Compensation Strategy and Design Framework
Posted by: Mansour Baker
Designing a compensation strategy is to promote several key objectives:
Long-term value focus
- The system should place an emphasis on long-term value creation
- Measurement and compensation (for key executives) should be tied to overall company performance
- Executives should not be penalized for strategic long-term investments
Retention
- The compensation system should address medium-term retention goals (e.g., next three years) by limiting impact on current compensation
- Long-term retention should be encouraged through a vesting or deferral mechanism
Competitiveness
- The compensation system should adequately reward executives
- The system should ensure compensation is adequately liquid
Accountability
- Target setting and performance measurement must be rigorously enforced
- Incentive plans must be simple and transparent enough so that employees know how to “win”
HR Development
- Compensation system should help develop the ability of employees
- It should serve as a sorting tool for employees in such a way that everybody takes their most efficient location in the organization
Compensation model design has implications on culture, talent management and performance.
Culture
- The compensation model is a central piece in the definition of a company's culture
- Compensation structure and features will have a deep influence on:
- How achievement is recognized
- How people are perceived inside the organization
- Individual's willingness and propensity to take risks
- Working style and cooperation among employees
- Overall guidance and perceived objectives
- Pride in the organization
How will the compensation system shape the company’s culture?
Talent Management
- Remuneration is an important component to attract and retain the best people – key to ensure a strong pool of talent
- The compensation system design will have several impacts for talent management:
- Adverse selection of employees
- Overall churn and rotation of people (both executive and non-executive positions)
- Employees' willingness to develop and embrace new challenges
- Loss / acquisition of key competences
- Training effort
How will the new system change my talent management policy?
Financial Performance
Financial performance will also be significantly impacted by the compensation model, motivated by:
- Impact on incentives
- Changes in culture
- Talent pool evolution
The way system is designed will have an impact on:
- Business size and growth rates by business unit
- Shape of expenses curves
- Profitability performance
- Volatility of results
- Risk measures
- Stock price short-term and long-term results
- Dividend policy
What will be the impacts on financial performance evolution?
Choice of compensation model with implications on culture:
Individual Recognition / Perception
- Meritocratic system, where performance is recognized and compensated
- Individual effort is highly valued by the company and perceived by the entire structure (top management, peers, etc.)
- Main objective is to guarantee an egalitarian compensation system
- People are remunerated based on overall business performance, seniority and position – but not individual performance
Risk Appetite / Propensity
- Employees are encouraged to take risks and to achieve great results (losses are only partly penalized, while results are highly compensated)
- Company aims to be a safe ground for shareholders and employees
- Each employee is the first safeguard of company's risk policies
- Part of long-term growth is forfeited at the expense of risk minimization
Working Style and Relationships
- Promotion of a healthy competition environment, which fosters results and guarantees a continuous development for employees
- There is a hierarchical tension and pressure for results
- People are highly incentivized to cooperated and support each other
- Individual success and compensation are intimately linked with overall performance/ others success
Guidance and Perceived Objectives
- Creation of shareholder value is the ultimate goal of employees
- Objectives and compensation are leaned towards shareholder value
- Employees are centered around a common objective of growing the business and fostering company's long-term results
Pride in the Organization
- Company regarded as top employer, with better conditions than competition
- Most people are proud to belong to the company
- Company seen as good employer, but people have a weak link with the company (low loyalty level)
Choice of Compensation Model and Its Implications for Talent Management
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The 8 elements form the basis of a comprehensive incentive compensation system.
1. Participating employees
- Definition of which employees are included in the incentive plan
2. Mix/weighting of components (shape)
- Determination of appropriate mix and weighting of various components of performance included - generally varies by level in the organization
3. Metric selection
- Specification of how performance will be measured for each component defined in “shape”
4. Target setting
- Specification of the level of performance required to trigger various levels of payouts (minimum, expected, and stretch performance levels)
5. Period of performance measurement (short-term vs. long-term)
- Determination of time periods over which performance will be measured and rewarded
6. Range and amount of payouts
- Definition of payout levels by individual for each targeted level of performance
7. Delivery vehicles
- Form of payment (e.g., cash, stock, options) as well as vehicles to translate performance versus targets into amount of payout
8. Rules and exceptions
- Specific guidelines for treatment of special cases
A number of considerations drive participation in incentive plans.
Impact
- Degree to which individuals at each level can impact firm performance
Cost
- What is the total cost of plan as participation broadens
Affiliation
- Extent to which senior management wants to build greater affiliation with more junior employees, as well as greater focus on overall business
Values
- Senior management values: Degree to which junior employees “share the wealth” or “pay for the downside”
The percentage of variable components strongly influences the degree of compensation variability.
High Fixed Components
Pool split (illustrative)
- Base salary: 70%
- Annual bonus: 10% or ~2 months
- Long-term compensation: 20%
Advantages
- Lower risk of wide swings in compensation levels
- Variable compensation still significant
Disadvantages
- Reduces incentives for superior performance
Moderate Variability
Pool split (illustrative)
- Base salary: 50%
- Annual bonus: 20% or ~5 mos.
- Long-term compensation: 30%
Advantages
- Significant upside created for superior performance
- Deferred elements of compensation become strong retention incentives
Disadvantages
- Higher risk for individual executives
- Potential demoralization if targets missed
High Variability
Pool split (illustrative)
- Base salary: 35%
- Annual bonus: 30% or ~10 mos.
- Long-term compensation: 35%
Advantages
- Very strong incentives to meet targets
- Superior performance well rewarded
Disadvantages
- Potential demoralization if targets missed
- Wide swings possible in compensation levels
Two key issues need to be addressed when determining the composition of the variable component.
1. What mix of performances are included in each participant’s compensation calculation?
- Components included
- Weighting of components
2. How are the components combined into total performance for each individual?
Time horizon for payments defines the period over which performance is measured and rewarded.
Long-Term Incentives
- Promote sustained value orientation and value creation by linking short and mid-term compensation for key executives to overall business performance - long term (min. 3 years)
Annual Bonus
- Achieve short-term improvements by linking annual compensation to selected number of individual goals - short term (1 year)
Base Pay / Benefits
- Basis to guarantee standard of living and provide for retirement
A number of structures are possible for defining the payout range around the target:
- Straight line
- More carrot, less stick
- More stick, less carrot
- Threshold
- Greater variation around the target
Straight line or single “kink” typically used due to simplicity, but other options may work well in specific circumstances. More stick, less carrot' approach strongly incentivizes achievement of the target performance level.
Most companies use three primary compensation delivery: cash, stock and options.
Five Key Considerations:
1. Short vs. long term performance payouts
- Cash: Short term
- Stock: Long term
- Options: Long term
2. Perceived value vs. cost to company
- Cash: Value is clear. Impacts on company earnings.
- Stock: Minimal value is set (for mid time frame). Does not impact company earnings
- Options: Unlimited upside. Does not impact earnings of company
3. Value at risk (to recipient)
- Cash: None
- Stock: Exposed to company and greater market performance
- Options: Highly exposed to company and market performance
4. Accounting and tax issues
- Cash: Simple
- Stock: Mid
- Options: Difficult
5. Suitable level of participation
- Cash: Lower management
- Stock: Mid to senior management
- Options: Mid to senior management
- Capacity to “hold”
- Higher upside
- Sufficient base pay
How to design a compensation structure in 5 steps?
1. Reward Strategy
A clear linkage with the overall business strategy to describe how an organization will use reward policies and practices to deliver its business strategy which may include manpower plans, recruiting & retaining the right talent levels, motivating high performers, incentive-based schemes, etc.
Examples of Reward Strategy linkage:
- Demands of the Business Strategy, including cost constraints & manpower plans
- Underpins Organizational Change relative to jobs, career paths, etc.
- Should recruit and retain the right staff
- Should ensure that the organization motivates its high performers
- Develops performance-based incentives schemes to drive the business performance goals
- Fitting reward processes to individual needs & expectations of employees
2. Internal Equity
The purpose of internal equity analysis is to determine and assess the relationship between similar jobs as evaluated and corresponding pay levels. This is only possible if there is a proper linkage between job analysis and job evaluation. Job size must be equitably in relation to other similar jobs within the organization.
3. External Competitiveness
Proper external market alignment through an effective benchmark and positioning against reliable external market pay & benefits data.
Why Use Pay Surveys?
- To acquire accurate and reliable information about the external marketplace
- To view company practice/position within that market
- Track movements & changes in relevant pay markets
- Provide informed advice to senior management on changes required to the compensation structure
- As a guide to implementing internal salary administration and creating a salary policy
- To assure employees that organization is sensitive to market changes when reviewing pay levels
What are you benchmarking against?
Which market?
- Local (e.g., States, Region)
- Functional (e.g., IT, Accounting)
- Industry Specific (e.g., FMCG, Banking)
- International (e.g., US, Europe)
What element?
- Base salary
- Total Cash
- Benefits
- Total Compensation
Probably the most critical aspect of any pay survey is how jobs are measured.
Job Evaluation
- Uses established methodology
- Covers all jobs
- Consistent across functions
Job Matching / Mapping
- Uses generic job descriptions
- May be underpinned by job evaluation
- Unsuitable for unusual jobs
Job Title Matching
- Very inconsistent between organizations
- Unreliable results
4. Developing Compensation Structure
Structuring and assigning a compensation range/band against each relative job grade/job size. This is established by the desired “market position” and is tabulated using a percentage (%). Structuring an effective “right package” link between remuneration and job performance is very critical.
Country specific legislation will establish minimum wages, overtime pay, record keeping requirements, and equal pay affecting full-time and part-time workers in the private sector.
What is the basis for the pay range?
- External market
- Scatter of pay within the organization
What is the size of the pay range?
- 70% - 130% of midpoint
- 80% - 120% of midpoint
- 90% - 110% of midpoint
Correct pay for Jobs
- Too low – raise pay
- Too high – lower by freezing wages, transferring or promoting
5. Communication & Implementation
Keep your communication simple for your people to receive the right message. Apply a compa-ratio to migrate into the new compensation structure.
- Successful Pay management is heavily dependent on communication
- The way it is communicated is crucial
- How much information should be released?
- People most concerned with impact upon themselves
- People usually interested in how much others get
- People want to know “how they’re doing”
- People generally feel they are underpaid