Give what you get

How companies can leverage on executive compensation tools in a difficult business environment.

Executive compensation has to balance two potentially conflicting primary objectives: to attract and retain talent, and to reward for performance. The former requires compensation to be pegged to the market and here-and-now payments. The latter is about letting the business results fund the compensation costs, i.e., contingency payments. A compensation designer would typically try to achieve these two primary objectives by using different compensation components. Examples follow.

• Base salary: The salary level should be pegged to the market and provides some wage stability to the recipient. For example, UBS was reported to have increased the base salary of its investment bankers after reducing the bonus pool by 80% for 2008. This is presumably to strengthen talent retention as well as to reduce the at-risk part of compensation.
• Base salary increase: The overall increase in budget should take into account market movement, inflation rate as well as the affordability for the company. The allocation to individuals should then be based on the person’s performance and potential.
• Cash allowances: The allowances are supplements given for specific purposes, e.g., in lieu of a company car if that is a competitive practice.
• Short-term incentive: The overall incentive budget pool should be tied to annual financial results and therefore funded by that. The allocation to individuals then takes into account the team and/or individual performance.
• Long-term incentive: The incentive could be delivered in cash and/or stock. If the former is used, it works like a short-term incentive except that it is tied to multi-year performance and typically the award is given (vested) over time to support long-term achievement and retention objectives respectively. If the incentive is delivered in stock, the award could be subject to share price movement as in a stock option plan (where options are granted at the current share price and the recipients are able to exercise the options to buy the shares at a future date when the share price exceeds the grant price) or performance conditions as in a performance share plan.

During the recent economic crisis, the balancing of the two objectives took on a greater challenge when businesses were trying to preserve cash. While specific interventions depend on the financial conditions and business outlooks of a company, the following are some general suggestions:

1. Peg overall base salary increase budget at a level that would not erode the profit margin. Allocate this budget, however small, in a differentiating manner in favor of your best talent.

2. Ensure the annual incentive pool is tied to the company’s critical financial objectives for the next 12 months. Set the right expectation for 2010 if the business forecast is still uncertain. If the target annual incentive is significant, e.g., more than six months of salary, you may want to consider shifting some of this into the long-term incentive component in order to allow for the performance build up.

If performance does not fit nicely into a financial year, e.g., sales is made this year but profit realisation happens only a few years later, you may want to consider deferring a portion of any significant annual incentive into future years.

3. Revamp the existing long-term incentive plan. If it is in the form of stock options, the value of the options may still be of no value to the option holders (because the current share price is lower than the initial option grant price). If it is in performance shares, the timing and metrics may need to be reviewed to take into account the new risk management requirements. The timing needs to take into consideration the business value creation cycle and the metrics to address the appropriate risk appetite.

If there is no plan in place, this is a good time to consider one. For both the objectives of longer-term business achievement and talent retention, we need to think beyond the next 12 months.