Executive Compensation 101: Essential Knowledge for HR Leaders
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Executive Compensation 101: What You Need to Know
The way you handle executive compensation could make or break your business.
Think about it: if you get it right, your executives’ interests will be aligned with those of your organisation. They’ll be motivated to help your company achieve its goals, and you’ll see performance improve over time.
But get it wrong, and you could be looking at demotivated leaders, misaligned objectives and even the loss of key executive talent.
In this article, we’ll dive into everything you need to know about executive compensation, including the legislation you need to be aware of and our top tips for getting it right.
Ready? Let’s go!
The importance of getting executive compensation right
Company executives play a crucial role in helping an organisation achieve its goals. And providing the right compensation package is necessary if you want to keep these important folks happy and motivated — and prevent them from taking their talents elsewhere.
Plus, the way you structure your executive compensation can help make sure executives’ interests are in line with the company’s overall strategy. This can have big results for your company’s performance over time.
But there’s another side to the story too. Currently, there’s a lot of public scrutiny on executive compensation — and rightly so. In a time when many employees are struggling to meet the rising cost of living, executives receiving wildly inflated salaries and bonuses is seen as inappropriate and unfair.
That means you need to look at your executive compensation in the context of your overall compensation policy — and think carefully about how it looks to your employees and the wider public.
The legal side of executive compensation
Many countries have laws about executive compensation to keep things fair and transparent.
For example, in the US, the federal government requires all public companies to disclose how much they pay their CEO and their three other highest-paid executives. They also have to share the criteria they use to determine executive pay, and the ratio between their CEO’s pay and the median employee’s pay within the company.
In the UK, large listed companies also have to disclose and explain the ratio between their CEO’s pay and the pay for employees at the 25th, 50th and 75th percentile within their organisation. And in the EU, new legislation adopted in 2020 requires listed companies to report on the compensation of all directors on an individual basis.
All of this means that your executive pay practices are very likely accessible and open to anyone who’s interested. As you’re setting them up, you should think carefully about the message they send.
Key components of executive compensation to be aware of
An executive’s compensation is rarely as simple as a base salary and a possible annual bonus. Here are some of the many elements that often go into the full package:
- Base salary: Most executives receive a fixed yearly salary. Balancing this with different types of variable compensation is one of the most fundamental parts of your executive compensation strategy.
- Benefits: Like other employees, executives also receive benefits including healthcare, annual leave and life insurance, for example.
- Short-term incentives: Short-term incentives include things like bonuses: variable cash sums that are paid annually and contingent on meeting certain key performance indicators (KPIs).
- Long-term incentives: Long-term incentives are designed to reward executives for achieving long-term goals related to the success of the business.
- Equity: Executive compensation often includes equity-based rewards such as company shares or stock options.
- Deferred compensation: Deferred compensation is any type of compensation that the executive doesn’t receive until a later date, often for tax reasons.
- Retirement packages: Retirement packages might include cash, healthcare or other rewards that are given to executives after they retire from the company.
- Executive perks: Executives may also receive perks including things like club memberships, travel reimbursements or the use of company vehicles.
Four considerations when setting executive pay
As you can tell, there are a lot of different factors that can contribute to how (and how much) an executive is paid. But ultimately, it comes down to four main considerations. Below are the main things you need to consider when you’re setting up your executive compensation structure.
1. Fixed vs. variable pay
When you’re setting your executive compensation, you need to determine the right balance of fixed vs. variable pay — and there are arguments for both sides.
For one thing, you’ll probably need to offer executives a competitive base salary if you want to get them through the door. These people are knowledgable, seasoned professionals who probably have dozens of other opportunities to choose from — and that comes with a certain price tag.
But if too much of an executive’s pay is fixed, they’ll effectively be insulated from the impact of poor business performance. In other words, variable pay is crucial in motivating executives to drive the company in the right direction.
2. Short-term vs. long-term incentives
Executive compensation often includes cash- or equity-based rewards for meeting certain performance goals. And you need to determine whether you’ll pay these out immediately, or defer them until a future date.
The option you favour depends on your business goals and situation. For example, companies going through a transformation often opt for short-term incentives, because they encourage fast action and change. More stable companies might prefer to defer rewards to encourage executives to stick around and reap the rewards over the long term.
3. Equity vs. cash
The two most important elements of an executive compensation package are cash and equity — and deciding which one you’ll favour is a key part of putting your strategy together.
The advantage of equity-based rewards is that they encourage executives to think like owners. Because they’ll receive a higher reward if the company increases in value, they have a strong incentive to act in the company’s interests.
On the other hand, you could argue that the future value of the company’s stock is (to some extent) outside of an executive’s control. While the company’s performance is important, there are also external market factors that can have an impact.
If you decide to offer equity-based incentives, there are various different forms this can take, including stock options, restricted stock units and performance shares. We talked about a few of the different possibilities in our article on long-term incentive plans (LTIPs).
4. Individual vs. group rewards
Another important factor to consider is whether you’ll reward executives primarily for achieving individual goals, or tie their rewards to the company’s overall success.
This is highly dependent on your company’s culture. For example, some companies value personal achievements and might base a large portion of their executive’s variable pay on things like bringing in new business.
Other businesses have more of a collective focus. These companies tend to base their performance goals on things like shareholder returns, revenue growth or profit margins.
An argument against this practice is that it holds executives responsible for metrics that they can’t always control. To compensate for this, some organisations use a combination of individual and group performance measures.
Best practices in executive pay
There’s no one right way to do executive pay. The whole point is that it needs to be tied to your core objectives, goals and values — which are different for every organisation.
That said, there are some best practices for setting executive pay that almost every company could benefit from. Here are a few things to keep in mind as you put your policy together:
- Define a clear policy: With significant public scrutiny on your executive pay practices, you can’t afford to make ad hoc decisions. Defining (and sticking to) a clear policy for executive compensation ensures that the reasoning behind your pay practices is logical and consistent.
- Use relevant performance measures: Executive compensation should tie your executives’ motivations to your company’s strategy and objectives. To achieve this, you need to choose performance measures that are ambitious but achievable, and relevant to both the executive’s work and the company’s overall goals.
- Tie compensation to ESG targets: These days, the public cares about businesses’ commitments to ESG — and your employees do too. By tying your executive pay to goals that are good for your employees, the community or the planet, you can ensure your executives are committed to achieving these objectives.
- Consider your company values: Executives’ roles are intrinsically linked with the company’s strategy. That means that the pay structure you set up for them should reflect and reinforce your company’s culture and core values.
Designing an executive pay strategy that works for 2024
In the UK, the average CEO now earns 118x the salary of the average worker. And this gap has been widening for years.
At the same time, the increase in pay transparency legislation shows that there’s an appetite for equity and fairness when it comes to compensation. Alongside issues like the ongoing cost-of-living crisis, this means that hugely inflated executive compensation packages aren’t looked upon kindly by the general public.
Of course, no one is saying that executives don’t deserve generous compensation. But in 2024 and beyond, there’s a balance to be struck between paying these crucial people what they deserve, and ensuring you don’t undermine the public’s trust in your business. .
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Want to learn more about how to optimise your compensation structures in 2024 and beyond? Check out these articles:
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