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Remuneration Strategy Building Blocks

Posted by: Mansour Baker

​Designing a remuneration 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 system 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 with implications on talent management

Choice of compensation model with implications on talent management

​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 vehicles: 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  


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