Three Things that are Wrong with Most Executive Pay Plans
When a company experiences a decline in its financial numbers, the finger is often pointed at the easiest culprit: the compensation plan.
When a company experiences a decline in its financial numbers, the finger is often pointed at the easiest culprit: the compensation plan. The “plan” lacks the motivational effect desired, or the plan does not focus attention on desired behaviors; or the plan isn’t retaining the company’s key people. So you consider a redesign. But putting a new plan in place doesn’t necessarily guarantee it will work any better than its predecessor. Often, the plan is developed with little time, foresight, analyses or attention on the key issues that can significantly impact the ability of the plan to succeed. The fact is, plan mechanics aren’t usually to blame for the plan’s malfunction; there are inherently internal issues that affect the ability of the plan to focus attentionon the right activities. The problems typically fall into three main categories:
Overly Complex Plan Design. If you want to guarantee the demise of executive compensation plan, make it difficult to understand. Plan “designers” often tend to try to accomplish too much within the plan in order to satisfy all of the parties involved, but the irony is they end up not serving any aspect of the business very well. Or they try to address every possible performance scenario and put in so many caveats that it leaves heads spinning. To alleviate this issue, follow the “KISS” adage – Keep It Simple, Stupid!
Administration Gridlock. When plans are overly complex, they can be very difficult to administer on a timely basis. Often, the complexity also adds an element of ambiguity, because it is difficult to define all the scenarios and caveats of a plan when you’re are dealing with a multitude of layers and too many variables. When administration becomes difficult, plan participants can begin to question the plan’s administrators - and ultimately lose faith in the plan itself.
Unclear Goals. When an executive compensation plan is too complex and hard to understand, it become even more difficult to explain to the participants - the executive loses focus (since they cannot understand the plan or what the company really wants) and, in effect, their motivation is reduced. Many companies devote considerable time and resources to developing compensation plans, then fail to educate their executives about their compensation plans or adequately communicate their goals and objectives. As a result, the company may find that the executive are unable or unwilling to meet the performance metrics set forth by the plan, so they continue on a course that doesn’t reflect the appropriate business direction or realities.
A Systematic Approach
To avoid the need to continually reexamine the executive compensation plan, it is important to dissect the plan (and its inherent problems) in order to attempt to develop one that really works. Using a systematic process for assessment, design and administration will help to eliminate some or all of these issues and help you implement an executive pay plan that will be far more effective at meeting your company’s goals.
The following six-step process may be followed for a systematic approach to plan design:
Step 1: Clarify the Company’s Strategic Business Plan
It is not unusual for a company to attempt to design a new compensation plan without having a consensus among the Board and top management as to where their focus should be, which performance goals to emphasize, and (in some cases) what the role of the executive should be. In order for the plan to be effective, these focus items must be identified and prioritized. This strategy should be used in defining the concepts for the new pay plan.
Step 2: Determine the Desired Mix
The design of the executive compensation plan should begin with a determination of what the reasonable and appropriate compensation package is for the company’s executive positions. This should be based on reliable market data from the company’s peers and industry segment(s) against which the organization measures itself. In addition, the degree of variability should be defined – that is, what will be the mix between fixed pay (salary) and variable elements (consisting of short- and long-term incentives)?
For public companies, the mix tends to be more heavily weighted toward variable compensation, (including the use of stock-based awards), since equity is readily available, although the nature of the awards is shifting from stock options to restricted stock units, restricted stock, stock appreciation rights, and other programs. For privately held firms, the emphasis is typically on cash-based capital accumulation, however, many private companies are realizing the importance of some form of equity compensation within the compensation package in order to compete with their public counterparts.
Once the compensation package mix is determined, the company should decide on its intended Executive Compensation Philosophy, which will serve as the reference point for evaluating the current program and designing the new pay program.
Step 3: Develop a Draft Plan
In this step, the parts come together to create a plan that will support the organization’s Strategic business Plan in the most effective manner. The parts include:
· Basis for payment of awards (performance metrics and weightings);
· Form of payment (cash, stock, or combination);
· Timing of awards (current year, defined performance period, career-based, or deferred);
· Setting and performance targets and thresholds
· Award determination and funding; and
· Rules for administering the program
The plan should be designed with a degree of flexibility to recognize changes in business strategy, so that the entire plan need not be changed in this event. A key element of success here is to design a plan that has a clear focus for the achievement of the company’s goals, based on a consensus among the Board and Top Management.
Step 4: Modeling the New Plan
To anticipate how the plan may operate once implemented, the company should conduct a cost/benefit analysis to see how the executive will be rewarded under different performance scenarios. If they are performing at their level of expectation, they should be paid at the right level (typically at market), and vice-versa. A well-designed plan that was sufficiently modeled will help to motivate and retain a company’s key executives, and should also spotlight (and possibly eliminate) weaker members of the executive team.
Step 5: Implementation and Administration
Putting a new plan into operation requires a good deal of work and thorough communication, including a strong message from the Board top management that they unequivocally support the plan. This goes a long way ensuring that participants understand the organization’s commitment to the plan’s success. Communications should be targeted to the participants themselves, as well as the corporate staff that’s responsible for plan’s administration. The form of communication shouldvary for each audience, since each group has to understand it in a slightly different way.
When installing a new plan, careful attention should be paid to identifying and addressing transitional or phase-in issues, so as to not rankle the participants or demotivate them. Processes to transition to the new plan could include running parallel systems, grandfathering some performance objectives and other related issues. To ensure smooth implementation of the program and keep executives focused on desired results, an active system of communication and feedback should to continue to focus the executive’s attention on the desired results, an active system of communication and feedback should be established (obviously on a higher level than with programs covering the rank and file).
Top Management, the Compensation Committee and the Board should take the time to review performance against goals on a periodic basis so that they can identify areas for corrective action before the damage is done. Such a system continues to reinforce the company’s commitment to the plan’s success and can enhance the executive’s motivation and performance.
An executive compensation program requires a significant investment of time and resources; an appropriate communication mechanism will enhavnce the plan’s ability to accomplish its objectives and will in turn benefit both the organization (in increased performance) and the executive (with awards commensurate with that performance).
Step 6: Monitoring and Corrective Action
Once the plan is implemented, it will be easier to tell how effective it will be at focusing executive’s attention on the desired results. If the results don’t match up with expectations, the company needs to find out why and take remedial action. Be careful not to throw the baby out with the bathwater; redesign is an on-going process that must be carried out on a timely and continuous basis. If the plan is designed well and with sufficient flexibility, it may only need to be tweaked in order to shift the emphasis to the desired results
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.