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Right Reward for Right Performance

Aligning Executive Compensation with Good Governance
Dr. Yılmaz Argüden1

“Price is what you pay.
Value is what you get.”
Warren Buffet

Executive Summary

Establishing the right executive compensation system, choosing the key performance indicators, establishing thresholds, targets, and maximums, and making fair judgements of management’s performance are among the key challenges of boards of directors.

Attracting, retaining, and motivating a strong and effective executive team is critical for the success of the corporation. A key tool in doing so is the executive compensation system. This paper is intended to summarize the key decision parameters in establishing an appropriate executive compensation system, to provide guidance on how to set the targets for the system and how to evaluate performance. It also provides examples of key issues to consider in setting the executive compensation based on the characteristics of different industries and companies.

Introduction2

Boards have the basic responsibility to ensure sustainable improvements in shareholder value by providing strategic guidance and oversight regarding management decisions. In doing so, one of the most important decisions for the boards is the choice of the executive team as well as keeping their motivation and aligning their interests with long term value creation for the firm. Therefore, attracting the right people for key executive positions, making the right choice among the potential candidates; evaluating and rewarding their performance, and making changes to the management team whenever necessary are key board responsibilities.

The importance of selecting the team and clearly outlining what the board wants them to do is usually overlooked except in the recruitment phase. Yet, it continues to be important throughout their employment and forms the basis of the ‘business case’ which should be under continuous review. The key questions that need to be revisited regularly are: (i) Why do we pay?; (ii) How much do we pay?; and (iii) How do we pay?

Just like the players in a sports team, the members of the management team have to be measured against the targeted goals for the company and the composition of the team has to be evaluated against the new season’s targets. They need to be paid for their potential contribution to the team’s success and rewarded for performance3.

The answers to the ‘How much to pay?’ question depends on the talent market the company operates in, the positioning the board wishes to choose, their willingness to differentiate between people/roles/functions/geographies, and the role that reward plays in the overall employment proposition for executives.

A key function of boards of directors is to ensure that the risks taken by management on behalf of the shareholders are consistent and balanced, and that they have high likelihood of value creation4. For sustainable performance, a board has to ensure that a fine balance is realized among the following:

  • risk and reward,
  • short term and long term interests of various stakeholders,
  • ethical considerations and market practices, and
  • providing effective oversight versus motivating management to assume calculated risks for value creation.

To achieve balance in these areas, an organization needs an effective process for challenging management decisions, particularly those involving strategic choices that inherently involve risk taking. Successful boards of directors should not only watch out for the right balance in these dimensions, but also establish executive compensation systems that are aligned with company’s strategic thrust and minimizes potential self interested behavior (‘agency’ risks).

The tone at the top determines the tune in the middle. In particular, clear separation of management rights (taking initiative and implementation) and governance rights (guidance, approval, and oversight), is critical in minimizing potential ‘agency’ risks of the management such as:

  • fraud
  • cronyism, building a personal fiefdom with company resources
  • lethargy, focusing on excuses as opposed to delivering results
  • being too risk averse that may lead to overinvestment or opportunity costs
  • being too risk prone that may lead to betting the company

There are two important dictums in establishing a good compensation policy: (i) What gets measured, gets improved and (ii) What is rewarded is what you get. Therefore, compensation plans for the top executives are key tools for improving company performance.

Pay for performance is a goal embraced by boards. However, good intentions do not suffice. Measuring performance, matching rewards with performance, and aligning them with the complexities of multiplicity of goals for sustainable success is a tough task. This paper outlines an approach to make the appropriate judgments in establishing and managing an executive compensation plan, such a central function for the boards.

A good executive compensation plan should follow the following principles:

  • Clear, straight forward, fair, and competitive
  • Fits with the industry specific conditions as well as company specific strategy
  • Balanced with respect to key risks
  • Protects against potential ‘agency’ risks
  • Aligned with the boards best judgments about the key objectives for the company

Establishing the Structure of an Executive Compensation Plan

The structure of the compensation system has to be prepared by the compensation committee of the board (composed of independent board members) with help from independent outside advisors (free from conflict of interest) and approved by the board5.

First, an appropriate structure for the executive compensation plan has to be established based on the industry and company characteristics. Same structure does not fit all. The structure of an executive compensation plan should deal with the following decisions:

  • What portion of the executives’ compensation will be performance based?
  • What would be the incentive time horizon (vesting and disbursement timing of performance based compensation)?
  • How would the company’s risk profile influence both the choice of Key Performance Indicators (KPIs), and the structure of the plan?
  • How would availability of talent influence decision making on compensation plans?

The key elements of an executive compensation plan structure are (i) fixed vs. variable, (ii) short term vs. long term, (iii) cash vs. equity, (iv) pay vs. benefits, (v) vesting, deferral, and claw-backs, and (vi) severance pay, insurance, and indemnifications. These elements of the compensation package has to be aligned with the crucial areas of business performance both in terms of time horizon, as well as with the company’s risk profile based on its strategy, stage of business life cycle, financial structure, and available talent pool.

A key dimension of decision making on executive compensation is the proportion of compensation that will be at risk (defined as Variable Pay / Fixed Pay). Generally as the level of the executive gets higher, the proportion of compensation at risk increases as well to reflect the impact of his/her decisions on business performance. Start-up and growth companies tend to have higher proportion of compensation at risk than companies in mature or declining industries.

For example, a start-up company is likely to be more conservative with regards to salary, annual bonus, and benefits, but more generous with respect to long term incentives and equity participation. A growth company is likely to be more aggressive with respect to compensation at risk by giving a higher weighting to variable pay (annual and long term) elements.

Compensation at risk also increases with the potential contribution of the executives to business results. This is the reason why partnerships are prevalent in industries where human capital is the most important asset of a company, such as legal firms, consulting firms, and investment banking.

Another decision element with respect to compensation at risk would be the incentive time horizon (defined as Long Term Incentives / Annual Bonuses). The nature of the business and the incentive time horizon should be aligned. The executive compensation plan of a bank focusing on project finance or an insurance firm would probably require more emphasis on longer term incentives than a retailer or a fast moving consumer goods company. Nevertheless, every business has both short term and long term goals and the decisions of key executives influence their realizations. Hence, a balanced compensation plan should have both short and long term incentives. Not only major investments that have long lead time to materialize, but also issues such as market development, brand development, product innovation pipeline, talent development tend to have longer term perspectives. Therefore, the long term element of compensation systems should focus on strategic objectives that would materialize in multi-year periods.

Compensation philosophy of a company should also take into account the risk profile of the business. Businesses that work in a highly risky environment such as politically risky geographies, or fast changing technologies, or uncertain outcome of a mega project that could have serious detrimental effects on the company, or a high interest rate environment should lead the company to be more conservative in terms of its financial structure and assume less debt. Therefore, the compensation metrics for the executives of such companies should be different than those of mature businesses in more stable environments. For example, a business with high growth potential is less likely to focus on net cash generation than a highly indebted business facing difficult market conditions. Similarly, changing economic conditions may dictate different focus. One may give more emphasis on growth under a positive economic scenario, whereas focus may shift to reducing indebtedness levels under tight credit conditions. If the return on investment (ROI) for the company is higher than the weighted average cost of capital (WACC), then growth could be the focus of performance pay, otherwise improving returns may get the priority.

A key concept in establishing a compensation structure is to ensure that the compensation plan is risk adjusted. According to Richard W. Leblanc6, there are two main time frames and four types of approaches to align compensation with risk: before and after compensation accrues or awarded; and quantitative, qualitative, explicit and implicit approaches. Vesting period for long term incentives has to be aligned with the timing of potential realization of outcomes and risks for key management choices. Utilizing risk-adjusted-rate-of-return targets would be an ex-ante, quantitative risk adjustment. Especially in cases where potential realization of risks is likely to take a longer time frame, claw-back clauses (an ex-post explicit risk adjustment mechanism) are utilized to allow for appropriate ex-post evaluation of performance. Three of the risk management tools that are utilized frequently are: (i) deferral of incentive awards, (ii) upfront establishment of caps, and (iii) having claw-back provisions, especially for re-instatement of financials.

Another element of the compensation philosophy that needs to be decided is the need and availability of talent for the company. When talent is widely available the compensation levels need not be so aggressive. Whereas a high growth company, that needs to attract more new talent in an environment where it is difficult to find talent, has to be more aggressive with its compensation levels. In identifying competition for talent, boards need to take a broad perspective as competition for talent may involve not only the competitors within the industry, but also from other industries and geographies that may have skills gaps.

A critical area that is often not considered in detail relates to the termination agreements, change of control agreements, notice periods, and severance pay. They don’t need to be reviewed every year like ongoing pay, but they can cause big problems if poorly designed. Just like the marriage contracts these may be difficult to negotiate at the time of recruitment, but lack of attention to the clauses of such agreements could cause serious problems at the time of divorce.

So, the first conclusion is that one size does not fit all and each company should establish its own compensation philosophy and structure based on its own situation. Utilizing external independent compensation advisors to identify developing market practices, benchmarks, and to provide an independent test of the compensation structure and parameters would be advisable.

Identifying Key Performance Indicators

Once the key pillars of the compensation system are determined, the next issue to tackle is to identify the key priorities for the corporation and the parameters with which performance would be measured. There should be a limited number of parameters balancing each other. Multiplicity of goals is both a reflection of balancing the business needs, such as short term performance and sustainability; as well as to need to prevent gaming by the management.

A single goal such as share price would be open to influences such as general economic developments that may not be controllable by the management. Therefore, preference should be on relative performance rather than absolute measures. Unfortunately however, there are difficulties with relative measures as well: such as leading the management to a ‘herd mentality’ during sector wide euphoria or leading to increasing rewards during a downturn in performance, just because relative performance is good. Therefore, relative measures, too, should be balanced with absolute metrics7. Also, paying attention not only to absolute metrics, but also trends in performance metrics is valuable, especially when the board discretion is to be utilized.

Generally it is advisable to include both strategic as well as operational goals among the performance targets8. Similarly, making sure that a balance is established with regards to short term and long term goals is important. Especially for the long term goals establishing targets for improving quality of inputs for the shorter term may be an appropriate mechanism to ensure good outputs in the longer term.

Hence, second step in making the compensation system work is establishing the priorities for the business and choosing the performance parameters. There are four key issues regarding the choice of performance parameters: (i) they should be aligned with the strategic thrust of the company, (ii) they should reflect the risk appetite of the board, (iii) they should include lead indicators that may even be qualitative to make sure that what the board deems important for the future of the company is encompassed within the compensation plan, and (iv) they should be balanced.

What you measure is what you get.9 Therefore, focusing solely on the results and not enough on the way the results are achieved may lead the management to expose to company to too much risk. Therefore, boards should be careful in establishing the right performance parameters to avoid giving such perverted incentives.

One issue that the boards should be aware of is that the information presented to them is generally based on past performance and performance indicators that are easier to measure get precedence. Yet, most of the board decisions are made for the future. Focusing only on financials and not much on strategic objectives would be like driving a car by just looking on the rear mirror as financials are mostly result of previous strategic decisions such as location of the production facility, labor-capital intensity, degree to which a company shares its intellectual capital through licensing. Therefore, it is critical to include lead indicators and strategic objectives among the performance parameters to ensure sustainability of value creation in the future.

Companies who do not pay sufficient attention to lead indicators generally do not realize serious problems until after it becomes too late. Therefore, management and boards should pay attention to lead indicators just as carefully as the business results. For example, a decline in customer satisfaction today, may be an indicator for decline in profits in the future. A decline in market share in a particular niche may be an indicator of diminishing innovation capability of the company.

Customer complaints are also an important lead indicator. Failing to learn from them, may cause bigger problems in the future. Focusing only on results and not paying sufficient attention to organizational, process, and infrastructural developments may result in repetition of mistakes. Therefore, customer complaints should not only be dealt with swiftly to increase customer satisfaction, but also used to identify and remedy root causes potential emerging issues.

The onset of problems in most corporations is due to not being perceptive to change. For example, Xerox who failed to realize the importance of its own innovations missed a significant opportunity in the personal computer revolution. Therefore, indicators such as the proportion of income coming from products/services introduce in the last few years should be watched carefully.

Similarly, performance at new markets should also receive special attention. When boards do not fully understand the competitive dynamics of a new market, errors of judgment about too much or too little investment could be made easily.

Understanding the source of increasing or decreasing profits and variance analyses with the past performance or budgets are also key to identify potential problems. For example, if a significant part of a financial institution’s profit comes from trading activities, the board should make itself comfortable about the trading risks the company assumes. Similarly, if the source of profits is the value increase in inventories, due to events such as commodity price increases, the company should be financially prepared for the reverse trends. Otherwise, as the market trends turn the whole institution may be at risk.

The second conclusion regarding establishing the right reward for the right performance is to identify the key performance areas upfront and make sure that they are balanced with respect to strategic – operational, short term – long term, risk – reward, top line – bottom line, and financial – sustainability metrics.

Setting Targets and Thresholds

The third step in establishing an appropriate executive compensation plan is to set the targets for the prioritized key performance indicators. These targets should be benchmarked for relativity with peers and realized past performance, and expectations about them should be communicated to the management prior to the performance evaluation period.

Establishing thresholds, targets, and maximums for the short term and long term incentive plans is a critical step in compensation management10. If the metrics are set too low incentive plans become deferred compensation rather than a real incentive plan. By the same token if they are unreasonably high given the expected market conditions, they do not incentivize the management. Therefore, it is critical to compare them with previous years’ performance and benchmarks in the industry to ensure having sufficiently stretch, but attainable targets.

This is easier said than done11. Therefore, it requires time investment and ability to exercise judgment. In order to tie performance to reward and be fair in doing so both for the management team as well as for the shareholders, the boards would have to consider numerous scenarios up front. This dimension of establishing a good reward system is often ignored and causes ex-post dissatisfaction by either the management team or the shareholders, or even the public at large.

One of the best means of evaluating performance in an uncertain environment is to compare performance with the peers. Therefore, the first step is to identify the right peer group up front. This step requires not only making judgments about key competitors, but also having an understanding of the strategy and positioning of the companies in the peer group. In establishing the performance targets utilizing performance relative to this peer group would not only provide self control mechanisms for the changes in environmental conditions, but also reflect the competitive nature of the business environment. Yet, as stated earlier, there has to be a balance between relative measures and absolute metrics.

Second step in linking performance with rewards is to conduct stress tests up front: What would be the results of the established system be if the performance is widely off the mark due to uncontrollable situations? Would the board have to make adjustments to be able to keep the management team? Or if the performance turns out to be stellar would the rewards be reasonable? What if the stellar results were due to the market conditions rather than the management’s actions and they are behind the competitors’ results? How would risk adjustments to the performance be conducted? Are there limits to lowest and highest rewards (payout caps) and if so are they reasonable or would they invite gaming, such as delaying some sales for the next year to smooth the performance history or pre-booking them for the current year’s bonuses? What kind of commitments the reward system would result in if the board decides to change the management? Unless these and similar questions are answered up front, the boards may be faced with difficult decisions that may hurt their credibility in the eyes of some of the stakeholders.

Therefore, the third conclusion is: in linking performance to reward it is important for the boards to look at both the relative performance, as well as the absolute performance in comparison to the performance of the companies in the peer group. The boards would also have to make sure that stress tests are conducted and limits to performance parameters are established to ensure fairness for all stakeholders. Comparing the executive compensation growth with total shareholder returns would also be a good test.

In short, four key issues to focus for a good executive compensation plan are: (i) to have a limited number of objectives, (ii) to have balance among the objectives (short-term vs. long-term, strategic vs. operational, risk vs. reward, top line vs. bottom line, financial vs. sustainability metrics) (iii) to establish SMART (Specific, measurable, achievable, results oriented, and time bound) performance indicators regarding the key objectives, and (iv) to establish stretch goals and thresholds on each of these dimensions, taking into account previous realizations, benchmarks, and prevailing market conditions.

Judging Performance

The final step is to make a judgment about the performance at the end of the period. It is not recommended to have fixed formulas for success, but rather to identify a few, balanced, specific objectives upfront. Then the boards should not shy away from exercising judgment on the performance of the company to determine how well the management is doing on a regular basis. Mathematical formulas are no substitute for exercising keen judgment of business performance by the boards, taking into account the changes in the controllable and uncontrollable parameters of the environment and the performance of the key competitors. Therefore, even when a formula for success is set up front, part of the incentive compensation should be at the discretion of the board to allow for making necessary adjustments based on their business judgments.

However, discretion requires trust, both internally with executives and externally with shareholders. This trust can be enhanced where the use of discretion is well-understood and potentially sign posted upfront. Therefore, how the board is likely to exercise the judgments should be clearly communicated to the management not only in the end, but also in interim evaluations to ensure that clear expectations are set and ample time is allowed for the management team to deliver on those expectations.

The board should also be aware of the fact that performance evaluation is a repetitive game where both the board and the management learn from previous periods’ communications. Therefore, demonstrating that negative discretion could indeed be exercised when there is a performance deficiency and positive discretion when there is stellar performance builds credibility to the process for future years as well. Before making discretionary judgments about the performance the boards should also look into the developments in total shareholder returns and change in overall risks for the corporation. Such an approach would also help in disclosure of executive compensation and gaining the confidence of the shareholders and third parties.

Therefore, the fourth and final conclusion is that performance needs to be evaluated by the board based on their business acumen and judgment based on the original objectives. Performance evaluation cannot be delegated to mathematical formulas, although such measures may be utilized as key inputs in making such judgments. Exercising discretion is a key board responsibility that should receive sufficient focus and attention.

Key Questions & Relevance for Different Industries

In order to excel in implementing the art of executive compensation, the board needs to really understand the business and strategy of the company, its environment, and success factors and continually revisit this understanding and adequacy of the executive team for implementing the strategy of the company. Let’s try to cover how to handle the three key questions for executive compensation:

WHY DO WE PAY? :

Companies need capable executives who continuously come up with new initiatives to deliver shareholder value and deliver on the execution of those initiatives that are approved by the board. Attracting, motivating, and retaining a capable executive team requires competitive compensation to be provided for them. Experience and past performance are often utilized as lead indicators of future success. A successful manager, who does the job right (manages a function or task well), need not be a good a leader, who does the right job (takes the initiative in deciding what to do.) But generally, as the CEO is responsible for implementation, he should be both a good manager and a good leader. Yet what I have often observed is that boards often fail to evaluate the relevance of experience and past performance properly.

For example, a successful executive at a large multinational does not necessarily make a successful executive at a family owned local firm. As the success at the multinational may be predicated on the available corporate infrastructure and ability to focus on a single dimension of management such as marketing, whereas the need for the local firm, regardless of the similarity of the industry, may be to establish management systems and processes which requires a totally different skill set.

Therefore, the first step in identifying the right executive team is not related to the team itself, but to the strategy (lowest cost, differentiation, focus); stage of business life cycle (start-up, growth, maturity, declining); financial structure (capital adequacy, indebtedness, cash position, forthcoming investment requirements), and risk profile (risk philosophy, risk capacity, risk appetite, and risk tolerance) of the company.

The second step is matching the experience and skills of the potential executive team with the key challenges of the company based on its strategy, stage, financial structure and risk profile to ensure that the management team can handle them.

For example, a company selecting a differentiation strategy needs to focus on continuous innovation and good marketing skills to communicate the differentiation; whereas, a company selecting a low cost strategy needs to focus on operational excellence and cost controls. Therefore, the executive team to lead the company has to have the right skills for delivering on that company’s strategy.

In answering the ‘Why do we pay?’ question, the boards need to focus on not only the relevant skill set required for the leadership of the organization, but also on the leadership styles. The key is the consistency of the leadership style with the strategy of the company. This is an area that is often missed by the boards.

For example, the leadership style required in a military organization would differ significantly from the leadership style likely to succeed in a design center. Similarly, the leadership skills required at startup may differ from those needed at maturity. Thus, identifying the dimensions of leadership styles and the choices in each dimension can well be useful in identifying the right leadership at the right time for the organization.

The first dimension of leadership style is how to decide on the strategic direction. The boards need to decide upfront what kind of a leader would best deliver the results for the company. For example, while a visionary leader would motivate the organization around a vision which is innovative and exciting for the organization (e.g. Steve Jobs); an authoritative leader would be focused on calling all the decisions and being involved in planning and implementing the details of the decisions. An authoritative leadership may be more appropriate when significant resources are needed to implement key decisions.

On the other hand, participative leadership may be more appropriate for organizations that need numerous decisions to respond to market and customer trends. Such organizations tend to prefer distributed decision-making. Open communication, experimentation, and empowerment are critical for success in this type of leadership.

The second dimension of leadership is corporate values and culture. Once again the fit of the top executive with the corporate culture and values is critical for success. An organization that flourishes with entrepreneurship and innovation (e.g. 3M) would better be led by a leader that encourages initiative-taking and promotes creativity. An organization that needs teamwork for success needs a leader that promotes transparency, mutual trust, and joint work. Stars with high egos do not necessarily perform well in this kind of an environment. On the other hand, in environments where individual talent is critical for success, such as investment banks, the leader needs to be able to handle a high-stress environment where there is strong competition between employees for better performance. Finally, in environments where operational excellence and discipline is needed a leader who pays consistent attention to detail and continuous improvement would be preferable . Toyota may be a good example.

The third dimension of leadership relates to accountability and controls. Especially when it is difficult to measure the relationship between inputs and outputs, as in creative jobs (e.g. high tech companies), professional and ethical standards and values are the primary tools for establishing the corporate culture . When multiple decisions, each of which involves limited resource allocations, such as establishing customer contact points, are critical for the success of the corporation, financial results provide the best control mechanism. The choice of McDonalds locations may be an example of this approach and it is easier for the board to delegate the investment decisions to local managers and review the financial results rather than trying to centralize decision making on this issue. For companies involved in mass production where continuous process improvement is important for business success, an operational focus approach would be preferred. Key performance indicators, and responsibility and authority charts, have to be developed to monitor developments closely. When a company’s strategic position is handicapped, the focus tends to be on operational excellence.

The fourth dimension of management style is how to develop competencies. There are four different approaches to this issue: Process-oriented development of intellectual capital: Systems are more important than individual competencies. For example, establishing a CRM system takes precedence over developing individual sales competencies; rotations and multiple interfaces with customers’ decision-makers are common. Promoting from within: Employee loyalty is promoted. On-the-job training and employee development programs receive primary focus. Annual performance reviews place particular emphasis on skills development initiatives. Leaders with high people development focus are needed for this approach. Hiring the best: The key feature is keeping an eye open for the best performers in the industry and providing attractive compensation packages so as to be the employer of choice. This approach is seen most widely in fast-growing companies, where it is difficult to match the speed of people development with the growth of the company. Outsourcing or business partnerships: This approach is applied not only for non-core activities, but also for core activities where managing a network of highly capable individuals is preferred to hiring them. It is preferred especially in highly creative industries. One example would be utilizing a network of designers.

The fifth dimension of management style is relationship management. The key relationship area to focus is different for different industries and companies. For example, when the most important relationship is with customers and distribution channels, customer representatives tend to be key employees, whereas when productivity is the key, systems engineers and quality people tend to be more important. People management becomes the key success factor in highly service dependent industries. When there are very few key competitors in an industry, the key to success is to follow the moves of competitors very closely and devise tactics to counter them. Competitive intelligence and relationships with competitors become the key relations to manage. On the other hand, distributors of international brands or local joint venture partners of global firms need to be able to manage the relationships with key business partners and networks. This kind of relationship management requires a different approach than managing key employees or competitors. Particularly in industries such as energy, and telecommunications, the key relationship to manage is the regulatory agency relationships. Managing this kind of a relationship requires more diplomatic and political skills.

Therefore, in evaluating and choosing the most appropriate management style for the executive team, making an assessment in each of these dimensions will be useful for the board. The boards need to be clear on why they are paying (key challenges of the company and the required skills, experience, and style of management to handle these challenges), before undertaking the second question of how much to pay?

HOW MUCH DO WE PAY? :

Availability of talent and the market for talent are the key determinants of how much to pay. Therefore, once the need is properly determined, availability and where to access such talent become important questions. The market for executives tends to have intrinsic barriers that are driven by the culture, language, and headquarters of the company. Those companies, who formulate their cultures to enable forming multicultural executive teams, benefit from accessing different pools of executives. Yet, executives who are mobile enough to move jurisdictions seem to have a different market of their own. Therefore, companies with multi-location headquarters may even be more advantageous in accessing different pools of talent easier. However, the need to have a consistent executive compensation scheme for the top leaders reduces the potential benefits of accessing different pools.

In order to be able to properly identify how much to pay, the first step is to understand the market. Therefore, identifying a peer group and benchmarking with the executive compensation levels of the peers provides a good guidepost.

Selection of the peer group is an important decision. The peer group should include companies with similar size, risk profile, and if possible similar industry. While the peer group should include sufficient number of direct competitors, in cases where it is difficult to identify direct competitors the peer group could be extended with similar companies in other relevant industries to ensure that there is statistical significance to the comparisons and relevant position matching among the top executive teams. The KPIs utilized by the peer group companies could also be useful reminders for setting the performance KPIs for the company in question.

Generally, the peers are identified from the same industry. But especially when skills may travel across industries and there is limited availability of seasoned executives in a particular industry, broadening the perspective of potential pools may help identify the right skills at a reasonable cost.

The key metric to focus on is total compensation level, including the fixed and variable components, as well as benefits. When public companies do not make up a significant share of an industry in a particular jurisdiction, finding benchmark data may be more difficult. However, if the benchmarks are only public companies, one may be losing the best talents to companies owned by private equity or family groups.

The minimum requirement for boards to review are (i) the level of absolute pay of top executives over a 1-3 year horizon with respect to selected peer companies’ executives, (ii) the relative pay (ranking) with respect to peer companies’ performances (ranking), and (iii) comparison of increase in executive pay with the increase in total shareholder returns over a five year horizon. If the results of the executive compensation levels of a company do not fall within a zone of alignment of peers, then the board should analyze its goal setting, metric selection, and incentive leverage to identify sources of the problem. Undertaking this exercise regularly and before goal setting each year will help taking remedial steps on a timely basis.

HOW DO WE PAY? :

The key elements of an executive compensation plan structure are (i) fixed vs. variable, (ii) short term vs. long term, (iii) cash vs. equity, (iv) pay vs. benefits, (v) vesting, deferral, and claw-backs, and (vi) severance pay, insurance, and indemnifications. These elements of the compensation package has to be aligned with the crucial areas of business performance both in terms of time horizon, as well as with the company’s risk profile based on its strategy, stage of business life cycle, financial structure, and available talent pool.

The first question to answer in order to determine how to pay is: What portion of the executives’ compensation will be performance based? The answer depends both on the industry which determines the level of controllable parameters and the seniority of the executive. As the CEOs have the largest latitude in controllable parameters, their pay should have the highest percentage of variable pay among all executives. Similarly when the cost structure of a company is mostly determined by the location and labor-capital intensity that is decided by the board, or if the company is a price taker, there is less room for the executives to make a difference. Hence in such industries the percentage of performance based pay could be less than in those industries where the executive decisions may have a bigger impact on company results.

In deciding on executive compensation the boards would also need to consider how much of the performance will be team based and how much of it individual based. Lack of team based component in performance pay tends to lead to less cooperation between executives over the long term.

The second question is: What would be the incentive time horizon of performance based compensation? The answer to this question depends on the investment realization time frame. For example natural resource companies who undertake mega projects that are realized over 5-10 years need to have a longer time horizon in their compensation packages than technology companies who make or break within a couple of years. When the time horizon is long, there should be interim goals that would lead to vesting to motivate the executive team on the way, but disbursements should be weighted towards the realization of the project.

A key test that needs to be implemented is the risk assessment of compensation plans. Pay policies should not lead to gaming and/or excessive risk taking. For example, a loan officer getting a bonus only for hitting 100% of origination target and nothing for 90% will be more willing to offer credit to risky clients. Therefore, paying bonuses in increments at lower thresholds than targets, and establishing delayed disbursement and claw-back provisions are advisable. Similarly, there should be caps on performance payments based on overachieving performance targets. The incentives that change of control arrangements provide at time of a potential take-over should also be considered. There should be double trigger requirements (not only takeover, but also firing) before such compensation kicks in.

Evaluating performance should not be limited to the results of few KPIs established as the targets, but also include assessment of how the company has responded to unanticipated events during the year, how the company has prepared for the future with respect to the value of its brand, investments in talent, risk management systems, and the progress in other strategic initiatives.

One caution for the say on pay initiatives is not to force the boards towards more formulaic methodologies just because formulas are easier to evaluate on desk research, as such an approach would take away from boards exercising business judgment, a critical step in having appropriate executive compensation.

One of the key issues of compensation decisions is that it is a multi-period repetitive game and decisions at one year influence the expectation in the next.

In summary, establishing an appropriate executive compensation plan and managing it through exercising business judgments and communicating it to all the stakeholders including the management and the shareholders is an art. This is a key board responsibility that requires focus and continuous effort to excel.

Notes

1 Dr. Yılmaz Argüden is the Chairman of ARGE Consulting and the Chairman of Rothschild investment bank in Turkiye. He has served as a board member of more than 50 institutions in different jurisdictions. He is also an author, a columnist, and an adjunct professor of strategy at the Bosphorus and Koç Universities; a member of the Private Sector Advisory Group of the Global Corporate Governance Forum; Vice-Chairman of the Governance Committee of the Business and Industry Advisory Committee (BIAC) to the OECD; Chairman of Turkish-American Business Councils; and the National Representative of the UN Global Compact;. He was selected as a “Global Leader for Tomorrow” by the World Economic Forum. www.arguden.net
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2 The author is grateful to Carl Sjostrom from Hay Group; Doug Whitehead, chair of compensation committee of the board of Inmet Mining; Hurşit Zorlu, CFO of Anadolu Group; Mark Reid from Towers Watson; Pınar Ilgaz from ARGE Consulting; and Dr. Richard W. Leblanc from York University for their constructive comments on previous versions of the paper.
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3 However, one should just keep in mind that pay is also as part of a contract for an individual’s services and time and that contract typically gets negotiated at the time of recruitment. Pay is therefore also for the attraction and retention of talent and in order to get the right candidate who most likely has choices one needs to make an investment and accept some of the risk. For top management the pay formula often becomes very rigid, in particular where there is transparency and paying for true performance can as a result become very complicated.
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4 Yılmaz Argüden (2009), Boardroom Secrets: Corporate Governance for Quality of Life. Palgrave Macmillan.
E-book ISBN: 9780230248298 ; Print ISBNs: 9780230230774 HB 9780230248038
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5 While this paper focuses on executive compensation for the top executives, how the pay philosophy/structure established for these senior people is cascaded downwards throughout the other executive ranks (primarily layers 3 and 4) is as important in terms of driving corporate performance. Incentives for these groups have to be aligned. Balanced scorecard approach helps such an alignment processes.
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6 Richard W. Leblanc (2011), Risk-Adjusted Compensation: What Every Compensation Committee Needs to Know In Practice; NACD Directorship, December 2011, http://www.directorship.com/risk-adjusted-compensation-what-every-compensation-committee-needs-to-know/
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7 Relativity relies on having a good comparator group and that the constituents of that group report in the same way. This is why one rarely sees financials measured on a relative basis, even if the accounting rules were followed in an identical way the structure of the organisation (e.g. financial gearing), location (e.g. currency), and market (e.g. services vs. manufacturing) can lead to significant and unintended consequences.
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8 Apart from strategic and operational performance targets, a third area for performance targets could be personal development goals. However, providing a high weight for this area is generally more meaningful for people who are at lower ranks in the organization.
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9 Yet one has to be humble about the ability to get it right. The most perfect performance measure may be inappropriate for compensation purposes. It may be too complex to be understood by executives or they may feel they have insufficient influence over its outcome. A good example of this is relative Total Shareholder Return which has been the most popular measure in long-term plans for a decade in mature markets. Yet, it is now being realized as an ineffective incentive measurement, as the overall market conditions seem to have a bigger impact than the management decisions.
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10 Companies tend to design their whole processes around the single target scenario but understanding the range of performance outcomes and what they mean for the business can be equally critical and it helps ensure that pay is appropriate at all levels of performance. A classic case is that one pays the same for +/- 15% of a $1bn budget as for a $10m budget.
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11 A measure may be inappropriate because a credible up-front performance range may not be set robustly, especially with multi-year plans in fast-growing or cyclical industries. The right measure with the wrong targets can be actively de-motivating to management.
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“This is a pre-print of an article published in the April issue of International Journal of Disclosure and Governance.
The definitive publisher-authenticated version of the Manuscript Number 1110243 (JDG.2013.14),
‘Yılmaz Argüden (2013), Right Reward for Right Performance: Aligning Executive Compensation with Good Governance’
is available online at: http://www.palgrave-journals.com/doifinder/10.1057/jdg.2013.14

Dr. Argüden
yarguden@arge.com


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