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Design the Right Compensation Plan for Your Business

Susan Carpenter, Founder, MFP Employee Benefits and HR Services, LLC

For every dollar of revenue an employer raises, an average of fifty cents is spent on compensation and benefits, particularly at the executive level. But what does an organization get for its investment in its top team? What can it expect? Solid, well-devised executive compensation packages are great tools for driving organizational goals and objectives.

As an employee benefits and human resources consultant, I work with companies both large and small in designing competitive executive pay plans and compensation packages. My business is often engaged, it is to review current plans to assess if an organization is compensating adequately to ensure it can stay competitive when recruiting and retaining executive-level talent.

Market Data is Key to Ensuring Competitiveness

The process of executive compensation review often begins with data-data acquired through market data studies that illustrate if an organization measures up compensation-wise to similar organizations. Using market data to evaluate your executive pay plan requires a careful look at base pay, annual short-term bonuses, and long-term incentives.

Compiling a market study for assessing executive compensation is a detailed process, which involves these steps:

  • Determine the labor market: How easy will recruitment be? Most CEO searches reach out to a national or international market to recruit, so when looking for competitive market data, an organization must match the industry market rate.
  • Determine the CEO responsibilities: Will the CEO come into a stable organization, or will they be required to double sales in the next two years? Knowing what skills the organization needs in its CEO is critical to finding the right candidate and developing the appropriate compensation based on organizational goals.
  • Develop the market study by gathering data on several different types of executive compensation: Gather market on all three kinds of competitive compensation for executives, including base pay, short-term incentives, and long-term incentives. Keep in mind that long-term incentives can take the form of cash, stock, phantom stock, stock options and other vehicles to reward growth.

For further information, see the Sample Market Data Pay Tool for CEOs, which can be found in the Related Media section of this article.

Compensation Plans Can Drive Your Organizational Goals

Establishing an executive compensation plan involves a strategic planning process to ensure the plan aligns with short-and long-term goals. It is much like a funnel. High-level overarching goals are set and broken down for consumption by the various levels of the organization. As they cascade down, there is smooth alignment.

For example, goals established at the executive level might address financial benchmarks, growing market share, retaining business, or meeting quality or productivity outcomes. Sometimes, as executives work to accomplish established goals, misalignment occurs. Examples include:

  • Large base pay packages with small incentive opportunities tend to promote the status quo. There needs to be enough of a compensation "carrot" available to executives to make them interested in growing the organization. Typical pay packages for the CEO include a base pay with 50 to 100 percent of base pay available in a short-term bonus and over 100 percent of base pay available in a long-term incentive.
  • Executive compensation packages need to be checked to ensure conflicts do not exist between short- and long-term goals. Sometimes executives are tempted to make decisions that generate short-term cash and provide them a generous bonus, but their decisions are detrimental to the organization over the long term. For instance, in a manufacturing environment, preventive maintenance is important. An executive may put off such maintenance so the plant exceeds a productivity goal. As a result, short-term goals for productivity may be met, but the putting off maintenance jeopardizes the long-term life of the machinery.
  • Sales goals and sales compensation must be designed carefully to compensate properly for the sale of all product lines. Checks must be put in place to ensure the organization doesn't emphasize for sales of a low-margin product line and under-incent for sales of a high-margin product line. The design must focus on incentives at the expense of the sale of more high-margin products.

Think Beyond Financial Measurements When Developing Short- and Long-Term Goals

Companies often develop financial goals for executives, but other goals can be measured and rewarded as well, and long-term goals are just as important as short-term goals.

Short-term goals at the executive level, which often span of twelve months, might focus on staff retention, getting everyone through a specific training program, or implementing a new payroll or accounting system. Bonuses on short-term goals are generally paid out three to six months after the close of a fiscal year.

Long-term goals on the other hand, which are generally multi-year initiatives, might be based on opening up new markets or territories or overseas expansion and might be paid out over a multi-year period. For instance, if the long-term goal at the executive level is to expand into ten states, a short-term goal within the long-term goal might be to expand into two states. Here, an executive would be rewarded in the short term for expanding into two states and then receive a bonus again when the larger ten-state objective is met.

Developing Compensation for CEOs Requires Board Involvement

In many cases, a board will charge a compensation committee with negotiating a pay package for the CEO. To begin the process, boards often hire consultants to provide them market competitive pay package information.

To begin the process of determining CEO compensation, the board needs to consider the overall objectives of the company and compensation philosophy. Stock price is almost always a big component of the CEO's pay package.

Many boards take the approach of creating an overall CEO pay opportunity including short-term bonuses and long-term incentives above the market median. Boards should be mindful of this tendency and keep it in check. Additionally, boards need to be flexible and change the CEO's pay components yearly to adjust to the businesses goals and objectives.

Rollout of Your Incentive Plan: Aim for Fourth Quarter Prior to the New Fiscal Year

Companies often wait until the beginning of a new fiscal year to do their executive compensation planning when it should really occur in the third and fourth quarters of the previous year. A good goal for organizations is to develop their plans for rollout in the fourth quarter, so executives understand the goals and objectives and how they will be rewarded.

The compensation redesign process can take three to six months. It is normally a collaborative process within the organization and involves feedback from executives. It also involves determining if systems are in place to measure the outcomes upon which executives will be rewarded in the coming year. If such systems aren't in place, that process alone can take an additional three to six months, and even then, an organization may not be able to use the data generated from the systems right away since they often need refining and readjustment.

There is much work involved in developing an executive compensation plan that keeps you competitive, integrates short- and long-term goals, and contains performance measurement systems that tie back to compensation. But in the final analysis, your compensation structure drives the performance of your top talent—your executives. To maximize organizational performance, executives must be properly incentivized and goals must be aligned.

©2007 Ewing Marion Kauffman Foundation. All rights reserved.

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