Executive Rewards: Ensuring That Financial Rewards Match Performance

Executive Summary

• Executive pay is used to attract and retain executives, and to drive performance.

• Business strategy objectives are cascaded down the organization and used as performance targets for the variable element in the reward package, in order to provide a clear line of sight.

• Reward packages for executive pay include base pay, short-term incentives, benefits, long-term incentives, and perks. Base pay is determined by the market rate in similar organizations.

• Variable pay incentives usually take the form of an annual bonus scheme, or, in the case of long-term incentives, deferred bonus and/or stock option plans.

• Reward packages are decided by remuneration committees as an important aspect of good corporate governance; the decisions are made by nonexecutive directors, with transparent reporting in annual reports. In the United Kingdom stockholders vote on the report.

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Introduction

Effective management of executive rewards resides at the heart of a network of pressures and issues of central relevance to the management of organizational performance. These pressures can be represented diagrammatically to show how stockholder interests and corporate governance issues impact on business performance, objective setting, the motivation of executives, and the position of the organization as an employer in specific labor markets; and how all of these are affected by corporate values/culture and vision (Figure 1).

Figure 1. Reward at the centre of internal and external pressures

However, the economic events of 2008 have reminded us all that these issues are conditioned by the broader economic climate in which corporations operate, where survival is more risky and uncertain irrespective of size, sector, or ownership structure. The rapid disappearance of banks such as Lehman Brothers, the exposure of massive manufacturers such as General Motors, Chrysler, and Ford to recessionary problems, the collapse of house prices, of normal financial processes, and of currencies means that organizations are facing a strategic inflection point, which is affecting all aspects of reward. The topic of executive rewards must be seen as a dynamic field, and this caveat informs all that follows. Nevertheless, there are systematic and enduring influences in the linkages between reward and performance.

We will examine rewards to show the major impact of reward policies and practices on organizational performance. This article takes rewards from the organizational perspective, and the starting point is an examination of the significance of corporate values, vision, and the culture of rewards.

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Corporate Values/Culture/Vision

Corporate values and vision statements are an explicit expression of the formal values and vision of the organization, including the sometimes implicitly preferred behaviors and attitudes of managers in their leadership roles. These values may be published but, if not explicitly stated, will still emerge in the actions of senior managers and the founders. The objectives of a reward policy can be summarized as:

• Building stockholder value (or sustaining value for the citizen in the public sector).

• Being competitive in the recruitment of executives.

• Motivating and retaining executives.

• Being cost-effective.

• Being seen as fair by employees.

• Providing a degree of security for employees.

How these objectives are interpreted in any organization is contingent on that organization’s values and the nature of its objectives—for example, profit maximization, market share, and service provision.

A number of authors have suggested that there are specific best practices to drive a philosophy of rewards that will support the corporate vision. For example The New Pay, by Schuster and Zingheim (1996), was a reward ideology that emphasized the strategic role of rewards and the supremacy of the marketplace. Key features of The New Pay were:

• Emphasis on external market-sensitive pay rather than annual increases.

• Risk-sharing partnership with employees rather than entitlements.

• Variable, performance-based pay.

• Flexibility in pay systems.

• Lateral promotions rather than career paths.

• Employability, not job security.

Later, the same authors argued that there are general reward principles that include aligning rewards with business goals; extending the “line of sight” of all employees to see the relationship between individual performance, corporate performance, and their rewards; and recognizing the market value of the individual with base pay, while rewarding results with variable pay (Zingheim and Schuster, 2000).

These ideas have gained currency over the last 20 years. Even though the economic storm now raging across the globe challenges some of this received wisdom, the ideas remain consistent with the prevailing concepts of market capitalism.

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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).

Figure 2. Linkages between objectives and rewards

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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Corporate Governance Issues

Reward for Failure

Much attention has been paid to excessive pay increases and bonuses for senior executives, especially where these appear to be awarded regardless of the corporate performance achieved.

Criticism of directors for receiving massive bonus and termination payments typically happens when there seems to be an element of reward for failure. UK directors in the FTSE 100 companies are paid more than in the rest of the FTSE companies, but they do not receive the massive sums seen in Fortune 500 companies in the United States. There is a tradition of higher rewards in financial services. A big bonus culture existed in financial services among those dealing in the markets, as well as in the boardroom. Whether this was a cause of the recession is not yet clear, but it may have increased the propensity of managers and traders to take higher risks.

For most directors in the United Kingdom, pay and bonus awards were marginally reduced in the period from 2003. There are a number of possible reasons. Some companies have reduced notice periods for chief executives to around 12 months, which has encouraged more reasonable termination payments. Stockholder activism among both institutional stockholders, such as the Association of British Insurers, and small stockholder groups means that stockholders are likely to be consulted before new schemes are introduced. The court of public opinion is assisted by a vigilant press and the transparency rules. Accounting rules are now generally applied that require the cost of stock options and LTIPs to be fully expensed in the accounts. Increased volatility in share prices and the massive fall from the last quarter of 2008 onward have made stock options much less attractive, so there is less likelihood of big payouts at a later time when the executive cashes in the shares.

Base pay and total rewards are typically decided according to the market capitalization, the total number of employees, and the financial turnover of a business with respect to its industry comparators, but they are also, of course, contractually negotiated. Pressure from institutional investors and the press/media has created interest among the general public in this area, fueled by a number of high-profile cases where corporate failure has not been reflected in reductions in bonus or reward. As a consequence, director-level rewards are now very highly regulated and scrutinized compared to other employee groups.

Remuneration Committees

There is a convergence in corporate governance arrangements, based on the principles of transparency, the need to justify pay awards, the independent judgments of a remuneration committee, an accent on the process rather than on the content of rewards, and compliance with the rules as a condition of being listed on the appropriate stock exchange. Some of these principles were found in the original voluntary rules of the stock exchanges (for example in the Combined Code of the London Stock Exchange). Statutory provision has reinforced these rules—Directors’ Remuneration Report Regulations 2002 (UK), Sarbanes–Oxley 2002 (US), SEC rules (US), NRE Act 2001 (France), and in Germany, the Cromme Code (2002). The UK regulations of 2002 require listed companies to have a remuneration committee of independent (nonexecutive) directors, which must produce and publish a report as part of the annual company report. This must include a statement of reward policy, the role of the remuneration committee, proposals for directors’ pay going forward, and must include a graph showing comparisons in terms of TSR with a named broad equity index over the previous five years, stating the reasons for selecting the index. Stockholders must be given the opportunity to vote on the remuneration committee report at the AGM. The stockholders’ vote is not binding, but it would be unusual for a company and CEO to implement a pay award to the directors if this was voted down.

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Making It Happen

• Effective reward policies for senior managers and directors can only be created if there is a clear line of sight between their performance goals and the business objectives. This requires:

• strategic planning and accurate budgeting;

• clear accountabilities, cascaded down the business;

• realistic, measurable, demanding performance targets for the short and long term.

• Job evaluation techniques such as the Hay system can help to review accountabilities systematically.

• Base pay should be decided from market data on rates, with comparator organizations in the same industry sector that have similar market capitalization and employee numbers.

• Variable pay is used to recognize and drive performance. Short-term performance will need bonus schemes to be designed with annual performance targets, and there are design decisions to be made about whether there should be a threshold performance level, any weighting on particular targets, etc. Bonus is normally a percentage of base pay (typically 20%–40%). Long-term incentives might include a deferred bonus paid out after two or three years, with further performance conditions attached, and/or stock option schemes.

• Decisions on rewards are made by remuneration committees for director-level pay in quoted companies, with annual public reporting and stockholder involvement.

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