Rising Compensation Challenges and How to Mitigate Them
Inflation, threats of recession, and high employee turnover are just a few of the issues Boards and management teams must contend with in 2023. These challenges are coupled with increased regulations, continued shareholder institution noise, and the SEC continuing to impose greater requirements on executive compensation disclosure. Needless to say, more companies are finding themselves between a rock and a hard place, and the efforts companies are making to stay ahead of the issues and limit any negative exposure carry with them additional time and expense. While public companies continue to undergo the most scrutiny in today’s executive compensation environment, companies across all markets – public, private, and not-for-profit – need to understand market best practices and processes that will set them up for success in this increasingly demanding environment.
One of the most expensive events a company can experience is litigation, costing companies in cash, time, and depending on the case, exposure and branding. In an age and marketplace where lawsuits have become the norm, not the exception, it is necessary for companies to be proactive in reviewing and addressing compensation-related issues to avoid the litigation process. High-profile lawsuits regarding Say-on-Pay, breach of fiduciary responsibility, compensation-related disclosures, and variable pay incentive plan designs perceived to motivate excessive risk taking have cost public companies millions of dollars in damage.
Additionally, public, private and not-for-profit sectors must remain focused on the issue of gender-based wage disparity, as pressures from both a strengthening whistleblower environment and new state and federal government legislation push companies to absolve compensation malpractices. The enforcement of fair pay compliance will continue to remain a focus of the media and state regulators (Lilly Ledbetter Fair Pay Act of 2009) but is also a top priority for the DOL’s Office of Federal Contract Compliance Programs (OFCCP). Plans include federal and state level agency-driven investigations of employer pay practices and future legislation dictating practices of smaller companies currently outside of the qualifications of federal mandates. Regardless of the potential threats companies face or the current markets they fall under, it is in a company’s best interest to proactively address any issues with compensation to mitigate the challenges a lawsuit could potentially produce.
The new regulations related to Pay-for-Performance disclosures at public companies are another potential risk point. The intention of this ruling is to provide shareholders greater transparency around the correlation of actual pay received or to be received in relation to performance achievement. While this will likely be a better disclosure than the Summary Compensation Table in terms of showing pay reality, it also potentially exposes companies to greater risk if the correlation is weak or non-existent. As such, it will be of significant importance for companies to assess this disclosure carefully and be prepared to craft narrative around this new disclosure.
Lack of Retention
Employee retention has remained a key issue for companies across all sectors over the past three years. Aside from the obvious COVID-related employment issues, we experienced the Great Resignation and Quiet Quitting, both of which put companies in dire straits which they have not fully recovered from. Further, advancements in technology, the expanding flow of information, and a growing talent gap in skilled labor positions have all played a part in the hypercompetitive labor market public, private and not-for-profit companies face today. Companies are facing a number of challenges in this environment, from managing the cost of attracting/replacing top talent to help deliver value to the shareholders, to retaining and motivating key executives with efficient and easy-to-understand incentive structures.
While long-term incentives remain the primary vehicle for mitigating retention risks, their power has been diminished in the current environment due to concerns of a pending recession. Employees still value equity and other long-term incentives, but companies have been required to utilize other methods, in combination with equity, to achieve the desired results. As such, there has been an increase in the use of cash-based retention awards, which depending on the position, range from one year to three years.
The more important trend is the increased focus on base salary to both attract and retain executive talent. While base salary levels have always been important, they were rarely a determinant in the stay/quit decision tree at the executive level. This is no longer the case today, with more and more executives wanting to ensure base salary increases are pacing with the market, which over the past 2 years has increased an average of 10% – 15%.
Companies with little to no retention on executive teams, or that have base salary programs which have not kept pace with the market are running the risk of losing their key employees. This volatility in the labor market plays an important part for not-for-profit and private companies as well, as they explore new alternatives to compete with public companies to attract talent or retain current key players.
As companies work towards expense control in a hyper-inflationary environment, which is experiencing year-over-year increases of upwards of 10%, it is clear that compensation-related costs are typically some of the largest investments a company will have. Throughout COVID, many companies implemented across-the-board salary and bonus freezes to reserve cash. As the impacts of this crisis dwindled, many of those companies anticipated returning to implementing a standard annual salary increase (2.5% – 3.5%). This simply did not turn out to be the case. Shortly thereafter, inflation began to rise, and employee salary requirements rose in kind. Base salary increases in 2022 averaged over 6% across all industries and 2023 increases were projected to be approximately the same. Companies that failed to maintain this pace now find themselves at a competitive disadvantage. Couple this phenomenon with the hypercompetitive labor market that emerged, and it is easy to see how new employee hires began to create pay compression issues within the existing job hierarchy. If left unchecked, these issues will begin to exacerbate attraction and retention efforts.
Preventative Action: Compensation Reviews
Market best practices dictate compensation reviews as a means of defense against these internal and external influences on corporate governance and executive compensation. A company’s review of the current labor market can provide insight regarding the appropriateness of the organization’s pay structure and effectiveness of its policies and procedures. A review may also highlight any inconsistencies or issues that may rear problems in the future.
In completing a compensation review, regardless of it being an internal review or that of a third party like a compensation consultant, the following topics should be reviewed for consideration:
- Institute, communicate, and document a compensation philosophy.
- Verify all disclosures are accurate and in compliance with laws and regulations.
- Examine internal threats from company processes and programs which could result in litigation.
- Identify, justify and/or correct pay gaps and pay compression issues – unnecessary turnover results in increased compensation costs.
- Review shareholder engagement processes – a proactive approach helps in determining shareholder priorities while mitigating litigation risks.
- Establish a strong peer group – compensation should be influenced by internal metrics and culture as well as external market data. Peers should be comparators, not necessarily competitors.
- Establish a pay for performance philosophy when applicable.
While the above list provides some of the more important areas to focus on, there are many other areas where a company can benefit from completing a compensation study. Companies with strong compensation programs are not only positioned to attract, motivate, and retain top talent, they are better suited to handle unpredictable events due to the inherent benefits afforded by a reviewed and updated compensation program. Contact NFPCC specialists today to get started with your compensation review.