Fundamentals of Executive Compensation

By Decusoft
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Are you new to the world of executive compensation? Do you want to make sure you have the foundational skills you’ll need to create executive compensation programs that will help you cultivate, inspire, and keep the talent you’ll need to meet your company’s goals? If so, you can use this DecuSoft guide to discover the basics of a successful executive compensation policy.

What is executive compensation?

Many factors impact executive compensation programs today. As a compensation manager, your focus should be on the alignment of pay and performance with pay programs influenced by multiple factors. 

Executive compensation is significantly different from traditional pay packages for hourly employees or salaried managers and practitioners. Executive compensation is highly weighted toward incentives for real performance and results. However, if an organization underperforms, the executives’ salary is usually reduced to a fraction of their potential compensation or compensation goals. In contrast, if an organization meets or exceeds its annual goals and the stock price rises over time, the executives will be rewarded significantly more.

Compensation packages for senior executives consist of a few basic components: 

  1. Base salary
  2. Annual incentives / annual bonuses 
  3. Long-term incentives
  4. Benefits and perquisites

Objectives of Compensation Management 

Companies in the United States often talk about attracting, motivating, and retaining the talent needed to achieve corporate objectives. Many organizations are also concerned about the alignment of pay with performance and what that means for their organization. After the 2008 recession, many companies began using executive compensation to discourage excessive risk-taking and instead placed more emphasis on benchmarks for performance rewards. 

Pay Mix 

The executive compensation pay mix includes both fixed and variable compensation, short and long-term compensation, and cash versus equity compensation. These variables may change with the organization as it evolves and grows. This is the mix of cash compensation and other benefits for CEO pay or other corporate executive compensation

Market Competitiveness 

Pay positioning is very important. All companies want to be competitive within their market and their industry. Your organization will have to research and define what being competitive means for you. Traditionally these are targeted to median levels. But it is also important to remember your compensation management program needs flexibility. Flexible compensation could mean creating a unique compensation structure for a business unit focused outside of the traditional corporate perspective. These departments could include new product development, new strategies within the organization, and going above and beyond for high-demand roles. 

Components of Executive Compensation

For each of these factors, we must understand how they attract, retain and motivate individuals. We have created this helpful guide to understanding the elements of executive compensation

  

Base Salary

Base salary is fixed compensation paid to an executive for services rendered. Base salary is a stable source of income for individuals, even if no bonus is paid, and is usually set at the beginning of the year. This is often negotiated during the interview process and agreed to in an employment contract called the executive employment agreement. The base salary provides security and predictable income for day to day needs of the executive officer. In an executive compensation program, the base salary is usually a small percentage of the overall total compensation package. However, since target annual and long-term incentives are often expressed as a percentage of salary, changes in salary resonate throughout the pay program. 

Adjustments

Usually, compensation is only adjusted after an annual review, promotion, or significant change in responsibility. Market adjustments should be made to reflect the competitive market, promotions, significant changes, profitability, the stock market, and performance measurements for top executives.

Disclosure

Be prepared to discuss and defend the rationale for initial positioning and any changes, particularly in instances where the pay is high vs. the market or when company performance may be viewed as weak. We recommend that you have a solid understanding and rationale for where and why base salaries are set for your shareholders. You can peg to a certain percentage of the market or use other factors to create your base salary range. 

162(m) “The Million Dollar Cap”.

Section 162(m) of the Tax Code, also known as “The Million Dollar Cap,” limits the tax deduction that publicly trading firms can take on salaries to “covered employees” to $1 million in any given year. Corporate executives, with the exception of the CFO, are included in this provision. Section 162(m) of the tax code originally contained an exception regarding some types of performance-based payments. Since base salary is not performance-based companies will lose a tax deduction for base salaries in excess of $1 million, excluding the CFO. 

Setting Annual Incentives for Executives 

Compensation is earned and paid based upon achievement of performance goals over a one-year period. We recommend you motivate performance and align executives with the company’s short-term performance objectives when setting goals for annual incentives. In a well-designed compensation program, annual incentive targets support the company’s long-term business plan/strategy. Opportunities for senior executives are most often defined as a percentage of base salary.  Targets are reflective of market opportunity for the position and internal pay equity considerations. 

Compensation committees often chose specific metrics for the executive to follow that align closely with the board’s approved business plan. This is good practice for internal and external communications as well. Selected performance metrics should focus on and drive firm performance. The most common annual incentive plan metrics among public companies are set up as follows: 

Source Steven Hall & Partners

Based on this aggregate data, over 87% of companies are using earnings for AIP performance metric valuation. Only 3% of companies mention they use stock performance in their annual incentive plan. When creating annual incentive plans we recommend choosing metrics the executive can have a measurable impact on or control over in a given year. Because stock prices fluctuate and cannot be controlled by executive action we do not recommend using these to measure performance. Stock price performance can end up being a lagging indicator of performance year over year. 

Goal Setting

Goal setting is the most complicated aspect of incentive plan design for managers, committees, and compensation teams. Goal setting can be difficult because of the inability to forecast future performance. The 2008 economic downturn saw many executives lose their payouts in spite of performance and drive, simply due to the economic conditions at the time. This provided a difficult environment to forecast future performance for many firms. Some organizations couldn’t predict if they would be able to stay open in six months, let alone make predictions long term. This was handled by creating multiple shorter-term goals ranging from a 3-6 month period. In later years this has improved and reverted to an annual goal scheme. 

In general, goals should be realistic, motivational, and reflective of a business plan and budget. This business plan and goal plan should be reviewed and approved by a company’s board of directors. This plan should be cognizant of any outside factors, including company stakeholders and institutional investors, and estimated provided to Wall Street. In the event of a drastic change from previous years’ performance, this should be communicated to internal and external stakeholders well in advance. You do not want to surprise executives with the news that there will not be a payout because performance is drastically different from last year. 

As always, we advise you to be aware of what other organizations in your industry are doing and what your direct competitors are offering. These factors should not dictate your compensation plan, however, it is important to be aware of industry averages and direct competitors so there are no surprises in the future. 

Finally, you should be aware that businesses are under increasing scrutiny from larger shareholders and proxy advisory firms when it comes to goal setting. Shareholders want full disclosure of your compensation incentive plan details and visibility over the goal-setting process. Shareholders want full disclosure for goals including the specific target, what the performance minimums and maximums were, and other determining factors. You should expect that your performance targets will be examined in various ways before approval. Some companies have been reluctant to disclose this information in the past. They cited concerns over competitive advantage, however many shareholders and advisory firms are pushing back on this. Additionally, many firms are creating pay-for-performance analyses based on your plan. These firms are not necessarily using the performance metrics or goals you have created. 

Key Takeaways for Designing Executive Compensation Plans:

  • Communication internally and externally is key
  • Always set appropriate goals and expectations for your management team
  • Look backward towards historical levels of performance
  • Look forwards to future projections of performance
  • Examine industry averages 
  • Examine competitor plans where data is available

Targets for incentives: 

Minimum

The lowest level of performance for which a bonus is earned. Typically pays out at 25-50% of target, annual incentive can be earned depending on the rigor of performance goals. At this level, you would pay a bonus that is less than target, proportional to what was accomplished. 

Target

This is the expected or budgeted level of achievement the executive must attain to secure their target bonus. This level pays out at 100% of target. 

Maximum

Payouts are capped and no additional payouts are made for better performance. At this level performance is deemed to be exceptional, however, at some point you will stop paying for additional performance. The maximum is often set at 150% and 200% of base salary depending on the rigor of goals. This is a risk mitigation technique. Executives will avoid pushing too fast or overextend their teams in hopes of a larger bonus. This can be viewed as risky behavior internally or externally.

Source Steven Hall & Partners

Probability of attainment – Rule of Thumb

Based on those three outcomes there exists a general rule of thumb that corresponds to the probability of attainment. 

Your executives should be achieving the minimum threshold of performance 90% of the time, or 9 out of every 10 years. Your executives should be achieving the maximum threshold 1 out of every 10 years or 10% of the time. The remaining eight years’ performance should range on the continuum between threshold and maximum, with a tendency to cluster around the target. If your executives are constantly performing at the maximum threshold for performance, your goals may not be rigorous enough to stimulate growth. This could call into question the goal-setting process of your compensation committee. If your executives are consistently performing below the threshold your goals may be unrealistic for the organization at this time, or the incentives may not provide enough of a draw to motivate performance. 

Other Considerations

Most annual incentive programs at public companies are structured to comply with IRC Section 162(m); regulatory requirements include: 

  • Incentives paid are subject to a shareholder-approved plan. 
  • Payment is determined through objective performance criteria established by a committee of outside, independent directors. These criteria must be set by outside independent directors on an annual basis. 
  • Compensation committees must certify in writing the amounts paid and the goals achieved. This is typically done in the form of the proxy statement under the compensation discussion analysis report. 
  • Plans can only provide for negative discretion only. The Compensation Committee can decrease the payment after the approved plan is set but cannot increase based on discretion. The plan must be re-approved every 5 years by its shareholders unless it is a formula-based plan. 

Long-Term Incentives for Executives

Long-term incentives are awards earned and paid based upon achievement of goals over a period exceeding one year. This is one of the most important aspects of executive compensation programs in 2020. Usually, 50-60% of an executive’s pay is based on long-term incentives. Goals for long-term incentives may be based on stock price or business performance. Typically these are equity-based, but a small number of firms use cash. 

The purpose of long-term incentives is to:

  • Align executive and shareholder interests
  • Attract, retain and motivate
  • Focus participants on critical performance criteria
  • Provide competitive pay opportunities based on performance
  • Create wealth

There are three main forms of long-term incentives for executive compensation. These include appreciation vehicles, time vested value vehicles, and performance vested vehicles. 

Appreciation Vehicle  

Stock options and stock-settled appreciation rights – Stock options are the right to purchase shares of company stock at a specified price (exercise price) during a specified period of time (term). Stock settled appreciation rights or SARs are slightly different, however. In a SAR there is only value delivered to the participant if the stock grows from the day of grant. If so there will be an exercise price for an option. SARs work the same way in theory as stock options, however, when they are settled you are only delivering the profit in shares.  

Positives: 

  • Alignment with shareholders
  • Easy to communicate
  • Leverage
  • Fixed expense

Negatives: 

  • Not viewed as performance-based by some
  • Not tied explicitly to company financial performance
  • Dilution; stock-settled SARS are less dilutive than options
  • Expense recognized even if option expires worthless

Time-vested full value vehicles

Restricted stock or restricted stock units (RSUs) – The grant of shares, or the promise of the grant of shares in the case of RSUs, contingent upon meeting the requisite service period. There is only value delivered to the participant if the stock grows from the day of grant. We usually see a 3-4 year time frame for these options. 

Positives: 

  • Strong retention value and popular with employees
  • Alignment with shareholders
  • Less dilutive
  • Easy to communicate
  • Fixed expense

Negatives: 

  • Viewed negatively as “pay for pulse”
  • Not tied explicitly to company financial performance
  • No leverage

Performance-vested vehicles 

These are usually similar to RSU’s however the participant must also meet a performance goal for these. Performance-vested shares / PSU Shares (or the promise to receive shares in the case of PSUs) are granted contingent upon achieving associated performance goals and meeting the requisite service period. 

Positives:

  • Strong focus on performance
  • Alignment with shareholders; popular with advisory firms
  • Fixed expense may be subject to reversal if performance goals are not met
  • May be less dilutive

Negatives:

  • Challenges in setting performance criteria
  • Poor goal setting may lead to the perception that they are less valuable
  • Reversal of expense is not possible for awards earned based on market conditions (stock price/TSR)

Source Steven Hall & Partners

Performance metrics

  • Performance measures should be aligned with business strategy
  • Represent the key driving factors of corporate and shareholder value
  • Create clear plan for employees that focuses their efforts and matches their level of accountability

Absolute metrics

  • Dependent upon the ability to predict future performance
  • May not be viewed positively by shareholders

Relative Metrics 

  • Can serve as “plugs” when absolute performance is difficult to predict
  • Possibility of payouts for negative/poor performance that is merely “less poor” than that of some comparators

Source Steven Hall & Partners

Relative TSR (Relative total shareholder return) is currently the most popular LTI performance metric.  Relative performance is useful when absolute performance is difficult to predict. It is viewed favorably by shareholders and shareholder advisory firms. However, it is often not directly within management’s control and the “phoenix effect” can penalize steady performers. Selecting the “right” comparator group is critical and expense must be recognized even if the award is not earned. 

Other Considerations

IRC Section 162m
Options and performance-vested shares should qualify as performance-based compensation, but the restricted stock will not. 

Change in Control
This represents a significant concern for shareholders and shareholder advisory firms. Majority practice has evolved from automatic accelerated vesting (single-trigger) to requiring loss of job as well (double-trigger.) 

Benefits and perquisites represent a diminishing portion of total compensation for executives. The level of shareholder distaste exists far in excess of value of the benefits/perquisites delivered and now focuses on “irritants.” The remaining perks today generally support the health and productivity of executives. SERPs that provide additional benefits to senior executives are under pressure such as retirement plans focused on just senior executives.Excess/Restoration Plans remain acceptable. Severance and change-in-control benefits are now being revisited in light of pay-for-non-performance concerns. There is a decline in severance multiples and an elimination of excise tax gross-ups

Share Ownership Guidelines

The level of stock ownership you require from your executives. Most firms require that executives hold a certain number of shares. The value is most often defined as a multiple of base salary

– 6x base salary executive pay viewed as “robust” for CEO compensation.
– 1-3x base salary for CEO direct reports

Shares counted towards the policy typically include shares owned outright and both unvested and time-vested restricted stock. Options and performance-vested shares are not typically included.  Until guidelines are met, it is not uncommon to require executives to retain a percentage of shares (often 50%) post vesting/exercise, net of taxes. 

Clawbacks

In general, most corporate governance officers require that companies “clawback” incentive compensation awards paid to executives if the performance upon which those awards were based is later found to be erroneous. The implementation under Dodd-Frank has been delayed for years. Most companies’ human resources departments and good corporate governance practices have implemented policies in the interim. It is important to understand that these policies will need to be revised when Dodd-Frank regulations are finalized, particularly with respect to types of performance restatements and treatment of long-term incentive awards

Final Thoughts on Executive Compensation

Executive compensation is a difficult topic to get right. There are dozens of variables to consider and numerous indicators of performance that need to be weighed when developing a robust executive compensation package. With a well-designed plan, your organization can attract top talent and properly incentivize them. Getting executive compensation right can mean the difference between positioning your company for long-term success and continual disappointments and under-performance. If you are interested in learning more, check out our Complete Guide to Compensation Management.