Executive Compensation Should Reward Competence

Strategic executive compensation means that its payment motivates executives to achieve the targets to the level required or expected by the top management.

Decision on compensation is always an important one.

For example, this is a very important factor in the employment contract of a CEO, the top executive.

It is not easy to determine whether such decision is right at the time it is made since organizations are operating in a dynamic environment.

The organization's board determines the level and components of CEO's compensation and those of the senior management team.

The management team makes all other compensation decisions subject to the compensation policy approved by the board.

Determine the levels of executive compensation long before the executive is recruited or at the latest by the time executive is offered employment.

Compensation issues can cause problems if wrong decisions are made. Once the decision is made, there is no possibility of going back on your words without negative repercussions.

Examples include paying excessive compensation even if performance is not satisfactory and giving priority to short-term actions and not the long-term interests of the organization.

Bench-marking can help in identifying the best compensation practices.

Adopt strategy to develop the right remuneration system for your executives.

Executives Play Strategic Roles
Executives have the responsibility of providing effective corporate leadership in helping the organization to succeed and prosper.

This is why they are rewarded commensurate with the level of their responsibility and how well they have done their jobs.

The quality of the pay package must motivate executives to give their best for the good of the organization.

Aligning Executive Compensation to Financial Outcomes
One of the effective methods of ensuring that senior employees perform their jobs is to align executive compensation to corporate outcomes including increasing shareholders' value.

Further, determine executives' pay based on the importance of the tasks or job that they perform.

An outdated basis for determining pay is the so-called 'celebrity status' of the position held.

When determining executive compensation, consider the following:

  • Comparative importance of the job in achieving the objectives of the organization
  • The degree of risk exposure. The risks include physical risks but can also those that are financial in nature
  • Seniority of the position within the organizational hierarchy
  • Performance level

Performance Measures Determining Executive Pay
The performance measures organizations can use to determine executive compensation include:

  1. Net Profit
  2. Return on Equity
  3. Return on Investment (which includes return on investment on people)
  4. Share Price Performance (which reflects shareholders value)

We can see that the compensation payable is measured against the financial performance of the organization.

Share price will indicate whether CEOs are achieving the targeted shareholders value that their compensation is subjected to. This is accepted by many as one of the requirements that CEOs must satisfy to merit their pay in addition to continued tenure of service.

Relationship of Executive Compensation to Shareholders Value

In a nutshell, the main determinant of executive compensation is shareholders value. However, there are indications that this is changing.

This is especially true of the CEO's pay package.

Shareholders value must also determine the kind of compensation of each and every chief officer such as Chief Operating Officer, Chief Financial Officer, Chief Technical Officer, Chief Information Officer, the Chief Marketing Officer and Chief Human Resource Officer.

Important Executive Pay Issues
Compensation consists of fixed monthly salary and bonus.

Bonus forms a large portion of executive pay. Some CEOs get paid part of their bonus up-front, that is, when they report for duty. The balance may form part of their 'at-risk compensation.' If they do not attain the required targets, they will forfeit it.

In the worst case scenario, they may have to leave the organization or their employer / board may terminate their service.

During times of recession, it can happen that the government of the day will intervene. This can result in non-payment of the bonus or a substantial reduction in the quantum payable.

However, self-regulation by organizations is a better option.

Non-cash compensation or benefits include the use of executive jets and paid annual holidays for the executive and members of his or her family. It had occurred a few times in the past that this type of compensation was not managed well.

It invited a lot of criticism. It was even reported that some CEOs in some countries continued to enjoy substantial benefits even after leaving the organization. In addition, it was reported that a few of them have not performed very well as CEOs.

This is why corporate governance legislation exists in some countries.

Corporate governance usually requires the establishment of 'a fully independent compensation committee" and excludes directors who are former employees.

It is very essential that the committee chairman must possess an extensive knowledge of compensation issues.

Well-defined Executive Compensation
Clearly state the quantum of executive pay and the terms and conditions under which it is payable as stated in the employment contract.

Provide for the situation where the state of the organization's financial performance is not favourable.

Where the required key performance target is not achieved, provide in the employment contract that the only option is termination with cause, that is, poor performance.

Components of Senior Executive Compensation
The four basic components, according to Kevin J. Murphy, are:

  1. Base salary
  2. Annual bonus
  3. Stock option, and
  4. Others such as long-term incentive and retirement plan

Long-term incentive and retirement plan are intended to retain employees.

Executive pay is so important that you need to carefully consider every aspect of it.

For example, it is said that stock option must not exceed one year's wage.

You need to specify easily-understood terms for payment or non-payment or reduction of compensation based on specified grounds.

If forfeiture is one of the terms, state it and ensure that executives understand the position of their pay if they fail to satisfy certain conditions or when specified conditions arise. This includes times of poor financial performance and or economic recession.

Ensure the clarity of every term. It is important.

Timely and Regular Reviews
Regularly review your executive compensation to ensure that it retains its strategic intent and achieves its objectives.

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