ARTICLE | February 16, 2023
Total rewards programs provide compensation, benefits, recognition, and developmental rewards to employees for their achievement against specific business goals. This holistic approach is especially important in designing effective compensation packages for your executives and key employees.
Each program component should reinforce the others in attracting, rewarding, motivating, and retaining the executive talent necessary to achieve your company’s goals.
A well-balanced executive compensation package generally includes base salary, short- and long-term incentive pay, and various benefits and perks (e.g., enhanced retirement benefits, executive wellness programs, company cars, country club memberships, etc.).
Actual program structure and elements may vary among companies due to size, industry, objectives, competitive challenges, and company culture, but the holistic process of developing an effective executive compensation strategy is usually very similar.
The first step when designing an executive compensation program is to identify your primary objectives. For many employers these include:
- Attract, recruit, and retain effective executives.
- Reward incumbent executives.
- Create incentives that align executives’ actions with the company’s goals.
- Maximize tax efficiency for the executive and the employer.
Designing an executive compensation program should start with understanding your company’s goals and what role you want the executive to play in achieving them.
Establishing clear objectives allows your decision-makers to formulate a compensation arrangement that aligns with company goals. Your objectives may depend on your organization’s business model, life cycle, and other factors, and your executive compensation packages should be tailored to those unique short- and long-term objectives.
For example, a new organization may need to focus on attracting executive talent in specific functional areas. Similarly, a newly promoted executive may be better incentivized if their performance metrics are changed to better align with the goals and responsibilities of their new position.
Whatever the circumstances, the process should start with understanding your company’s goals and what role you want the executive to play in achieving them.
15% of companies that offer equity/share ownership to attract or retain employees
Increasing an executive’s base salary can appear to be one of the simplest elements of a compensation package, but it’s important to understand the competitive market position for the executive’s role. The key factors in determining appropriate base salary for executives are competitiveness and reasonableness.
This component of pay provides the executive the security of a guaranteed amount that does not adjust based on performance. Market data is readily accessible for your company to review and benchmark against industry norms, and reviewing the compensation data for your industry regularly will help you keep your compensation packages updated and competitive. You should also consider the percentage of your total rewards program that should be guaranteed salary. Once determined, base salary is generally adjusted annually.
“If we could ignore compliance and operational aspects, we could design some really pretty castles in the air, but they wouldn’t help your business. At the end of the day, it has to be something you can administer reasonably easily.”
Mark Ritter, Senior Director, Washington National Tax, RSM US LLP
Short-term incentives, typically structured as annual bonuses, are intended to reward executives for achieving your short-term business objectives. These objectives are usually based on annual income statement goals but may vary depending on your industry, business type and maturity, company strategy, market conditions, and other factors.
The metrics for determining annual bonuses may be financial or non-financial.
Financial metrics may include revenue growth, gross revenue, or net revenue, while nonfinancial metrics may include operational goals such as safety, quality assurance, innovation, or expansion into new markets.
Annual bonuses are often tied to company-wide goals, such as increased earnings before interest, taxes, depreciation, and amortization, or EBITDA, as well as targeted elements of personal performance, such as an increase in direct sales or development of a new product line.
Bonus plans are typically designed to provide threshold (minimum), target, and maximum levels of bonus payouts based on performance. A payout tier is designed to make sure the executive sees the performance goals as achievable and to incentivize them to exceed the basic goal if they reach it during the year. The general rule of thumb: A goal should be 80% achievable at the threshold level to guard against the risk that it may seem unachievable to the executive.
The mix of organizational and individual goals is often affected by the executive’s “span of control”—the person’s ability to individually affect a particular metric or outcome. For example, a CEO is better positioned to affect organizational goals such as increased EBITDA than a chief legal officer, whose scope of duties and authority is narrower.
While base salary and bonuses are common forms of compensation across job classifications, long-term incentives usually focus more on the C-suite and other key employees and are a core component of executive compensation planning. Companies typically seek to provide executives with longer-term compensation incentives (usually ranging up to three to five years) because turnover at such a high level in the organization is relatively costly, and the executive team is often driving strategies that may take multiple years to implement.
Like short-term incentives, long-term incentive awards are typically based on either financial or operational performance. Grants to executives may be made in any year and may either overlap a previous grant or be awarded following the end of a previous multiyear grant.
As part of a balanced compensation strategy, your company may choose to include a cash-based or equity-based long-term incentive. To determine which long-term incentive plan is best for the company, consider several questions:
- Is it desirable for executives to be owners? How does this affect current owners?
- What incentive do your executives consider sufficiently valuable to motivate them to achieve the company’s long-term goals?
- Is equity compensation needed to attract talent until the business generates enough cash flow?
- Are the existing owners of the company seeking exit strategies from the business?
- What are the tax consequences to the employer and the executives?
- What leadership groups does the company need to incentivize differently?
Thinking through these factors in addition to the goals established at the beginning of the planning process will help you whittle down which long-term incentives will best suit the needs of your business.
Share-based compensation can be a great tool for incentivizing executives because a portion of the executive’s overall compensation is aligned with the owners’ value in the company. This type of award may be actual equity in your company or may consist of cash bonus payments calculated against stock performance over a specified period.
If your company is considering equity compensation, your existing owners must be willing to share ownership. Carefully consider whether opening ownership to a wider group of individuals would create dilution concerns or require changes in governance or decision-making.
Common forms of equity-based incentives include:
- Company stock
- Stock options (incentive and nonqualified)
- Restricted stock
- Stock bonus and employee stock purchase plans
- Phantom stock
- Stock appreciation rights
- Profits interests and capital interests (in partnerships)
Understanding the benefits and challenges of each equity compensation option will help you drive individual and organizational performance while avoiding unintended consequences and undesirable costs.
Setting performance-based criteria
Whether cash-based or equity-based, most long-term incentive compensation is based on strategic drivers that will encourage or discourage certain behaviors by executives. Long-term incentives should focus on and align your executives with your company’s and owners’ long-term goals.
Similar to annual bonuses, long-term incentive compensation may be tied to financial or nonfinancial metrics. However, long-term incentive compensation typically focuses more on balance sheet goals, such as shareholder value, ROI, year-over-year revenue growth, and similar financial measures.
Nonfinancial measures, such as customer or employee satisfaction surveys, the completion of a project, or quality control measures, can be additional criteria.
Tailoring the metrics to important measures for your company and areas that can be affected by the individual executive can focus your executives’ time and effort on meeting your company’s unique needs.
Long-term incentive programs allow companies to set up time- or performance-based vesting requirements as well. Time-based vesting requires the executive to provide future services to receive the benefit. For example, they must be employed three years from the date of grant to receive the payment. Performance-based vesting typically requires the executive to achieve a certain goal before they vest in the award.
Time-based restrictions can stand alone or accompany performance-based conditions. For example, a common plan design is to provide that the executive will vest in the award upon either completing three years of employment or achieving a stated goal, whichever occurs sooner.
Regardless of program structure, vesting requirements provide a retention incentive in addition to the performance incentive.
Long-term incentive plans often include a deferred compensation feature, which enhances your executives’ retirement savings using a nonqualified deferred compensation plan. These plans permit a great deal of design flexibility, as long as applicable special income tax rules are followed.
Another important area of design flexibility is payment timing (within certain parameters). For example, your plan may provide for either a lump sum payment or installment payments, typically of some specified amount per year. This allows you to plan for the cash flow impact such plans may have as they grow over the years.
Other benefits and perquisites
Don’t forget that a total rewards approach to executive compensation often includes indirect and noncash compensatory items. Sometimes these have a greater psychological appeal to executives than what it costs your company to deliver them. These items of compensation are generally called perquisites, or perks.
Perks are generally noncash fringe benefits that provide immediate financial rewards beyond wages or other incentives. When designing compensation packages, consider the benefits and perks an executive might find attractive (perhaps from a status standpoint, for example). You may consider doing market research or involving an executive in crafting full compensation packages that offer the most appealing perks.
Bringing it all together
Ultimately, how you structure executive compensation depends on a holistic mix of components and performance metrics that are closely aligned with your company’s overall goals and objectives. Expanding your executive compensation plans beyond base salary and short-term incentives can make your plan more focused and effective.
Of course, this can also affect your costs and tax obligations, leading to intricate accounting, regulatory, and documentation considerations. Experienced, knowledgeable professionals can help you weigh them as part of establishing a sustainable compensation philosophy that serves your business and your valued employees.
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This article was written by Mark Ritter, Antoinita Thompson and originally appeared on 2023-02-16.
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