Executive Pay: It’s Not All About Performance
While not all pay is justifiable, executive compensation continues to be unnecessarily painted in a severely negative light. In the world of governance, it is a common topic which bands together the masses against the few, falsely highlighting inequity and greed. While several cases of this nature do exist, they are highly uncommon and are the exception, not the rule when it comes to executive compensation. There have been several examples in corporate America that cause us to shake our heads in disbelief.
- Warner Bro’s CEO David Zaslav who receives $246m in 2022 amid a 60% stock price decline.
- Viacom’s payout to former-CEO, Tom Freston of $78mm for his one year of service in 2006.
- Chesapeake’s discretionary bonus of $75mm to former-CEO, Aubrey McClendon in 2009 after he was forced to sell his 31.5 million shares to meet margin loan calls.
With regulation of executive compensation coming closer to a reality, there is an associated heightened sensitivity to overall compensation levels and the process by which these decisions are made. Setting compensation is no longer a check-the-box-process but a dynamic process compelling Committees, executives, and human resources professionals to justify pay packages and provide enhanced rationale for every decision.
So where is the line of reasonableness, and how is this ever-moving boundary line identified? In short, it is the valuation and measurement of a person’s internal and external value to the organization.
While performance at the individual and corporate level is certainly a consideration for determining the compensatory value of a person’s internal and external value to the organization, it is not the only factor. There are a number of strategic and tactical factors that can and should be considered to help create the right compensation package. The following is a robust list of non-performance factors for compensation decision makers to consider.
Pay for Market
The bellwether and ultimate foundations for determining pay for similar roles and responsibilities should be what other companies competing in similar markets pay. In fact, this scientific analysis is such a critical input to determining pay that WorldatWork (certifying body) has dedicated an entire certification course — Market Pricing: Conducting a Competitive Pay Analysis — to accredit compensation and benefits professionals on this topic. Inputs such as job description, roles and responsibilities, company industry, company size and geography are all key considerations in market pricing.
While the approach of “keeping up” and the associated self-inflicted ratcheting effect that can occur, the reality is if it doesn’t pay its people competitively with the market, somebody else will.
This has never proven more true than over the past two years with annualized national inflation averaging over 8%. In response, many companies increased salaries at unprecedented rates over this period, driven by an attempt to maintain employee buying power, and solidify retention. This had the effect of propelling salary increases nationwide by an average of 6% in 2022 and 6.5% in 2023, outpacing prior year averages by over 3%. Companies choosing to not make salary increases in kind saw significantly higher turnover rates than peers that averaged 5% or greater increases.
Pay for Retention
Highly competitive industries continue to face retention issues as the post-COVID era has yet to see a talent war deceleration. What many investor advocacy groups and governance experts fail to realize is there is a need for retention in certain industries and it is now simply a cost of doing business. To compete for highly sought after skills, pay for retention is a reality. This is accomplished through a variety of monetary and non-monetary methods, including retention grants of restricted stock, cash-based retention bonuses, benefit programs, and deferred compensation programs. Undoubtedly, there is a link between pay for retention and pay for performance, and both should be considered to design a proper compensation program.
Pay for Investment, Not Pay for Cost
An organization’s single most important asset is its employees. However, some companies don’t understand this is a key investment decision, not simply expense management. The result is usually uncertain until value is realized, as with any investment. This is generally accomplished through a compensation philosophy that offers employees an above market total rewards package. In the long-term, it’s better to invest in a strong compensation structure in the front end versus having dissatisfied employees and high turnover resulting in larger expenses to replace and re-train personnel.
Pay for the Past
In some cases, when justifying compensation for highly paid executives, experts are required to defend compensation decisions made by a company. Under Section 162, the Internal Revenue Code states that a taxpayer may deduct compensation if reasonable through nine specific considerations. Some of these include the employee’s qualifications and work experience, the size and complexity of the business, compensation of similar roles, and the amount paid to the incumbent in past years. The last factor under IRC 162 suggests a straightforward compensation strategy to compensate key employees for all their years of service. Specifically, this is helpful when an executive(s) has served and performed well for many years, yet compensation has failed to keep pace with performance. The referenced compensation for prior years’ service analysis offers a judicious and reasonable way to develop out-of-the-box compensation arrangements which are tied to value created over time.
Pay for Experience
Employee experience is the key driver in determining pay penetration within a position’s established range. The importance of this factor has been highlighted in recent years with the stronger focus on equitable pay arrangements. Positions should and most often do have pre-determined limits associated with roles and responsibilities; however, where a particular person falls within that range is most accurately driven by prior experience in that role or something similar. So, while fair pay is important and should not be ignored, it is improper to align all people in the same position due to differing level of experience.
Pay for Intangibles
As accurately stated by one of our clients, “A spreadsheet at the beginning of the year cannot determine performance better than I can at the end of the year.” Companies should be consistently refining their variable pay programs to ensure the proper balance of formulaic versus discretionary measurement is present given the specific circumstances they face. A program that is entirely formulaic may create alignment to actual performance but may not necessarily drive intended results. Having a discretionary component allows management teams and compensation committees to align individual performance with the intangibles a formula cannot capture. It remains a staple in annual incentive programs for companies of all sizes simply because it is widely accepted that purely formulaic programs cannot capture everything.
Not all pay is justifiable, but there are certainly more factors in the equation than the headlines would lead you to believe. Companies should rely on both internal and external factors in making compensation decisions throughout all levels of the organization. Bottom line: To find the best employees, you must first pay competitively…it’s the foundation of the attraction, motivation and retention continuum. You can’t motivate or retain someone you can’t hire.