How Effective Executive Compensation Plans Work

Article excerpt

An overall perspective, and some examples, on how economic value-added (EVA) plans can be used constructively in the complex world of executive compensation.

Effective executive compensation schemes establish an internal marketplace for executive decisions and actions, rewarding patterns that add value to the corporation. While phrased and constructed to be meaningful in the local context, they point in the correct economic direction, toward EVA (economic value added)(1). They address executive compensation as a comprehensive package. They are understandable, not only to executives, but in a macro sense to other stakeholders including shareholders, members of board compensation committees, and investor analysts. They balance long-term and short-term aspects, overall corporation and individual unit aspects if applicable, and retention as well as incentive. This article provides a framework for designing such plans and rites real examples of EVA plans in use.

For better or worse, executive compensation schemes constitute a major part of the marketplace for executive behavior. Some people believe that compensation really doesn't impact performance, but I side with organization design expert Jay Galbraith, who says the trouble with compensation plans is they do work. Of course, financial remuneration isn't the whole story, as rewards for executives can include promotion, intrinsic satisfaction, and other factors.

In the U.S., board compensation committees have responded to increasing public scrutiny, SEC disclosure requirements, and their own desire to do the right thing by becoming increasingly interested, educated and thoughtful in structuring and valuing executive compensation.(2,3) This has begun to compete with inappropriately-executed good intentions, fads, myths, cronyism and ignorance as major determinants of executive compensation. Major public U.S. companies' proxies now disclose significant information on not only compensation, but its rationale and its relationship to measures of corporate performance, and the inside word is that the underlying internal logic is improving. Canadian companies, whose compensation policies and levels have their own characteristics but also some degrees of linkage with U.S. and other world capital and human resources markets, are encountering reflections of these trends.

Even within executive compensation, executives generally receive a portfolio of devices adding to the overall package. These are designed to attract, retain, provide incentive and reward for performance over various relevant time frames. It generally takes more than one or two vehicles to do all that. It's the rare executive who, like Lee Iacocca, has been compensated entirely with stock or stock options plus, say, a $1 salary. In fact, recipients discount the value of packages that are highly skewed toward risky elements. Typical packages include:

* Base salary, rising by level of responsibility and subject to periodic merit increases based on after-the-fact perceptions of performance. This can attract and reward; it may not provide as much incentive, and it only retains until someone tops it.

* Annual bonuses, the design drivers of which differ sharply among various companies. These are typically after-the-fact judgmental rewards for short-term performance, but some are far more complex and contain objective incentive elements that may or may not reinforce EVA.

* Long-term incentives, whether stock-related or formula-related. Payouts tend to be calculated by a predetermined formula, with only the judgment of the compensation committee available as a last "sanity check." These arrangements are designed to motivate and retain in the meantime, and reward later.

* Participation in benefit plans applicable to most employees.

* Supplemental executive benefits programs such as deferred compensation plans, and perquisites such as executive financial counseling. …