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Remuneration Challenges

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The new executive remuneration paradigm

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Written by Diane Doubleday and Mark Hoble at Mercer   
Friday, 21 November 2008
This is a time for organisations to take a balanced approach to executive rewards.

As the global financial crisis unfolds, directors and senior management teams are trying to come to grips with the implications for their business strategy and for their employees.  

Governments are imposing restrictions on executive remuneration at financial institutions which benefit from rescue efforts, and these constraints may be a harbinger of future regulation of executive remuneration programmes, particularly in the US and Europe.

Shareholders are seizing the moment as well.  They are calling for constraints across industries, continuing their demands for pay for results and decrying pay for failure.

This is a time for organisations to take a balanced approach to executive rewards – one that recognises the external realities while continuing to support human capital strategy.  

The new paradigm:  balance executive remuneration programmes

The most effective executive remuneration programmes are designed to meet a range of objectives. Remuneration programmes must be competitive enough to attract and retain the right talent, and incentive plans must focus executives on the most critical priorities of the business.

The remuneration programmes must also be responsive to shareholder interests by providing a meaningful relationship between pay and shareholder value creation.  No matter how good your remuneration design, you will confront challenges from time to time.

However, a balanced programme will deliver balanced results, which means it will be much more effective at meeting the full range of objectives outlined above.
 
A well-balanced executive remuneration programme helps mitigate the biases in any single remuneration plan or measurement approach (see exhibit). “All or nothing” plans that evaluate results using only one or two performance metrics or hold executives to rigid performance criteria (e.g. absolute year over year improvement) fail to recognize the context in which performance occurs. Unexpected profit windfalls or a bull market can lead to overremuneration, while an industry downturn can result in remuneration outcomes that do not adequately recognize executive contributions.  
 
Meanwhile, too much emphasis on annual incentives or over reliance on highly leveraged equity vehicles, such as share options, can encourage excessive risk-taking. With the migration away from share options towards performance share plans, the time horizon for many executive remuneration programmemes has effectively shortened – to the detriment of executive focus on sustained, long-term value creation.   

Balance should always be a fundamental guiding principle when designing remuneration plans, but in a volatile market it is crucial.  While companies need to maintain a strong focus on their business objectives, there are numerous opportunities to improve the fairness, objectivity and effectiveness of remuneration delivery and performance measurement:
  • Performance Metrics – Choose metrics across your plans that provide a balanced picture of performance results and capture each of the following dimensions of performance to some degree: growth, profitability, efficiency or returns and shareholder experience (total shareholder returns over time).
  • Target setting – Revisit your target setting process to ensure that you incorporate a wide range of internal and external perspectives into the target setting process, from the annual budget and management estimates, to historical industry performance and macroeconomic indicators.
  • Measurement approach – Strive to use a mix of absolute and relative performance measures. Absolute measures enable the executive team to unite behind shared goals, while relative measures allow for a more objective assessment of performance by recognizing external conditions impacting your industry.
  • Vehicle selection – Use a blend of cash and equity remuneration, consider the weighting between both, and adopt a portfolio approach in granting annual equity awards. Different equity vehicles provide varying amounts of retention value and leverage and granting a mix of long-term incentives helps reduce the impact of market volatility and smooth wealth accumulation over time.  With the volatility in the equity markets and depressed share prices in many sectors, organisations will be particularly challenged to determine competitive and affordable equity grant levels.  
  • Time Horizon – Use a balance of short-term (1 year), mid-term (2-4years) and long-term (5+ years) remuneration elements. In particular, companies should look for ways to promote a longer view of performance. Companies can consider tactics such as deferring a portion of the annual bonus award into performance shares, implementing mandatory share holding requirements and adopting executive ownership guidelines to better align executive interests with long-term value creation.

Final thoughts

In times of uncertainty, it can be difficult not to take action, but the situation calls for a certain amount of restraint. Companies must take care not to overreact and mistakenly over deliver to executives to address retention concerns.

Today we have flexibility in designing incentive plans; if shareholders perceive that the pay-for-performance relationship is being abused, companies may find themselves facing concerted shareholder efforts to curb excessive executive remuneration.

Executive pay is going to be in the spotlight for the foreseeable future. Any action should be based on careful analysis and deliberation, and most importantly, the rationale behind the decisions must be able to be explained to a skeptical audience.  
 
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