3 Big Challenges in Executive Compensation

by Brad Federman and Joel Myers

We all know executive pay has become a significant issue. The challenges associated with executive compensation are highlighted in the headlines:

“The Coming Battle over Executive Pay”

“CEO Pay Is Out of Control”

“The Overpaid CEO”

According to Bloomberg Pay Index, the highest paid executive in 2016 was Mr. Marc Lore, CEO of U.S. E-Commerce for Wal-Mart Stores, Inc. He was paid a total of $236,896,191. This included $346,154 in base salary, $1,055,136 in bonus, and $235,594,901 in Acquisition Awards, Pension, Deferred, and other. In January 2106, Wal-Mart committed to increasing all associate’s wages to a minimum of $10.00 per hour. We may be surprised by the magnitude of the difference, e.g. $10.00 per hour for a Wal-Mart cashier versus $113,892 per hour for Mr. Lore, this is actually positive news for some 500,000 Wal-Mart associates. When we think about the dynamics between executive and general employee pay, we’re left with some questions.

  • Does the pay difference between occupants of the C-Suite and shop floor contribute to lack employee commitment and engagement?
  • Do pay programs contribute to behaviors that conflict with the best interests of customers, shareholders, and employees?
  • Are executives insulated from the effects of changing business/market positions?

The answer to each of those questions is “Yes, but it does not have too.” We have all too often see the impact of executive compensation structures that breed distrust, create sabotage, destroy morale, land people in jail, hurt the customer and even pay executives more when company performance falls.

Commitment & Engagement

Boards of Directors in publically traded companies are learning from activist shareholders about the importance of pay transparency. Say-on-Pay initiatives demand increased disclosure of pay philosophy, plan architecture and award calculations. This public information encourages a more thoughtful approach to senior executive pay. It also makes pay information more accessible. A behind-the-curtain look at executive pay is now available to the public, including employees, who may now ask informed questions about pay practices for the exclusive benefit of executives.

This pressure for increased shareholder transparency also impacts internal communications with employees regarding pay. In our work with employee engagement surveys, we find that employees seek understanding, equity and fairness in pay. Company leadership recognizes that disclosure builds trust. More and more, companies are documenting their compensation philosophy and the basis for making pay decisions. This addresses employees’ desire for understanding. Publicized guiding principles for making pay decisions give employees confidence that their interests are being considered.

Equity & Fairness

Fairness regarding pay decisions is often more a matter of perspective. Again, looking at lessons from executive pay reporting, public companies must now disclose unique pay arrangements that may impact only one or two individuals. Knowing that any special arrangement will become public knowledge tends to discourage such actions. It is these special arrangements that create perceptions of favoritism. If an organization follows a consistent compensation philosophy and guiding principles, precedent-setting arrangements will not occur.

Perceptions of inequity result in ill-will and lack of trust, which results on declining morale. When deciding whether or not an employee feels he/she is being paid equitably, the comparison is with others who work in similar jobs, not an executive in the corner office. Employees expect organizational leadership to be paid competitively, just as they are. However, their point of reference is other employees who are in similar circumstances.

Executives view pay in a similar way. First, they look at their compensation relative to others within their own company. Then they look more broadly at pay relative to similar positions in other, similarly-sized companies within their industry. Privately held companies may feel constrained relative to publically traded peers by their lack of stock-based, long-term incentive plans. With creative design, however, private companies can develop plans that mirror their public competitors through the use of value appreciation plans.

Misguided Objectives

Beginning in 2011 and continuing until it was discovered and made public in 2015, Wells Fargo employees were rewarded for creating bogus accounts. In 2015, Wells Fargo lost a suit in California which cost the company hundreds of millions of dollars in fines and penalties. The cause was attributed to a lucrative bonus plan that set unreasonable goals for sales of new accounts. Over 5,000 employees were terminated, including a number of highly placed executives.

The 2008 financial crisis resulted in The Great Recession. Millions of people lost their life savings. A mountain of legislation was created in an attempt to prevent a recurrence. Prominent Wall Street executives were imprisoned. Contributing to these poor decisions were incentive plans that ignored sound financial analysis in favor of exorbitant bonus schemes.

A once prominent, family-owned business established pay practices that placed a higher priority on preserving the status-quo and immediate return over long-term reinvestment and growth.

These are illustrations where the objective was personal gain over sound business practice. The principles that guided the pay systems and the behaviors that the plans rewarded were contradictory to the organizations’ wellbeing and future prosperity. We cannot say that the plans were unsuccessful, but we can say that objectives were wrong – driven by personal gain. In these examples, employees were rewarded for behaving in ways contrary to the greater good.

Executive Pay vs Economic Conditions

Components of executive pay include base salary, annual incentives, long-term incentives, benefits, and perquisites. The largest elements are annual and long-term incentives. Figure #1 shows how CEO pay has fared relative to the S&P 500 and typical worker pay. The variability in pay closely mirrors the S&P 500. However, the impact of this variability on lifestyle is far different for executives than for the typical employee.

First, the magnitude of the real change in pay for CEO’s versus the typical employee is almost 1,000:1. Between 1978 and 2014, executive pay went up 997.2% versus a 10.9% increase in real earnings growth for the typical employee. For executives, variability as a result of economic conditions meant reduced annual and long-term incentive payments. Base salaries, which define standard of living, continued to increase at about the same rate or slightly more than the typical employee.


Figure 1

Another measure of CEO pay sensitivity relative to performance is how changes in Total Shareholder Return (TSR) compare with executive rewards. The following chart shows the increases in CEO pay relative to increases in TSR between 2009 and 2016. In these post-recession years, year-over-year TSR increases ranged from +1.0% to +32% while CEO pay increased more steadily between +2.0% and +6.0%, with 2008-2009, a recession rebound year, showing a 31% increase.


Figure 2

The trend in Figure #2 from the Harvard Law School Forum of Corporate Governance and Financial Regulation generally reflects a positive relationship between pay and TSR. However, digging a bit deeper, 2015-2016 changes in S&P 500 index revenue and EBITDA were 1.8% and 0.9% respectively. This resulted in reduced annual bonuses, offset by increases in base salaries and long-term incentive grant values.

Action Plans

As a company considers employee and executive reward system, here are some key takeaways from this research:

    • Be open and communicative about reward systems.
    • Develop a written statement of compensation philosophy with guiding principles.
    • Continually monitor systems to validate that rewards are aligned with objectives. Take action when misalignment is recognized.
    • Make variable pay variable. An incentive plan that always pays out is not an incentive, it is an expectation.
    • For executives, keep base salary increases modest, consistent with increases for typical employees.
    • In privately held companies, consider long-term incentives for senior leadership.

While ensuring the mechanics of executive compensation are essential they do not account for everything. Sometimes it boils down to the way things look. If the company does better and is more profitable than ever causing executive compensation to increase, but the average employee is doing worse you can expect problems. The back drop makes a difference. The symbolic value of actions makes a difference. Sometimes employees just need to know you are all on the same team.

Brad Federman, COO
F&H Solutions Group
bfederman @fhsolutionsgroup.com
www.fhsolutionsgroup.com

Joel Myers, Management Consultant
F&H Solutions Group
jmyers @fhsolutionsgroup.com
www.fhsolutionsgroup.com