Compensation Philosophy

To help achieve a company’s compensation objectives, compensation committees will typically develop a compensation philosophy to guide their decision-making. The compensation philosophy describes high-level principles rather than prescribing specific design details but does provide direction on key aspects of compensation design. This chapter provides an overview of the main concepts considered in forming a compensation philosophy and how they are established. Those concepts are as follows:

• Target Pay Positioning
• Definition of Competitive Market
• Pay Mix
• Internal Equity
• Pay-for-Performance Relationship

Target Pay Positioning

A target pay positioning statement provides the compensation committee with guidelines on how to competitively pay their executives. Committees can develop a target pay positioning for each element of compensation (e.g., salary, bonus, and long-term incentives) or may simply state a target positioning for total direct compensation (i.e., the sum of base salary, annual target bonus, and long-term incentives combined). The target pay positioning pertains to the target pay opportunity for the executive, rather than the actual level of compensation delivered based on performance results.

The most common approach is market-median target pay positioning: selecting the level at which half of the competitive market provides a greater pay opportunity and half provides a lesser pay opportunity. The rationale for this approach is that if the competitive market is appropriately defined, there is no need for the company to set target pay levels above or below those of the typical competitor. It is critical to remember that the target pay positioning relates to target pay opportunities, and actual pay realized will vary from target based on the company’s performance. Executives with target pay opportunities set at the market-median level will have the opportunity to earn actual pay above or below that level, again, based on performance.

A minority of compensation committees will establish a premium pay positioning under their compensation philosophy (i.e., target pay levels set above the median), which provides executives the opportunity to earn more than most of their peers at other companies. Lululemon Athletica, for example, has a premium pay positioning philosophy for executives. In 2023, the company explained that they design their executive compensation program to deliver total compensation (e.g., salary, annual and long-term cash awards, equity awards and benefits) at levels between market median and the 75th percentiles. They believe that this approach contributes to their ability to recruit executives globally, and to attract and retain world-class leaders who drive their vision.

Other reasons for establishing a premium pay positioning include the following:

• Challenges in Attracting Talent: The company may have difficulty attracting the desired talent due to its geographic location (e.g., rural area), challenging business conditions, or a difficult work environment.
• Requires Premium Talent: The company may feel that their current talent is superior to that of the market and that in order to attract and retain that level of talent, they need to pay more than comparable firms do.
• Firm Outperforms Market: The company may have demonstrated levels of performance that consistently exceed the market. As a result, their performance objectives may be set higher than their competitors’ objectives, and target pay levels should be aligned with the targeted performance levels.

Unsurprisingly, a premium pay philosophy tends to be popular with executive management. Unfortunately for executives, shareholder advisory firms and some institutional shareholders tend to raise concerns when they see companies setting target pay opportunities above the market median. They will be skeptical of any rationale that the company uses to justify a premium pay positioning and will closely examine the actual relationship between pay levels and performance. If, as a compensation committee member, you find that the company needs to adopt a premium pay positioning, you should prepare to be criticized by shareholder advisory groups.

Less common than premium pay positioning is a company that has a discount pay positioning — one that targets pay levels below the market median. Where this is the case, the company may have a mix of pay that is different from other firms in the market. For example, the firm may have target base salary and bonus levels that are above market median and, as a result, decide to have long-term incentives and total direct compensation opportunities that are below median. Alternatively, the company may provide a generous supplemental executive retirement plan (SERP) and therefore feel that target total direct compensation does not need to be competitive with the market median because of this above-market retirement benefit. In other situations — for example, a turnaround company with near-term cash constraints — short-term cash compensation may be positioned well below median with the company providing above-median or top-quartile, equity-based, long-term incentive compensation to reward executives for successful completion of the turnaround.

The target pay positioning philosophy should generally be stated as the average the company expects to pay its executives. There are a number of valid reasons why the pay levels for a given executive may vary from the market median value:

• Any value within +/- 15% of the market median is essentially at the market median from a statistical perspective. Market-median values are drawn from the peer group or published survey data and can be expected to vary over time. It is an error to view this data with too high a degree of precision.
• Executives may have responsibilities that are substantially greater (or smaller) than those of the most relevant competitive benchmark position (e.g., finance executive who oversees legal and human resources vs. a finance executive without those additional responsibilities).
• Executives may have long or short tenure in the role.
• Executive may be a consistently high performer over a long tenure in the role.
• The position may be viewed as more or less important within the organization than in the broader market.
• The committee may have retention concerns about the specific executive.

A compensation committee can tie its hands and limit its ability to exercise judgment if the target pay positioning statement is too rigid or is applied dogmatically. It should be viewed as a guideline rather than a hard-and-fast rule. As Gary Heminger stated, “Don’t be so prescriptive that there is no flexibility; give yourself an opportunity to adjust up or down” for specific circumstances that may not fit into a dogmatic approach to market-median pay positioning.

Key Questions for Committee Members to Ask:

• Do we position pay at market median? If not, what is our rationale for the current approach?
• Has our target pay positioning been the basis for external criticism? Do our critics have valid concerns?
• Does our company conform to our target pay positioning on average or are we systematically high or low relative to what we target? If we are high or low, should we rethink our target pay positioning?
• Where individual executives’ pay differ from the target, are we comfortable with the rationale?

Definition of the Competitive Market

Closely related to the target pay positioning statement is the definition of the competitive market. The target pay positioning statement provides a guideline on where to position pay relative to the market, but the company must determine what it views as its market for executive talent in order to make the statement effective.

The most important step in determining the competitive market is identifying the type of companies with which your organization competes for executive talent. Which kind of firms do you go to when you are looking to recruit executive talent? What firms do you tend to lose executives to when they decide to leave? For most roles, this will likely lead you to a list of firms within your industry or in related industries.

For executive roles, it is important to consider firms of comparable scale to your own firm. While White Castle may try to recruit retail management from McDonald’s, it is not appropriate to compare compensation levels for senior executives across two organizations of such different scales. The most commonly used measure of scale is revenue, which is a good indicator when comparing firms within a single industry. However, across industries, profitability and/or market capitalization should be considered as well. For a very low margin business (e.g., a retailer or a wholesaler), revenue may overstate the scale and complexity of executive roles. We will address the definition of the competitive market in more detail when discussing peer groups in Chapter 11.

Key Questions for Committee Members to Ask:

• Are these companies comparable to us in terms of size (e.g., revenue, assets, profits, or market capitalization)?
• Should we consider critical criteria other than size (e.g., global, branded, etc.)?
• Do we lose talent to/attract talent from these firms?
• Is there anything about the makeup of our competitive market that may skew the pay data to be too high or low?

Pay Mix

Relatively few companies make an explicit statement about the precise percentage of pay expected to be delivered as salary, annual incentive, and long-term incentives (LTI). However, almost all public companies will state that at-risk pay (i.e., annual incentive and long-term incentives) will be the majority of pay for senior executives and will represent a higher portion of total pay for the CEO and the most senior executives than for other employees.

For the CEO, a market-median target pay positioning for each pay element (e.g., salary, annual incentive and long-term incentives) will typically result in a pay mix that results in more than 50% of total direct compensation delivered in the form of long-term incentives. In fact, for CEOs of large companies, the typical pay mix is close to 10% base salary, 20% annual incentive, and 70% long-term incentives. Within the market, the mix of pay elements will vary depending on the perceived importance of near-term and long-term performance and the goals of the company.

Beyond the target pay mix across different elements, the company may have a philosophy about the mix between cash and equity-based compensation. While most public companies deliver 100% of their long-term incentives in the form of equity-based compensation, other companies either denominate or settle a portion of their long-term incentives in the form of cash to address executive concerns about liquidity and exposure to stock price volatility (i.e., emphasizing the objective of attraction and retention of executives over alignment with shareholders).

Shareholder advisory groups have a high degree of interest in the mix between performance- and non-performance-based pay. For example, Institutional Shareholder Services (ISS) will tend to view salary, time-vested restricted stock, and time-vested stock options as non-performance-based pay. Their perspective is that an incentive plan needs to require the achievement of explicit performance criteria in order to be considered performance-based pay. Many companies will address this by indicating which elements of the compensation program are considered to be performance-based. In many cases, compensation committees view stock options as inherently performance-based, as the stock price must increase for the options to have any value.

Key Questions for Committee Members to Ask:

• How does our pay mix compare to market benchmarks?
• To the extent it does vary from the market, is the variance consistent with our compensation philosophy (e.g., more/less pay at risk, more/less cash, etc.)?

Internal Equity

Internal equity is currently a hot topic among critics of executive pay levels. Many observers have noted a significant disparity between the pay levels of the CEO and other senior executives, and between the CEO and rank-and-file employees. Because of these concerns about pay disparities, Congress added a requirement to the Dodd-Frank Act for companies to disclose the ratio of the pay of the median employee to the pay of the CEO.

As a practical matter, most compensation committees are more focused on ensuring that pay levels are competitive with the external market than they are with the relative pay levels within the company. It is hard for committees to understand the relevance of comparisons between the pay levels of a CEO and a bank teller or sales manager. Each position requires fundamentally different skills and experience, and as such, they are paid very differently in the labor market.

CEO Pay Ratio

Based on the final rules from the SEC to implement section 953(b) of Dodd-Frank, companies will be required to disclose the ratio of the pay of the CEO to that of the median employee of the company in their proxy statement. While most board members and compensation consultants view this ratio as a figure with very little relevance to compensation decision-making, certain legislators and activist investors pushed for its inclusion in Dodd-Frank and worked behind the scenes to accelerate the SEC’s implementation of the rules for the required disclosure. The stated rationale for the requirement is that the ratio may be useful information for shareholders to assess how the company pays its employees. However, it seems that the underlying intent for the rule is to shame corporate boards for paying CEOs significantly more than they pay other employees and to place the most scrutiny on companies with the largest discrepancies between the pay of the CEO and that of the median employee. In practice, numerous factors will influence the ratio that have very little to do with how competitively a company’s employees are paid (e.g., industry, company size, nature of workforce, degree to which company outsources, geographical makeup of workforce, percentage of part-time employees, etc.). As a result, the CEO pay ratio will consistently be difficult to interpret.

Unfortunately, the CEO pay ratio will also be challenging to calculate, as most companies have a limited ability to identify the pay level of the median employee; this is particularly true for companies that operate in multiple countries. The table below provides a summary of the key provisions of the final disclosure requirements.

Summary of Disclosure Requirements
Aspect	Requirements
Employees Included	All employees (includes part-time, temporary, non-U.S., etc.) employed at fiscal year-end (potential to exclude up to 5% of non-U.S. employees)
Definition of Compensation Used to Identify Median Employee	Companies have discretion to determine an approach as long as it is a reasonable estimation of annual total compensation, as it would appear in the Summary Compensation Table (e.g., W-2 earnings, salary plus bonus, salary plus bonus plus long-term incentives, etc.)
Method for Calculating Median	Companies can use the total population or representative statistical sampling of the employee population
Annualized Compensation	Companies can annualize pay for full-time workers who are employed for only part of the year, but cannot annualize pay for seasonal, part-time, or temporary workers
Definition of Compensation for Ratio	Summary Compensation Table definition (includes salary, bonus, equity awards, non-equity incentive compensation, change in pension value, and all other compensation)

An area where compensation committees do (and should) focus on internal equity is among members of the senior executive team. At times, positions within your company may be difficult to benchmark externally because of differences in your organizational structure from what is typical in the broader market. In these cases, competitive data may be a less important input into decision-making than the relative importance of the positions within your organization. The compensation committee and executive management must use their judgment to determine when certain jobs should be paid comparably even when the competitive market pay data suggests otherwise.

ISS incorporates the ratio of the CEO’s pay to the pay of the next highest-paid executive into the compensation quadrant of its QualityScore governance tool. While the results of this tool do not factor directly into ISS’s vote recommendation on a company’s Say on Pay proposal, the results include an indicator of concern about the compensation program. Shareholder advisors and some institutional shareholders view a high ratio between the CEO’s pay and the pay of the next highest-paid executive as a potential indicator that there is not a strong successor in place.

Key Questions for Committee Members to Ask:

• Is the ratio between our CEO’s pay and other senior executives’ (e.g., the CFO’s) pay comparable to the ratio in the competitive market? If not, why?
• Are the direct reports to the CEO paid at similar levels? If not, why (e.g., differences in market data, differences in responsibilities, etc.)?
• Are executives with comparable responsibilities (e.g., business unit leaders) paid at similar levels? If not, why (e.g., differences in scope of business unit, additional responsibilities, etc.)?

Pay-for-Performance

Much like beauty, pay-for-performance is in the eye of the beholder. Depending on how performance is defined, how pay is defined, what is used as the basis for comparison, and what time period is examined, people can arrive at very different conclusions about the nature of the pay-for-performance relationship. In the current environment, getting the pay-for-performance relationship “right” is the most important aspect of the pay philosophy and one of the most challenging areas of compensation design.

In terms of pay philosophy, most companies will simply state that they intend to have pay levels move with the performance of the company (i.e., higher pay levels when performance is strong and lower pay levels when performance is weak). Some companies will take this approach a step further and add a component of relative performance (e.g., state that they expect pay levels to be in the bottom quartile when performance is in the bottom quartile and pay levels to be in the top quartile when performance is in the top quartile). Most of the challenges related to maintaining the pay-for-performance relationship come in its implementation, rather than in the philosophy statement.

Key Questions for Committee Members to Ask:

• Have we committed to a pay-for-performance approach in our compensation philosophy?
• Do we define performance on an absolute or relative basis, or some combination of the two?
• Can we demonstrate that we are complying with our compensation philosophy in how we set performance goals and determine actual pay levels?