Getting Executive Compensation Right

When it comes to executive compensation, it’s best to be cautious about giving advice. There’s a great deal of variation across industry sectors and geography, a multitude of designs available, and many different factors to consider.

Yet the board of directors is ultimately responsible for making executive compensation decisions. It’s an important responsibility because having the right plan is a key factor in driving organizational performance.

Given these stakes, how can savvy directors make the best compensation decisions?

In this vital area of decision-making, there’s one skill that will serve you well regardless of the type of board you sit on, the kind of organization you serve, or your level of expertise. That’s knowing what questions to ask.

In this post, we’ll share a few broad questions to think about and examples of targeted questions to ask in the boardroom.

What’s Our Compensation Philosophy?

A compensation philosophy is a formal statement that documents an organization’s position about employee compensation and creates a framework for consistency. Its purpose is to provide direction, guidance, and clarity for making compensation decisions that are based on the organization’s vision, mission, values, and strategic objectives. Board approval of the compensation philosophy is more than a rubber stamp. It’s an opportunity for directors to make sure it fits with the organization’s culture, size, resources, and goals.

A typical compensation philosophy includes:

• Objectives. These are the guiding principles and goals, such as fairness, accountability, transparency, flexibility, etc.
• Internal and external pay equity. Internal equity is essential for compliance and to build employee engagement, while external equity is needed to attract and retain employees in a competitive labour market.
• Peer group. This defines the group against which the organization will compare itself. Usually these are companies in the same industry, of a similar size, and in the same general geographical area. The sector is a significant factor – there’s a lot of variation among publicly traded companies, private companies, non-profits, charities, and governmental bodies.
• Pay positioning. The target ranking of pay vs. market, such as the 25th, 50th or 75th percentile.
• Compensation mix. The mix of components such as base salary, short and long-term incentives, and benefits.
• Performance curve. The threshold, target, and maximum payout of incentive plans.
• Alignment. How incentives motivate and reward performance that furthers the organization’s mission, strategy, and business goals.

Questions about compensation philosophy:

• Does the compensation philosophy support our strategic direction?
• Do we as a board understand and approve the risk inherent in the compensation philosophy?
• Does our compensation philosophy need to be revised in light of HR realities such as remote and hybrid work, DEI (diversity, equity, and inclusion), and labour shortages?
• Does the compensation philosophy appropriately reflect our goals and values?

How Is the  Plan Developed?

Designing an executive compensation program usually involves choosing an external compensation consultant, collecting and analyzing relevant information, projecting outcomes under various scenarios, and assessing the impact on the budget.

Since modern executive compensation packages can be quite complex, many organizations need outside help. The board has the right to obtain its own advisors, so it’s not at all uncommon for the board to engage a compensation consultant to provide advice and assistance.

Consultants play an important role in advising management and boards on items such as peer group selection, incentive design, regulatory requirements (which differ widely and change constantly depending on the type of organization), and communication. In addition to providing valuable expertise, the right consultant brings a fresh, independent perspective to the process – challenging the status quo, proposing alternatives, and uncovering risks.

Using up-to-date compensation information across a broad range of industries, they work with management and HR to define performance metrics, develop a plan design, and model outcomes under various scenarios. Management then makes a recommendation to the board.

A key consideration for the board is the affordability of the plan. To assess this, directors need to know what it will cost under various scenarios, and how the plan will contribute to achieving the organization’s goals.

Questions about plan design:

• How confident are we in the methods used to develop the executive compensation plan?
• Do our metrics capture the performance that pay should be linked to?
• What’s the range of potential payouts under the incentive structure? Are they all reasonable?
• How will we ensure appropriate board oversight of the executive compensation plan?
• Are we comfortable with the ratio of CEO/executive pay to the rest of the workforce?
• Does the plan reflect principles of racial and gender equity?

Do We Have the Right Balance?

The components of compensation plans vary considerably among organizations. Within an organization, there can be structural variations depending on individual roles and levels in the hierarchy, so it’s quite common for an executive compensation plan to differ from other employees, and for the CEO’s plan to differ from the rest of the executive team.

In general, compensation plans consist of some combination of the following components:

• Base salary.
• Bonuses, typically cash incentives based on annual goals.
• Long-term incentives, often in the form of equity.
• Benefits, including life and health insurance, pensions, paid vacation, etc.
• Company-sponsored savings or investment plans.
• Perquisites (“perks”), such as professional development, company cars, business cell phones, use of corporate properties, etc.

There’s no perfect plan design that combines these components in the exact right way. What works best for one organization, or one group of employees, might not work at all for another, or it might work right now but not in the future.

Keep in mind that many organizations have a very simple plan that consists of only a base salary and standard benefits. Many sectors of the economy – especially any organization that’s government funded – don’t offer their executives any kind of bonus, incentive, or pay for performance.

The factors that drive compensation choices include strategic objectives, attracting and retaining talent, ownership structure, culture, corporate governance, and cash flow. A good framework for thinking about these choices is finding the right balance along four different dimensions: fixed versus variable pay, short-term versus long-term, cash versus equity, and group versus individual.

Fixed versus variable. Base salary is fixed whereas short- and long-term incentives are variable elements contingent on achieving certain goals. The exact mix reflects company size, industry, culture, and risk appetite.

Short-term versus long-term. Short-term incentives are paid out in the year they’re awarded, generally in the form of a cash bonus. Long-term incentives are paid over some future period, generally as equity.

Cash versus equity. Equity as an incentive tool is not an option for many organizations such as private companies, non-profits, and governmental bodies. When equity is available, the mix reflects business maturity and size. When cash is scarce, offering equity can attract and retain key employees. Once established, larger companies tend to pay a higher proportion of equity than smaller ones.

Group versus individual. Culture and values have an impact on the individual/group balance. Within an organization, executives tend to have more control over metrics than other employees, with the CEO having the most control. As a result, executive incentives tend to skew toward organizational performance rather than individual.

Questions about balance:

• Is our mix of short-term versus long-term incentives right for this point in time?
• If equity isn’t available to us, what can we do to encourage executives to think like owners?
• Does the plan encourage executives to appropriately balance risk and reward?
• How do we balance stakeholder expectations with the ability to attract and retain talent?
• Does the plan balance our financial and strategic goals with our values in terms of purpose, sustainability, and social responsibility?

Is the Plan Aligned with Our Strategy?

Executive compensation starts with the organization’s strategic plan. The right compensation plan can support strategic goals, but when they’re not aligned, trouble can ensue.

For example, a balance of short-term and long-term incentives can support a goal of promoting profitable growth, whereas a turnaround strategy requires incentives that are aligned with critical short-term objectives such as cash flow and expense management. A risky transformation strategy is best supported by making a large part of executive pay contingent on successful execution. And phantom equity, multi-year cash incentives, or profit-sharing programs are all options to support a long-term orientation when equity is unavailable.

Questions about strategic alignment:

• Does the executive compensation plan support the strategic direction of the organization?
• How exactly is the business strategy reflected in the incentive program?
• Are the right performance metrics being used given the current circumstances?
• How are metrics, individually and collectively, tied to overall strategy goals?
• Should our commitments to DEI and ESG be incorporated into the executive compensation plan? If so, do the metrics reflective our current priorities in these areas?

What are the Plan’s Key Risks?

Any compensation plan with variable pay has the potential to incentivize employees to act in ways that could adversely affect an organization. The board should carefully consider the risk that plan components might inadvertently encourage misconduct or excessive risk-taking. Extreme outcomes of the plan design can also create risks that bear thinking about.

Here are some risks to which compensation plans tend to be vulnerable:

• Financial Risk. Plans may place an undue financial burden on the organization or fail to motivate desired behavior, impacting financial success.
• Operational Risk. Processes involved in administering compensation may increase the likelihood of errors, miscommunication, misconduct, or negligence – particularly if the plan design is complex.
• Talent Risk. Poor design or poor execution could result in loss of critical talent and inability to attract required talent.
• Reputational Risk. The design of the plan could attract negative attention from the media (“headline risk”) and stakeholders including investors, donors, and customers.

Questions about risk:

• How well do we understand the executive team in terms of motivators, risk appetite, and relationships?
• How do we ensure executive compensation is integrated into board discussions about risk?
• Are we comfortable with the risks inherent in the compensation plan? How will we monitor them?
• How do we assess whether our pay practices are defensible and competitive?
• How effective is the plan in terms of motivating and rewarding desired performance?
• How will executive compensation hold up under scrutiny from stakeholders?
• What’s the maximum potential payout under the most extreme scenario? If such a payout made the headlines, could we justify it?

Your takeaways:

• The board of directors is ultimately responsible for making executive compensation decisions.
• The board’s role includes finding the right balance of fixed versus variable pay, short-term versus long-term, cash versus equity, and group versus individual.
• A good compensation plan can align people’s behavior with company strategy and lead to better performance.
• Regardless of the type of board you sit on or the kind of organization you serve, you can add value to the discussion by asking the right questions about executive compensation.

Resources:

• The complex role of the board in setting executive compensation. Deloitte Center for Board Effectiveness. July 2023. © 2023 Deloitte Development LLC.
• How to Create an Effective Compensation Philosophy. Rhonda Gardner. Academy to Innovate HR. September 2021.
• Compensation Packages That Actually Drive Performance. Boris Groysberg, Sarah Abbott, Michael R. Marino, and Metin Aksoy. Harvard Business Review. January-February 2021.
• 20 Questions Directors Should Ask About Executive Compensation Second edition. Elizabeth Greville, LL.B and David Crawford, CFA. © 2011 Chartered Professional Accountants of Canada.
• How to Help Directors Increase Oversight of Executive Pay. Don Delves. Harvard Business Review. July 2009.

Thank you.

Scott

Scott Baldwin is a certified corporate director (ICD.D) and co-founder of DirectorPrep.com – an online hub with hundreds of guideline questions and resources to help directors prepare for their board role.

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