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Business Ethics Checklists

Creating Executive Compensation


Checklist Description

This checklist outlines the importance of creating remuneration packages to attract and retain executive talent while still ensuring value for shareholders’ money.

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Definition

The level of executive remuneration has risen sharply in many of the World’s developed economies over recent decades, with the pay gap between those at the top of the corporate tree and those at the bottom growing ever wider. While this growing divide may trouble some on ideological grounds, the need to set compensation levels at the right level to attract and to retain talented executives has never been greater. Moves to link executive remuneration to performance have found increasing favor over recent years. The objective is to reward executives on the basis of their achieving predetermined measures of the success of the business. While middle-ranking managers may benefit from bonuses linked to relatively simplistic targets such as annual sales increases, the performance-related element of top executives’ remuneration can often be more complex, depending on a variety of factors that include company earnings, outright share price performance, and share price performance relative to the company’s peer group.

In the United States, executives can expect to benefit from a combination of salary, bonus, stock options, stock grants, and a range of long-term incentive contracts. Over recent years executives have increasingly benefited from a shift to offer stock options.

Specialist independent remuneration committees have increasingly been established by leading listed companies wishing to strike the balance between rewarding top talent and making sure that shareholders’ interests are well served. This approach typically stands up well to shareholder scrutiny by distancing executives from the role of effectively setting their own levels of remuneration.

Cultural factors can also have a considerable influence over the acceptable boundaries for top-level managerial pay. Remuneration packages which aggressively leverage private-sector executive remuneration to performance have been widely accepted in countries such as the United States for several decades, though in more conservative countries such as Japan the link between pay and performance has historically been more tentative. However, recent moves by activist investors to extract better shareholder returns in Japan have seen the performance culture penetrate through to boardroom salaries. In other countries such as the United Kingdom, elements of performance-related pay have also percolated into the remuneration packages of senior public service workers as a result of the need to compete with the increasingly incentive-driven private sector for top managerial talent.

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Advantages

  • A balanced, well-structured executive remuneration package can help to attract and retain key decision makers.

  • Transparency in executive remuneration can find favor with institutional shareholders and is an important element in sound corporate governance.

  • A mix of short and long-term performance-related elements can provide further incentives for executives to deliver success. Granting longer-term share options can help to further align executives’ and shareholders’ interests.

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Disadvantages

  • The perception that executives may be excessively rewarded for moderate or poor performance can be very damaging to morale among lower-ranking employees.

  • Poorly conceived incentive schemes can skew performance toward particular targets that may not necessarily align with the success of the business.

  • During boom years, the pay scales in remuneration structures can be equivalent to an arms race as companies compete to attract recognized industry talent. This potentially leaves companies committed to paying excessive rewards for apparent failure during leaner times.

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Action Checklist

  • Gain a full understanding of how existing remuneration policies operate before rushing to implement changes.

  • Study the remuneration arrangements employed by the wider market and compare those used by your own company.

  • Consider the cultural factors within your company which could effectively limit acceptable multiples between the potential remuneration of executives and that of lower-ranking employees.

  • Introduce some element of performance-related pay to avoid alienating key workers at lower levels of the corporate structure.

  • Consider how the performance strength of individual executives can be judged in relation to the overall performance of the company or division.

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Dos and Don’ts

Do

  • Make sure that any new proposed executive reward scheme is in keeping with the culture of the company.

  • Target consistency and fairness in creative executive compensation. Inflated remuneration to tempt talent from rivals could generate ill-feeling.

  • Consider the tax implications before introducing changes to remuneration policies.

Don’t

  • Don’t underestimate the resources needed to effectively develop and manage executive remuneration policies.

  • Don’t aim for a remuneration structure which incentivizes managers to shift focus to hitting short-term targets. Opportunities to deliver long-term benefits could be missed.

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Further reading

Book:

  • Berger, Lance A., and Dorothy R. Berger. The Compensation Handbook. 5th ed. New York: McGraw-Hill, 2008.

Article:

  • Cahill, Miles B., and Alaina C. George. “Executive compensation incentives in a volatile market.” American Economist 49:2 (Fall 2005): 33–43. Online at: www.jstor.org/stable/25604323

Website:

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