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The fact is, an executive’s compensation is tied to what expertise they can bring to the table and reflect their investment in the business. And how can a company thrive and compete without a leader who is completely committed to the success of the organization?
The short answer – it can’t.
What Is Executive Compensation?
Executive compensation refers to a comprehensive compensation package offered to executives to drive their own performance as well as that of the organization. It may include pay, incentives, stock options, perks and benefits, bonuses, retirement plans, and other rewards.
The factors that drive components of the plan should be aligned with company performance and include the firm’s strategic objectives, ability to attract and retain talent, ownership structure, culture, corporate governance, and cash flow.
How Executives are Compensated Differently from Other Employees
Executives have a more complex compensation package than other employees. They typically receive a higher level of pay and benefits that aligns with their significantly higher responsibility and accountability for overall company performance and to internal and external stakeholders.
Why It’s Important to Get it Right
Executive compensation for most types of companies have high visibility, and failure to structure packages correctly can have numerous negative results.
When it comes to executive compensation, the Harvard Business Review advises that the focus should not be on how much is paid but how it is paid. The authors caution that for too many organizations executive compensation is determined independently of their performance.
Companies that get it right make the connection between the how and the amount, structuring compensation to ensure that business objectives are met or exceeded.
In addition, there are multiple factors that must be considered when creating an executive compensation plan. It’s important to understand the role that each of these variables plays in attracting, compensating, and retaining the best executive for your organization.
- Retention – It’s critical to retain top executives to maintain stability and ensure profitability.
- Public sentiment – Executive compensation packages are often visible and scrutinized by a number of interested parties.
- Regulatory – Publicly traded companies have oversight by governmental regulations.
- Board of Directors – Boards may have concerns about their role in the approval of compensation packages.
- Shareholder returns – A poorly executed plan is likely to result in unfavorable results for shareholders.
- Failure to perform – Executive compensation is multi-layered. As the HBR study points out, If the right checks and balances are not in place, an executive can potentially continue to receive compensation for poor performance, even after leaving the role.
Types of Executive Compensation
Executive compensation will always be based on the needs of the organization and expertise of a potential executive hire. That said, packages should be constructed in a way that will drive results.
The Harvard Business Review suggests that modern compensation packages that drive performance are based on the following four dimensions. Your pay strategy may include variations on these dimensions but they are the most common types of executive compensation structures.
- Fixed vs. variable. A fixed strategy represents a specific salary amount. Variable or discretionary pay may be based on metrics, such as company performance. Variable pay can be a strong motivator for positive performance.
- Short term vs. long term goals. You may elect to include one or both of these dimensions into your plan, depending on business objectives, competition, and other variables. Short-term goals may be reviewed at short intervals such as weekly, monthly, or quarterly. Long-term goals consider future objectives and external forces over a period of three or more years.
- Cash vs. equity. Plans may also include one or both of these structures. Executives may only receive direct compensation. While a high salary is attractive, it doesn’t necessarily provide strong incentives to exceed. Conversely, including equity in the company serves as a strong motivator for the executive to ensure that the company continues to be high-performing. It also ensures that the executive remains with the company as long as possible.
- Individual vs. group. Individual pay is tied only to the executive’s performance which should be sufficient to ensure a high level of performance. But the thought process is that if the overall performance is not acceptable, the executive can point to things outside of their control. With group incentives, the theory is that the executive is responsible for the performance of their teams so using this type of pay ensures that the executive is managing their team’s performance as well as their own.
SHRM (Society for Human Resource Management) further breaks down the design of executive compensation into the following most common categories.
This typically refers to the actual annualized pay before incentives are calculated. The amount of the base salary may be determined through market trends but is also heavily influenced by sales revenues, assets, industry type, and other factors.
Annual incentives and bonuses
Pay-for-performance plans align incentives with executive performance which reflects on company performance.
Long term incentives
These incentives are generally structured to be measured over a period of three or more years which provides built-in retention and a higher probability of the desired performance in order to receive them.
Stock plans can be significant incentives for executives to ensure the highest level of performance for the organization.
Perks, benefits, and plans
Among other things, perks may include additional benefit plans or contributions, company cars, technology resources, vacations, and access to executive memberships or clubs. Some perks may be taxable to the executive, so it’s important to structure it correctly to avoid a loss of compensation as a result.
Enhanced retirement plans can be paid to executives or highly paid individuals that are exempt from certain regulations.
Deferred compensation provides a way for highly paid executives to defer the tax liability until a future date.
Even though there are numerous variables that can be included in your plan, the best plan design is the one that most closely meets the needs and objectives of your company.
How to Design a Great Executive Compensation Plan
An executive compensation design plan can be complex but it doesn’t have to be difficult when done correctly.
One key to success will be to consider how various factors will influence a plan’s design. These may include:
- Life cycle stage of the organization (startup, growth, maturity, renewal/decline)
- Type of industry
- Structure (for profit, non-profit, etc.)
- Size and revenue
- Regulatory requirements
The plan will be most successful if it is designed specifically for the unique factors of your company. Indeed, executive compensation plans for small, non-profit organizations will differ from those for public companies.
Taking the time to create an organized, understandable, and equitable executive compensation plan ensures success for both the executive and the organization.
Review the following steps to ensure that you have all of the information you’ll need to build a great executive compensation plan.
Step 1: Identify Goals
Identify the organization’s strategic goals and align them with the compensation plan as you design it.
Step 2: Benchmarking
Benchmarking executive compensation plans is an option if you can find relevant data. But comparing executive compensation plans is a bit different than benchmarking for other positions. Remember that executives are paid differently than other employees. Compensation specifics vary widely according to the organization’s life cycle stage, revenues, regulations, etc.
One size definitely will not fit all in the case of executive compensation. You may want to consult with someone who specializes in executive compensation plans.
Step 3: Involve Stakeholders
If your company is a non-profit, you may need to involve the board of directors, or they may even determine the compensation plan. Some organizations have a compensation committee that will determine what should be included in the plan.
In some cases, companies may be required to follow Say on Pay (Dodd-Frank Act) rules that enable shareholders to have input into executive compensation.
Step 4: Determine Eligibility
Determine who is eligible for the plan. It is generally senior leadership, highly compensated individuals, or C-suite (CEO, COO, etc.).
Step 5: Create the Compensation Mix
Identify the desired components of the plan including pay, bonuses, perks and the method as outlined above.
Step 6: Finalize and Communicate
Seek feedback and approval from appropriate parties. Document it and communicate it to appropriate parties.
Your plan is ready to implement! Remember that it’s a dynamic initiative that should be reviewed and adjusted regularly to continue meeting your company objectives over time.
Congratulations on implementing a strategic initiative that will have beneficial results for your organization now and in the future!
Tips for Negotiating with a Candidate for an Executive Position
Even after you’ve created an air-tight plan, you may still receive a counteroffer from a candidate. Review their objectives against your plan and organization’s strategic goals to ensure your offer is comprehensive and considers the total value that they bring to the role. This can include underrepresented categories in your organization, specialized skills, organizational cultural fit, reputation, or other factors.
Determine what the candidate really wants and, if possible, add in enhancements or perks as necessary that are allowable under the plan and still align with your plan goals.
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