Pay Mix, Internal Equity, & Pay-for-Performance
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).
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.
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Summary of Disclosure Requirements |
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Aspect |
Requirements |
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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) |
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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.) |
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Method for Calculating Median |
Companies can use the total population or representative statistical sampling of the employee population |
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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 |
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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?