Executive Compensation Plan and Packages17/08/2020
Executive compensation, also known as executive pay, refers to remuneration packages specifically designed for business leaders, senior management and executive-level employees of a company.
Executive compensation includes benefits such as salaries, perks, incentives, insurances etc.
The Executive Compensation refers to the financial payment and other non-monetary rewards given to the top executives in exchange for their services to the organization.
Executive compensation differs substantially from typical pay packages for either hourly workers or salaried management and professionals in that executive pay is heavily biased toward rewards for actual results. Hence if a company underperforms, the executives typically receive a smaller fraction of their potential pay. Conversely, if a company meets its annual objectives and the stock price responds long term, the executives stand to receive a much larger payout.
This section of the site describes the typical Executive Compensation program and explains the most commonly used terms. It includes several charts, including one below that shows the share of compensation that is at risk by executives, as compared with managers and hourly employees.
The pay packages given to the senior executives of corporations often consist of six components:
- Base salary
- Incentive pay, with a short-term focus, usually in the form of a bonus
- Incentive pay, with a long-term focus, usually in some combination of stock awards, option awards, non-equity incentive plan compensation
- Enhanced benefits package that usually includes a Supplemental Executive Retirement Plan (SERP)
- Extra benefits and perquisites, such as cars and club memberships
- Deferred compensation earnings
Executive pay is structured to reward company performance and align executive pay with shareholder value. As a result, unlike most other employees, a majority of executive pay is at-risk; in other words, executives may never receive it. However, if executives and the company perform well, they along with the company’s shareholders stand to gain much more from superior performance.
Importance of executive compensation
Senior management and executive-level employees play a crucial role in the company as they’re the ones making the strategies, taking importance decisions etc. In order to keep them motivated and satisfied it’s important to set the right benefits package.
This type of compensation is negotiable between the employer and potential executive and can defy the organizational norms on compensation to regular employees.
Components of executive compensation
- Short Term Incentives (STI)
- Long Term Incentives (LTI)
- Guaranteed Severance Package
- Perquisites, like club memberships, private planes
- Insurance, health insurance for self and dependents
Objectives of executive compensation policy
- The manager should be incentivized so that they adopt those strategies, investments, and actions that result in the increase in the shareholder value. Thus, an executive aligns his interest with the interest of the shareholder.
- The remuneration package should be designed such a way that it motivates the executives to work harder, take risks and take unpleasant decisions such as termination or retrenchment, aimed at increasing the shareholder’s wealth.
- The executive compensation is often designed with the intent to retain the executives during the bad times caused due to the adverse market and industry factors.
- The cost of the executive pay must be limited to the extent where the shareholder’s wealth does not get affected and, in fact, maximizes.
Generally, the executive compensation packages are designed by the board of directors, particularly the compensation committee, which is comprised of the independent directors. The purpose for which the committee is created is to pay incentives to the executive team who play a significant role in decision making and is responsible for the corporate strategy and the overall value creation of the company.
Effective Executive Compensation
- Use Metrics as the Basis for Incentive Compensation
A common mistake for incentive-based compensation is promising incentives that are not tied to specific metrics. By having only discretionary bonuses or incentives, executives are unaware what precisely they need to focus on to be successful.
For each executive, the metrics that are well within their control and follow the SMART criteria (specific, measurable, attainable, relevant and time-bound) should be used as the basis for their incentives. This way, they are aware of what they must focus on and they can optimize their work to achieve those specific goals. Sometimes metrics like revenue and profit are applicable, but, more often, there are better key performance indicators (KPIs) that should be used.
- Effectively Communicate to Ensure Understanding
Another common mistake companies make is when they assume that compensation plans are well understood by their executives, but the reality is that there are often gaps. Make sure every executive is fully aware of all of the components related to their compensation package.
If an executive does not have a clear picture of their total ability to accumulate wealth in their current position, the likelihood of looking for opportunities with more clarity of the upside is increased. Uncertainty is almost always bad for business, and this is a case where uncertainty on the part of a core team member can have unforeseen deleterious effects on a business.
Progress on a compensation plan should be addressed at least annually, outlining both short-term and long-term incentives. An even better idea is for quarterly communication where the core metrics to which incentives are tied are discussed. This prevents any miscommunication prior to when the awards are issued.
- Benchmark Compensation Levels
If you’re trying to attract top talent, your compensation needs to be competitive. Use benchmarking tools and publications to ensure you’re compensating your executives in the way you intend.
In our research, companies often believe they are paying near the top-end of the spectrum for each of their executives when, in reality, they are at or below the median compensation level for similar companies.
Make sure the benchmarks you use are meaningful and relevant to your company. Using multiple reference points to compare your company (for example, by revenue, industry, region, and revenue growth) will give you a much clearer idea of how competitive your compensation levels are.
- Value Company Equity Regularly
In our research, more than half of the companies we surveyed do not have a clear idea of what the equity awarded to their executives is worth. By granting equity-linked compensation but not tying them to any real value, you’re simply adding uncertainty to the executive’s total compensation picture.
If you plan on issuing equity-linked incentives, your company’s equity value should be appraised or estimated at least annually. At regular intervals (quarterly, annually, etc.), each executive should be told the estimated current value of their equity-linked incentives, as well as the expected future value.
- Include both Short and Long-Term Incentives
Providing a truly competitive executive compensation package usually requires that your executive team has both short and long-term goals from which they benefit financially should they be met.
A blend of incentive compensation that provides executives with cash incentives in the short-term and longer-term incentives that tie an executive to the overall success of the company helps to ensure your executive team is engaged and feeling rewarded for their hard work regularly.