How can companies recruit top executives while maintaining shareholder satisfaction?
Executive compensation currently stands as a highly examined component within the realm of corporate governance. These plans help organizations achieve success when they are designed correctly and make sure leadership follows company objectives. Improperly structured executive compensation plans generate controversy and talent loss that can result in scandals.
The truth is…
To create executive compensation that is both fair and competitive organizations must navigate multiple conflicting interests and adapt to fast-changing market trends. New data reveals S&P 500 CEOs received a 4% annual pay rise from 2012 until 2023 while their compensation surged by 11% in 2023 alone.
This article demonstrates the process of creating executive compensation plans that promote performance yet remain fair and competitive. Let’s dive in!
What you’ll discover:
- Why Executive Compensation Matters
- Key Components of Executive Compensation
- Market Trends Shaping Executive Pay
- Create a Fair Compensation Plan by Following These 7 Essential Steps
- Common Pitfalls to Avoid
Why Executive Compensation Matters
The way you compensate executives functions beyond payroll—it serves as a strategic mechanism with impacts that extend across your entire organization. A well-designed plan will:
- Gain and maintain the best leadership talent in today’s competitive business environment
- Ensure executive interests match company goals to propel organizational achievement
- Leadership teams should be driven to make decisions which build sustained value for the organization.
- Executive pay programs must meet the requirements of all stakeholders such as board members, investors, and regulators.
The stakes are high. According to advice from compensation consultants at Kavea, executive compensation packages that fail to balance these factors can lead to talent exodus, misaligned incentives, or shareholder backlash.
Think about it:
If your executive pay is too low your best leaders will move to competitor companies. Executive compensation that lacks performance-based links will lead to shareholder scrutiny and potential harm to company culture.
Key Components of Executive Compensation
Developing successful executive compensation packages requires a deep knowledge of essential components and their interaction. The most competitive plans typically include:
Base Salary
The base salary serves as the fundamental element of any executive compensation structure. Base salaries should be:
- Competitive with market rates for similar positions
- Reflective of the executive’s experience and responsibilities
- Stable enough to provide financial security
The portion of total compensation represented by base salary decreases as executives advance higher up in the company structure. The base salary represents just 25-30% of total compensation packages for top executives.
Short-Term Incentives (STIs)
Executives receive cash payments from performance-based bonuses that depend on reaching yearly objectives. Effective STIs:
- Focus on specific, measurable annual objectives
- Provide clear line-of-sight between actions and rewards
- Balance individual and company-wide performance metrics
Long-Term Incentives (LTIs)
At this point executive pay structures become intricate yet influential. LTIs generally consist of equity-based rewards which vest over a span of multiple years. The transition towards equity-based reward systems has dramatically changed CEO pay structures since LTIs now represent 66% of their overall compensation. The median LTI grant reached $10.6 million in 2023 after rising from $5.4 million in 2012.
Common LTI vehicles include:
- Restricted Stock Units represent equity awards to executives that become fully owned by the recipient after meeting specific vesting criteria.
- The right to buy company shares at a set price constitutes the definition of stock options.
- Performance Share Units (PSUs) represent stock grants that depend on the achievement of predefined performance targets.
Market Trends Shaping Executive Pay
Executive compensation often reflects broader economic conditions. CEO pay experienced a significant recovery in 2023 as business conditions improved after a downturn in 2022 because of economic uncertainties.
The following trends are currently transforming executive compensation structures.
Performance-Based Pay Dominance
Executive compensation structures no longer offer guaranteed payouts. The majority of companies now link executive compensation to performance metrics at rates between 70-80%, showing greater attention to long-term results.
ESG Integration
Performance incentive programs now integrate environmental, social, and governance measures both for short and long-term executive compensation plans. Stakeholders are demanding greater consideration of non-financial impacts on performance measures.
Retention Concerns
Due to the scarcity of executive talent in the job market companies have started to bolster their retention strategies by adjusting their compensation structures. Executive pay packages need to surpass the projected 3.7% average increase in salary budgets which are anticipated to stay stable during 2025 to ensure competitiveness.
Follow these seven steps to develop an equitable executive compensation plan.
Now let’s get practical. Follow this step-by-step method to develop an executive compensation plan that is both competitive and fair.
1. Establish Clear Compensation Philosophy
Start by defining your organization’s stance on:
- Determine executive pay positioning relative to market standards (for instance, 50th percentile or 75th percentile)
- Pay mix between fixed and variable components
- Identify which performance metrics are essential for your organization.
The compensation philosophy must support both your company’s broader business strategy as well as your organizational values.
2. Select Appropriate Peer Groups
Choosing proper benchmarks forms the basis of market competitiveness. Consider:
- Companies with comparable size indicators across revenue streams and market capitalization and workforce size
- Industry rivals who tap into identical talent resources
- Choose organizations that share your business model and growth path for effective compensation benchmarking.
When defining peer groups avoid the error of choosing aspirational peers which could lead to inflated compensation benchmarks.
3. Design Base Salary Structure
When establishing base salaries:
- Benchmark against your defined peer group
- Consider internal equity across your executive team
- Assess both the range of duties the executive oversees and their overall organizational effect
The base salary forms the foundation for executive compensation because numerous incentives are calculated based on this foundational amount.
4. Develop Short-Term Incentive Framework
Your annual bonus plan should:
- Set clear, measurable performance metrics
- Ensure your bonus plan encompasses both financial and operational objectives.
- Establish threshold, target, and stretch performance levels
The use of a “scorecard” approach by many companies involves weighting multiple objectives instead of depending on a single metric.
5. Craft Long-Term Incentive Strategy
This component stands out as both the most intricate and essential element.
- Select suitable equity instruments such as RSUs, options, and PSUs for implementation.
- Set performance measures for performance-based equity
- Establish appropriate vesting schedules (typically 3-5 years)
Organizations should implement multiple LTI vehicles instead of depending on a single grant type for their best practices.
6. Implement Governance Safeguards
Protect your organization with:
- Clawback provisions for misconduct or restatements
- Stock ownership guidelines
- Anti-hedging and pledging policies
The implementation of these safeguards resolves shareholder issues and supports proper governance standards.
7. Test and Model the Plan
Before finalizing your executive compensation plan:
- Model potential payouts under various performance scenarios
- Stress-test against unexpected business conditions
- Calculate the accounting and tax implications
Through modeling we can spot unintended consequences before they manifest in reality.
Common Pitfalls to Avoid
Even compensation committees with positive intentions may encounter these issues.
Overreliance on External Benchmarks
Market data remains crucial for decision-making but matching competitor compensation without scrutiny can trigger continuous pay increases with no performance correlation. Ensure that benchmark data reflects your company’s unique business circumstances.
Misaligned Performance Metrics
The use of incorrect metrics leads to undesirable behaviors among employees. An exclusive focus on revenue growth may reduce profitability and setting short-term profit targets could prevent essential investments from taking place.
Complexity Overload
Executive compensation plans which executives find difficult to interpret will not successfully motivate targeted behaviors. Clear communication paired with simplicity form the core components of successful plan design.
Time for Action
Executive compensation plans need continual evaluation and adjustments to ensure they remain competitive and fair.
Successful organizations treat executive compensation as a strategic instrument to:
- Attracts the right leadership talent
- Motivates performance that creates long-term value
- Aligns executive interests with stakeholders
- Adapts to changing business conditions
The framework provided in this article will help you develop executive compensation plans that achieve essential objectives while managing the challenges of executive pay.
Every organization must create its own approach which aligns with its specific business strategy, cultural aspects, and market position while existing best practices should serve as general guidelines. A high-growth tech company requires different approaches compared to a mature industrial firm.
Your executive compensation program achieves success when it produces leadership behaviors and business outcomes necessary for sustained organizational success.
