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Home > Corporate Governance Best Practice > Executive Rewards: Ensuring That Financial Rewards Match Performance

Corporate Governance Best Practice

Executive Rewards: Ensuring That Financial Rewards Match Performance

by Shaun Tyson

Relating Business Performance to Rewards

According to economic logic, there is a clear and consequential relationship, or line of sight, between the economic climate, the organization’s performance, and the rewards provided (Figure 2).

Certain linkages, such as that between strategies and accountabilities, are critical. The diagram demonstrates the importance of line of sight. There is also the question of how quickly strategies, accountabilities, and rewards can adapt in response to changes in the economic climate.

Objective Setting and Targets

Objectives are normally “cascaded” down from the business strategy—each business unit or department having agreed short-term (next year) and longer-term (three to five year) plans. Objectives are usually both financial and qualitative. Financial objectives are typically total stockholder returns (TSR) and return on capital employed (ROCE). Budget targets are also often used, as well as share price. In remuneration planning, the performance objectives should be measured, and they should be designed to drive the business forward: “Paying for value creation is the most reliable way of generating it” (Credit Suisse First Boston). Targets are usually discussed and agreed at the annual performance review.

The Reward Package

Reward packages are pay policies aimed at achieving behaviors and actions by senior managers that accomplish business objectives. A package consists of base pay, short-term incentives, benefits, long-term incentives, and perks (perquisites). Base pay is decided by reference to pay rates in comparable organizations (see below), and usually according to internal relativities decided by the job evaluation scheme in use.

The decision of where to be in the market is a matter for corporate policy (for example, at the market median, or the upper quartile rate), reflecting labor market pressures and attraction and retention strategies. Short-term incentives are usually annual bonus schemes. Long-term incentive plans (LTIPs) use stock options and/or bonuses, merit pay, company-wide share plans, and the like.

Benefits include pensions to which the employer makes a contribution, private health plans, life insurance, and similar personal benefits. Perks are fringe benefits such as status cars, concierge services, use of company accommodation, etc. In most countries such perks are taxable as benefits in kind, although the package as a whole should be constructed to be as tax-effective as possible. Benefits may be flexible, so that individuals can choose a mix of benefits and perks within the agreed total value package. In some organizations there will also be the opportunity to sacrifice a proportion of salary for benefits.

Reward specialists structure executive reward packages taking into account the proportion of the base pay to variable pay available in the bonus opportunities, and typically they seek to balance the various elements in the package to drive the performance (both short and long term) required to achieve corporate objectives. The trend is toward variable pay based on performance being a high proportion of the total reward package, especially as managers become more senior. In this way senior managers take a larger risk with their rewards, since variable rewards are related more directly to the performance of the business in market conditions, which may vary for any number of reasons. Irrespective of these market conditions, directors and senior managers are accountable for profit, cost, and market share objectives.

LTIPs are normally constructed using bonus and stock option plans. Stock options give the right to purchase a defined quantity of stock at a stipulated price over a given period, according to predetermined eligibility requirements. There may be stock appreciation rights—the share award is triggered by increases in the share price, at a time chosen by the executive in the time period allowed.

Stock options have been popular as a way to retain key executives, to provide them with a stake in the company, and, at a time when share prices were rising, the opportunity to acquire real wealth. The change from a bull to a bear market has diminished enthusiasm for stock option schemes because the schemes depend on rising share prices so that executives can gain in wealth either by owning an appreciating asset, or by selling the shares and realizing the difference between the stipulated price (the strike price) and the enhanced market price.

Various performance conditions may be attached to the granting of a stock option or bonus. These include improvements in TSR, ROCE, EPS, and EBITDA (earnings before interest, taxation, depreciation, and amortization), usually in the corporate figures produced for the annual accounts. Table 1 is example from BP in 2007 to show how the package works.

Table 1. Example of a reward package: BP executive directors as at December 2007. (Source: IDS Executive Compensation Review April 2008, ECR 326, p. 12)Salary p.a.Annual bonusBenefitsPerformance sharesTotalChief executive£877,000£1,262,000£14,000Zero vested£2,153,000Chief finance officer£591,755£781,117£5,036Zero vested£1,377,908

There is an annual bonus scheme. Performance measures and targets were set at the beginning of the year. Bonus opportunities were: on target (120%), and maximum (150%), of salary. The remuneration committee can, in exceptional circumstances, increase these payments, or reduce them to zero if appropriate. Targets for 2007 and 2008 were: half of the bonus is based on financial measures (EBITDA, ROCE, and cash flow), the other half on nonfinancial measures and individual performance. Nonfinancial targets were safety and people (including values and culture); individual performance targets were results and leadership.

The LTIP had three elements: shares, stock options, and cash; up to 5.5 times salary could be awarded in performance shares. Performance measured in TSR was compared to other oil companies. Although in this particular case shares were not vested (i.e. not passed into the ownership of the executives for 2007, due to operational problems that affected performance compared to other oil companies), high performance in previous years had resulted in substantial numbers of shares being vested. This demonstrates how the package reflects performance.

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Further reading

Articles:

  • Balkin, D. B., and L. Gomez-Mejia, “Matching compensation and organizational strategies.” Strategic Management Journal 11:1 (1990): 153–169.
  • Cascio, Wayne F., and Peter Cappelli. “Lessons from the financial services crisis.” HR Magazine 54:1 (2009): 46–50.

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