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?