Compensation Objectives

Part 2. The Basics of Executive Compensation Design

In this part of the guide, we will provide an overview of the basic activities that fall under the purview of the compensation committee. To assist you in your role as a committee member, we have identified key questions that you should ask or make sure have been addressed related to each topic.

Compensation Objectives

Most public companies share the same core compensation objectives in some form or another:

• Align the interests of management with those of shareholders
• Pay-for-performance
• Ensure that compensation functions as an effective incentive
• Attract and retain required talent to execute the business strategy
• Manage the risk associated with compensation

Some companies may have additional stated objectives that complement these five (e.g., manage compensation costs, ensure internal equity within the company, etc.), but in most cases, compensation design is founded on the objectives listed above.

It is difficult to argue with any of these objectives. What is important for you to understand as a compensation committee member is that there are tradeoffs among different objectives that make it a challenge to fully meet all objectives at the same time within each element of the compensation program. For example, the objective of aligning management and shareholder interests can conflict with the desire to attract and retain required talent. To enhance the alignment of both parties’ interests we ideally would tie a great deal of management’s compensation to stock price movements over the long term. However, managers will generally prefer immediate cash compensation over an equal amount of long-term, stock-based compensation, as it is less variable and more tangible. Said in other words, cash compensation tends to be most effective in meeting the objective of attracting top talent, while stock-based compensation is most effective in aligning management’s interests with those of shareholders.

There is also often a similar tradeoff between alignment with shareholder interests and pay-for-performance. To meet the objective of pay-for-performance, it is often preferable to pay management based on the financial results of the company, which tend to be a “truer” measure of management performance than stock price movements (especially over the short term). However, paying management based on financial performance rather than stock price can result in different outcomes for management and shareholders. In an “up” market, stock price appreciation may outpace financial performance, while in a “down” market, the reverse may be true.

Part of the role of the compensation committee is to review the compensation program holistically and ensure that it is effectively balancing all compensation objectives. This requires a great deal of judgment as it is challenging to assess how effectively different forms of compensation address each of the objectives, and it is not always clear what the appropriate balance among objectives is.

Key Questions for Committee Members to Ask:

• How do the designs help to align management with the interests of shareholders?
• How do the designs impact the pay-for-performance relationship at the company?
• How do the designs help us to attract and retain the talent we need?
• How do the designs affect the risk associated with our compensation programs?