Remuneration Strategy Building Blocks

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Remuneration Strategy Building Blocks

By Mansour Baker, SHRM-CP

Posted 16 April 2019

Revised 31 March 2020

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)

Exhibit 1

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

How to design a compensation structure for your business in 5 steps?

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 component strongly influences the degree of compensation variability.

High Fixed Components

Pool split (illustrative)
Base salary: 70%
Annual bonus: 10% or ~2 months
Long-term comp: 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 comp: 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 comp: 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 the components are 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 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)