
Use percentile ranking in comparison to the market to communicate your compensation philosophy and to translate the board's intention into practice. Compare base salary to the market on a percentile basis. For example, 50% of the peer group salaries come in above the salary of interest, while 50% of the salaries fall below.
Your pay strategy should increase the company's profitability. You don't want to under-compensate employees and cause them to leave. Similarly, you don't want to overcompensate and create corporate waste. Seek a balance between turnover rate and competitive market positioning.
To avoid increased fixed costs, recognize extraordinary accomplishments or contributions through annual incentive payouts, rather than through salary increases. Exceptions make sense for those whose salary falls below targeted levels.
The LTI mix will significantly influence LTI payout depending on corporate performance. As an illustration, see below four possible LTI mixes in relation to various levels of corporate performance. These four LTI mixes include:
- Mix 1 — 100% stock options
- Mix 2 — 100% restricted stock
- Mix 3 — 100% performance shares
- Mix 4 — 50% performance shares, 20% restricted stock and 30% stock options (this represents a "typical" large company LTI mix)
In our example below, Mix 1 fares well with superior corporate performance, but does poorly elsewhere. Most large companies use a blended/balanced approach of mixing stock options, restricted stock and performance shares (Mix 4). With this approach, the payout curve is flatter, but able to provide retention payouts even with poor corporate performance.
Performance Payouts under Various LTI Mix Scenarios |
||||
|
Performance |
Mix 1 |
Mix 2 |
Mix 3 |
Mix 4 |
|
Poor |
$0 |
$80,000 |
$0 |
$16,000 |
|
Below |
$0 |
$100,000 |
$50,000 |
$45,000 |
|
Target |
$60,000 |
$120,000 |
$120,000 |
$102,000 |
|
Superior |
$300,000 |
$200,000 |
$300,000 |
$280,000 |
|
Example based on beginning stock price of $10.00 and LTI performance award value of $100,000 |
||||
We recommend aligning pay and performance by reviewing industry data for one, three and five years in comparison with company performance and short- and long-term corporate outlook. Companies should calibrate the pay-for-performance curve so that median performance results in median payout, and great performance (75th percentile of industry performance) earns 75th percentile payout levels.
Align compensation with the business plan
Compensation alone won't ensure business plan success, but customized, strategic alignment of pay programs increases the probability. Equipped with the right information, compensation decision makers can create a compensation philosophy to stimulate a more engaged workforce and lead to a higher-performing organization.
As a result of the regulatory and media spotlight on executive compensation, many companies are tightening alignment of incentive compensation programs with business strategies to support payouts that match performance.
Outside advisors, lawyers and consultants play a substantial role in setting and describing performance measures and goals. Publicly traded companies must consider four major issues relating to performance measures:
- Use of short- and long-term performance measures that shareholders have approved (contained in incentive and equity plans)
- Clawback of incentive payouts if financial statements have been restated, causing failure to meet performance goals
- Adequate disclosure of performance goals (measures and levels) in the proxy filing
- Review of risk associated with performance plans and appropriate proxy disclosure.
These considerations alone can be overwhelming; however, the piercing public scrutiny of executive pay decisions and practices further complicates the overall process of setting executive pay.
Adapting to the global market
To compete in today's competitive and mobile market for top talent, companies must adapt their compensation philosophies to the increasingly global market, to include ESG, DEI and pay equity.
An effective compensation philosophy can enhance not only recruitment and retention, but also can motivate employees toward business objectives. Use the above five-point compensation philosophy as the underlying framework to determine compensation levels and program design.
Executive compensation philosophy begins with a thesis as stated in a compensation program objective, supported by peer group comparisons, pay positioning strategy and alignment with the business plan.
Gallagher can help you navigate your individual executive pay and organizational values amid tough public scrutiny.
