Evolving Compensation Plans to Drive Organizational Performance

Scott Esposito
Posted: 08/29/2011

Compensation is a broad topic, and in recent years it has come under increasing scrutiny from shareholders, regulators and boards. Over the past 50 years, we have evolved far beyond the old adage "a fair day’s wages for a fair day’s work." An entire industry has evolved around designing, administering and evaluating compensation programs; after all, this is important stuff!

Along with the proliferation of expertise and oversight, we are faced with shifting economic conditions and changing attitudes by shareholders and employees over how revenue is generated, the expected rate of return and how much of it should be shared with those entrusted to run the company. While a great deal of attention has been focused on how much compensation is appropriate, there are also shifting trends in the mix of compensation programs and the type of goals linked to variable pay plans.

The economics of compensation

Let’s start with a refresher of basic microeconomics: the demand for goods and services creates a demand for production. Businesses enter the market to engage in production based on an expectation that they will earn a profit on the sale of goods and services. Profit is the return for their risk taking. These businesses apply labor, capital, management and entrepreneurship to produce goods and services to compete for consumer dollars. This simplistic economic model illustrates an important point: labor is a derived demand and the primary reason to establish a company is to make money not to provide employment. Having said that, the need to hire and retain the right type of talent, in the required numbers, is absolutely essential to sustain a profitable business. With this perspective, the next item to consider is, how do businesses attract people to join their companies? The answer lies in the value proposition offered by companies to prospective employees; a combination of direct remuneration (i.e.: salary, benefits), recognition, career growth, work environment and alignment with the company’s culture and values.

With respect to direct remuneration, the forces of labor supply and demand determine what level of pay must be offered to compete for available talent. As skill level and experience rise, so does the market rate that must be offered to compete within a limited talent pool. At the senior management and executive levels, the talent needs become highly specific and operationally critical. The people who occupy these key positions develop winning strategies, run efficient operations and make sound decisions that directly impact top line growth and bottom line profitability. Although fewer of them are required, the very best are scarce commodities, generating fierce competition and a high market price. Indeed, two published statistics on CEO pay published in 2010 (The Wall Street Journal study of median CEO compensation packages and the AFL-CIO analysis of average pay at 292 companies provided by salary.com) reported total pay levels (salary, cash bonus, stock options, and long-term incentives) at $9.2 million and $7.2 million, respectively.

Pay for performance

Of course, pay at any level must be considered relative to the performance generated; the ultimate test for any pay system is its effectiveness in proportionately sizing rewards to the results that were delivered. Pay for performance is not a new concept but it needs to evolve to meet changing business and economic conditions. Pay entitlement, or the expectation of unlimited increases, has deteriorated steadily since the higher inflation periods of the 1970s and 1980s. In general, base pay has become a less effective compensation tool to reward good performance. To be sure, over the past decade we have experienced 3% salary budgets and shrinking promotional pools; in recent years, salary freezes, furloughs and outright pay cuts have further deemphasized the base pay element of total compensation. In the future, greater demands will be placed on salary budgets to make market adjustments, address pay inequities and enhance critical skill pay levels. In short, unless a high degree of differentiation is practiced, there’s just not enough of it to go around.

Variable pay, in its many forms including commissions, performance incentives / bonuses, profit sharing and gain sharing, is designed to reduce fixed cost and ensure incremental rewards can be objectively tied to incremental performance. Variable pay does something else, it serves as a powerful tool to communicate what metrics are important to the success of the company and the rewards available when good performance is demonstrated. This concept plays favorably with management and shareholders alike in that variable pay, by its strictest definition, does not represent an additional cost to the company but rather a self-funded payment generated by results. With a limited ability to reward good performance through base pay increases, broader use of variable pay based on individual performance will undoubtedly grow in popularity.

The Changing Landscape

Stricter oversight and regulatory requirements will continue to shape and influence how companies compensate their executives and the level of disclosure provided to shareholders. The Troubled Asset Relief Program (TARP) is a recent and highly visibility example of the federal government’s direct involvement in co-managing the operations of participating companies and restricting the amount of compensation that may be awarded until bailout funds are repaid. Other recent financial regulatory reforms include the "Say-on-Pay" which entitles shareholders to an advisory vote on executive compensation, further illustrating the concern and distrust the public has over the level of executive compensation and how it is determined. Other supporting reforms such as tightening the standards for serving on a board compensation committees and changes to proxy disclosures surrounding equity compensation will set higher standards for crafting executive compensation programs. There is also a growing movement to institute universally accepted principles and practices. Two organizations, the Independent Directors Executive Compensation Project and the Center for Executive Compensation have worked on practices that boards may voluntarily adopt to further improve and strengthen governance over executive pay.

Finally, our society has shifted its value system over time to focus more on how companies go about their business and what they do to positively impact the global community. Strategic corporate goals that define success in terms of diversity and inclusion, environmental preservation, green technologies, community welfare and employee development will continue to gain greater visibility and traction with current and prospective shareholders.

Achieving Balance

Given this combination of economic conditions and changing social values, how do companies attract and retain the best talent? The answer is twofold. First, compensation is but one element of a company’s value proposition, and to a large degree, it’s easily matched by competitors. Both Maslow and Herzberg taught us that pay, characterized as a basic need or hygiene factor, does not ultimately provide job satisfaction. Employee engagement, on the other hand, considers all aspects of work life and how well aligned employees are with the company’s mission. Progressive companies should measure and evaluate what factors drive high levels of employee engagement and develop plans to make their organizations great places to work. From a company perspective, understanding what drives employee motivation and elicits discretionary efforts provides a powerful basis for retention. From the employee’s perspective, inclusive cultures, flexible work arrangements, continued learning, ethical conduct and socially responsible operations will continue to gain a higher standing on the employer of choice checklist.

Second, while the amount of money allocated to compensation pools must to be directly tied to hard financial measures such as revenue growth, EBIT, cash flow and EPS, how those pools are distributed could be better balanced across financial and non-financial measures. Shareholders want to ensure that compensation paid to officers, managers and employees fairly reflect the wealth and value they create. However, beyond the top tier, the ability to directly drive hard results becomes less clear. Therefore, at lower levels in the organization, using variable pay plans and goal-based incentives to drive performance in non-financial goals such as diversity, talent development, employee engagement and continuous improvement results in a balanced score card that better aligns individual and organization performance.

Final Thoughts

Compensation is a powerful tool, but it must evolve over time to meet changing economic conditions, social values and employee expectations. A set of questions is provided below to help guide the evaluation of compensation programs:

  • Have you developed and communicated a total compensation strategy and is it understood by all the stakeholders?
  • Are compensation plans reviewed at regular intervals to determine if they are relevant, cost-effective and competitive?
  • Are appropriate mechanisms in place to measure pay levels relative to market and are adjustments made to cash compensation to stay within defined ranges?
  • Do base pay programs reward top performers and provide for internal equity and market adjustments?
  • Have variable pay plans followed good design practices: performance thresholds, pool share ratios, payment caps and sunset provisions?
  • Do incentives and other bonus plans fairly balance the achievement of financial and non-financial goals?
  • Do employees have a line of sight between job responsibilities and defined performance goals?
  • Do you have processes in place to measure employee engagement and where does pay, rewards and recognition fit in to the equation?
Scott Esposito
Posted: 08/29/2011

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