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Executive compensation philosophies have existed in most companies for a long time. The problem is that, too often in the past, companies adopted philosophies that sound like motherhood and apple pie. For example, many executive compensation programs state an intention to “attract, retain and motivate top talent” or “align executive and shareholder interests.” Of course companies need to accomplish both objectives—but there is no competitive advantage in having the same compensation philosophy as every other company. An effective compensation philosophy must go further and provide specific guidance that will help the compensation program to drive strategy execution. To achieve this end, the philosophy must be grounded in the mission of the business and reflect key strategic imperatives and talent needs. It also must be consistent with the company’s operating style, shared values, compensation history and overall culture.

The current environment, in which shareholders are asking companies to revisit their executive compensation programs, provides the perfect opportunity for companies to re-examine their compensation philosophies. Starting the design process with a robust discussion of what the company wants the executive pay program to accomplish, along with the implications for program design entailed by those choices, lays the groundwork for executive compensation to become a strategic lever rather than simply a means of staying competitive. Developing a compensation philosophy that is responsive to the company’s unique business strategy and talent needs heightens the likelihood that the executive compensation program will send the right messages about company priorities, aid in retaining the right talent and contribute to a strong pay/performance relationship.

In practice, a company’s compensation philosophy allows management and the board to make decisions within a mutually agreed-upon framework, rather than face each pay decision as if for the first time. The principles provide a yardstick for retrospective evaluation and a framework to guide the future direction of program design and administration.

Establishing the Foundation
Developing a compensation philosophy begins with answering the following four questions:

1. At what level should total compensation be positioned?
2. How should the mix be split between fixed and variable pay?
3. What should be the balance between annual and long-term focus?
4. How should variable pay be split between cash and stock, and what expectations should there be concerning executive stock ownership?

Several factors need to be considered when answering these questions:

• The company’s business needs and market characteristics—internal strategic, macroeconomic and industry-related drivers of compensation.
• The company’s talent needs—the role of pay in the employee value proposition, the types of employees needed to drive strategy, and the nature of leadership responsibilities and performance expectations.
• Role and prominence of pay—the importance of pay versus other rewards in the overall employee value proposition and the extent to which the company wants pay to influence executive actions and decisions.

The result is a matrix of issues that must be addressed to develop a philosophy and set of guiding principles that are grounded in the strategy and will work as a strategic tool. The issues that come into play in a philosophy are shown below in Exhibit 1.

FIGURE 1--THE FOUR QUESTIONS ARE ANSWERED THROUGH THE THREE "LENSES"

This balance of this article focuses on one company’s experience in developing a compensation philosophy for its leadership group that would support its new strategy and corporate structure.

Building the Philosophy
“Alpha Corp” was a company in turnaround. It articulated its aspiration to be a world-class manufacturer of innovative and high-value products and services to a targeted set of individuals; developed action plans to deliver profitability and growth; and established a vision of a performance-based culture. It needed to strengthen its manufacturing division, which ultimately would be its source of innovation and competitive advantage.
To create a performance-based culture with shared accountability, the manufacturing unit had to overcome a strong entitlement mindset. Further, the company required all of its business units to pull behind the strategy. In the past, business units had operated autonomously; but with the need for integration, a culture of collaboration was of paramount importance.

Alpha Corp’s strategic initiatives implied the need for certain executive leadership characteristics. The company’s product leadership goal required a focus on manufacturing and demanded innovation and flexibility, with a strong customer focus. Its mass customization model demanded operational quality. In terms of talent, Alpha Corp required leaders who were financially adept, challenged to excel, motivated by results and focused on enterprise success. While some existing leaders were ready to adopt the new business model and take on the newly aggressive performance targets, others would need to be recruited. To shore up its executive team capabilities, the company identified key talent needs, hired an executive vice president from the outside to run a crucial business and brought on other key hires at senior executive levels. Alpha Corp also shed employees who couldn’t cut it in the new operating environment.

When it began to focus on compensation, Alpha Corp had already implemented a number of critical elements to drive required changes in the organization. These elements focused on alignment, accountability, capabilities and the leadership performance that would lead to strategy implementation. Alpha Corp set aggressive but attainable financial goals and linked both financial performance and competency achievement to pay opportunity.
As its next step, the company began to define a holistic executive compensation strategy and philosophy that would guide executive compensation recommendations.
As Alpha Corp developed its compensation philosophy, it faced several challenges unique to its situation. Historically, cash compensation had been the main reward element. However, the corporation was newly public, so total pay opportunity now needed to be influenced by both financial results and market value creation.
Alpha Corp wanted to “harmonize” senior management compensation opportunities across business units, which previously had had different pay philosophies and wide variance in pay opportunities. The disparity could provoke potential divisiveness among team members and create difficulty working across units. Further, the company believed that, given the increased need for collaboration, it was important for senior management to focus more on corporate performance and results. Dispelling compensation variation across units would aid in attracting and retaining executives with general management skills and an enterprise mindset. At the same time, compensation opportunities needed to align more strongly with individual contribution.

In the past, compensation was cash-driven and deemed an entitlement. Consequently, when stock was introduced, it was undervalued because of its risk, despite the increased upside opportunity. In addition, the value of outstanding senior management equity awards was minimal, creating retention and motivation concerns and an increased sensitivity to and dependence on short- and medium-term incentives.

Aggressive performance targets were required for the turnaround. Because of the difficulty of achieving performance above target, participants perceived that payouts would be conservative. The company considered all of these factors related to business needs, talent needs, and performance and rewards strategy history when answering the four philosophical questions posed earlier.

At What Levels Should Total Pay Be Positioned?
Comparative Framework
A first consideration in developing the philosophy was the comparative framework, i.e., the peer group companies that would be used for pay and performance comparisons. Typically these companies represent competitors for talent, business and capital. Alpha Corp’s compensation committee adopted a very comprehensive approach to the comparative framework. While the peer groups had historically varied from one part of the organization to another, a more common set of peers was more appropriate to build the collaborative culture the company was seeking. Line positions were compared to a common set of industry peers, while all staff positions were compared to general industry competitors. Alpha Corp also selected a secondary set of peer companies for program design comparison. While the primary peer groups served as yardsticks for pay levels, the secondary peers indicated the types of programs competitors were offering. Alpha Corp recognized that it might not need to match competitors’ pay levels, given its smaller size, but it wanted to be alert to these companies’ compensation designs.

Total Pay Positioning
Because the company was in turnaround and its performance targets required significant stretch, overall total compensation was positioned aggressively—60th to 70th percentile—if performance targets were met. However, certain positions were targeted higher or lower than the overall compensation positioning, based on value to the business under the new strategy. Alpha Corp determined that overall total pay positioning at target performance could range from low (25th percentile compared to the market) to median to high (75th percentile or higher) based on a position’s strategic importance. Typically the positioning by role varied between the median and 75th percentile of the relevant competitive markets.

The target positioning sent a strong signal about the strategic shift that needed to take place. It also increased the prominence of pay, underscoring the transition to a performance-based culture.

How Should the Mix Be Split Between Fixed and Variable Pay and What Should Be the Balance Between Short- and Long-Term Focus?
Pay mix includes both the second and third aspects of the compensation philosophy. It considers both the mix of variable (annual plus long-term incentives) versus fixed pay (base salary) and the mix of annual and long-term components.

Because of its desire to reinforce a performance-based culture, the company decided that variable pay should be the most significant component. Base pay should compose approximately 25 to 35 percent of total annual compensation, and variable pay should compose 65 to 75 percent. The mix would vary by position, taking into account a position’s ability to influence results as well as competitive practice. This pay mix would also allow participants to benefit significantly if Alpha Corp achieved its ambitious performance targets. The current situation also suggested that there should be considerable potential upside via performance-based pay, and that individual pay should vary significantly based on individual performance.

While longer-term sustained performance was paramount, Alpha Corp realized that achieving annual milestones along the way would be critical. Therefore, the company decided to balance variable compensation fairly evenly between short- and long-term, with 40 to 50 percent coming from annual compensation and the remainder from long-term. The mix was constant across organizational levels, except the CEO, so the plan offered the same proportion of upside opportunity and value to all the executive team members.

The positioning and mix were departures from past practice, so the company adjusted targets over time as necessary, to align them with the philosophy.

How Should Variable Pay Be Split Between Cash and Stock?
The company determined that the mix of total variable pay should be heavily weighted toward stock, such that 70 to 75 percent would be delivered in stock and 25 to 30 percent in cash. The rationale hinged on several factors. First, executives needed to collaborate to drive total enterprise value creation. Second, equity awards subject to vesting would help drive retention of key talent. Finally, equity awards would reinforce the importance of delivering results for shareholders, encourage a long-term perspective beyond the three-year planning horizon, and facilitate and encourage stock ownership. Cash awards would reinforce the contributions each unit needed to make to achieve overall enterprise objectives.

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The current environment presents a good opportunity for senior management and the compensation committee to step back and revisit their compensation philosophies to ensure they are responsive to the company's needs and provide necessary guidance as programs need to adapt and change. Alpha Corp’s compensation committee determined that its compensation philosophy would continue to be relevant in the near term, and agreed that good governance would suggest a similar review in three years. The review would make sure that the rationale and implications of each principle were clear and continued to be relevant.