Imagine that you’re a manager at a large, publicly traded company. You’re pretty happy with your salary, but the recent salary freeze means you won’t be getting the 5% raise that you deserve.
Then you find out that the CEO of your company brings home $14 million a year.
Or put yourself in the shoes of the board of directors. You know that the CEO makes $14 million.
And new legal requirements mean you have to tell the government, the media, and your employees that the CEO makes 250 times more than the median employee salary at the company.
Now imagine that you’re the CEO. Your salary is going to be published, along with the 250:1 ratio.
And you’re going to be expected to justify it.
Executive compensation issues are a real pain.
You want to pay your executives well. But publishing numbers like “$14 million” and “250:1” seem sure to damage morale at your company.
What do you do?
You look at the data. Before we get into which data points you should look at, though, a quick note:
Executive Compensation Issues Are Complex
It’s important to acknowledge just how complex executive compensation is. Even with real data to back up your decision, there are a lot of factors that don’t fit into a spreadsheet.
Here are just a few competing priorities at play:
- Paying enough money to prevent another company from poaching your CEO.
- Offering appropriate incentives for hitting goals to improve executive performance.
- Finding ways to pay for rising executive compensation costs.
- Justifying huge gaps in salaries to other executives and non-executive employees.
- Accurately calculating salary gaps and executive pay ratios.
- Managing tax burdens for the company and executives.
- The increasing importance of social justice to consumers.
A full breakdown of any one of those could fill an entire book. Which is why executive pay is such a complicated issue.
But They’re Worth Figuring Out
You might wonder if it’s worth taking the time to get these issues properly sorted.
Yes. It absolutely is.
Because poor executive compensation practices can reduce the performance of your company. As we’ll see momentarily, large unexplained pay disparities can cause problems like reduced sales and high turnover.
That’s bad for everyone, from front-line employees to executives to shareholders.
With that caveat out of the way, let’s get into the best way to solve your executive compensation issues:
Use Real Data Drive Executive Compensation
That’s it. Seriously. It’s that simple.
If your executive compensation packages are driven by real economic data, your company will be more likely to succeed.
You might think that you’re using real data already, but many compensation committees use qualitative factors.
They might look at the median executive pay in a group of companies, then decide to offer some percentage more than the median because their company is some percentage better than those other companies.
Not exactly real data.
Here are five things you can use to not only make the right choice, but justify your decision. Which, as we’ll see, is important.
Real Data Point #1: Industry Benchmarks
Attracting and retaining executives requires competitive pay. So one of the first things that companies often do is to look at how much the CEOs of “equivalent” companies get paid.
This is the first place that you can misstep.
Because most companies look at executives outside of their own industry. Steven Clifford writes in the Atlantic that these “peer groups” are supposedly of similar size and complexity, but often include a variety of companies in industries that are, in fact, irrelevant.
If you’re figuring out how much to offer a new CEO at a software company, don’t look at how much the CEOs of grocery store chains get paid. Those companies likely won’t be competing for your candidates, and running those companies is inherently different.
Source: Orange County Register
“For their part,” says Clifford, “companies today stand by this practice.”
They also have a tendency to offer more than the median salary in the chosen peer group, continually driving the average executive salary higher.
Here’s Clifford again: “every time a CEO gets a generously-benchmarked deal, he sets a higher baseline for the next time any leader has pay negotiations.”
You can see how this spirals out of control rather quickly.
So what can you do when you’re trying to figure out how much to pay your executives?
Look at relevant industry peer groups and their median pay. And don’t immediately assume that you should be paying in the 90th percentile of that group.
You may want to offer more than average. But remember that what you offer is going to contribute to the cycle of excessive executive compensation.
This seems like a good time to mention the fact that you don’t want to attract a CEO only with compensation. If the best thing you can think of to attract talented executives is offering more pay, you may want to take a look at your company culture and values.
Real Data Point #2: Performance Tied to Specific Metrics
Most executive compensation packages include performance bonuses. It’s a great way to encourage executives to keep the company moving forward.
But performance-based pay has pitfalls, too. Lots of companies tie performance bonuses to measures that aren’t under CEOs’ control (or are too much under their control).
“For example, some companies base bonuses on earnings per share (EPS),” says Clifford, “which is profit divided by the shares of stock outstanding.” He continues:
“But EPS is not always a good measure of performance: Rising EPS may be due to nothing more than a good economy, increased industry demand, or even, in certain industries, a mild winter.”
“And, worse,” he continues, “EPS is easily manipulated. Using a few accounting tricks, CEOs can make EPS do their bidding. The stock may be down, the competition dominating the market, but the CEO still gets his bonus if he hits the EPS target.”
Both CEOs and hiring committees are complicit in making poor choices about performance bonuses.
Don’t fall into this trap.
Instead, tie executive bonuses to specific metrics.
The exact metrics that you choose will depend on your company and its goals. They might be profit-, share-, or growth-based.
Here’s the important thing to remember: your metrics should be resistant to manipulation and be based on executives’ and employees’ performance. Not the performance of the wider economy.
Here’s how Graham Kenny recommends setting those indicators:
- Recognize, as company law dictates, that a board’s primary responsibility is to look after the best interests of the company—not only those of shareholders.
- Develop a corporate scorecard focused on the relationships that the company has with its stakeholders, including customers, employees, shareholders, and suppliers.
- Acknowledge that the relationship between company and stakeholder is a two-way street.
- Develop measures on both sides recognizing that measuring performance is measuring relationships and that shareholder returns are driven by effective relationships with other stakeholders.
- Appreciate that those much-sought-after leading indicators are often those soft, subjective measures.
- Implement a short list of KPIs recognizing the cause-and-effect relationship between soft and hard measures.
In the end, you’ll need to choose the performance indicators that work for you. Don’t choose the indicators that seem the most obvious or the easiest to measure.
It takes time to figure this one out. Don’t rush through it.
Real Data Point #3: Unexplained Pay Ratio
How much more will your executives make than the average employee at your company?
It’s an important question to answer, because having a very high executive-to-employee pay ratio can lead to decreased morale and performance.
Ethan Rouen says that firms where CEOs are overpaid and employees are underpaid can suffer from weak governance, lower sales, and high turnover.
All of which are expensive in the long run.
Because companies are required to disclose this pay ratio, employees are going to see it. And if you’re not ready to justify it, be prepared for a backlash.
Rouen found that the primary driver of poor performance related to CEO pay is the Unexplained Pay Ratio. Put simply, the UPR represents pay disparity “not explained by economic factors.”
In essence, the UPR is how much more money the CEO is making than the company can justify based on a statistical analysis. For more details on how this works, you’ll need to download the full research paper.
When you’re figuring out how much to pay your CEO, it’s worth wading through the statistics to figure it out.
Because when you can offer a solid compensation package while still being able to justify it to employees, you’ll recruit top-tier talent without losing disgruntled employees over pay disparity.
Calculating Rouen’s UPR is a serious statistical undertaking, but it might be worth doing. If you have an analytics geek or stats enthusiast on your team, they’d probably be happy to help you out.
At the very least, take a look at some of the values he includes in Appendix A and keep them in mind when you’re putting together your offer:
Real Data Point #4: Shareholder and Customer Feedback
If you’ve read up on executive compensation issues, you’ve probably come across say-on-pay policies. These policies let shareholders vote on executive compensation.
Exactly what they get to vote on and how it’s carried out varies between companies. But these policies help keep excessive executive pay in check (though it doesn’t always work—see this review of research to see a few different results).
Even if your company doesn’t provide direct feedback in the form of say-on-pay, it’s important to take into account what your customers and shareholders feel about executive compensation.
Younger consumers prize things like sustainability and pay equity, and if you release an SEC filing showing that your CEO is paid 1,000 times more than the average employee, you’re going to lose millennial customers.
It’s worth getting feedback from both your shareholders and your customers about their priorities. You may find that offering a smaller compensation package pays off for the company in the long run.
This brings us to another difficult point: communicating to . . . well, anyone . . . exactly how your executive compensation works.
Stock options, performance bonuses, short- and long-term incentives, and other compensation measures make it difficult to people to understand who’s actually getting paid what.
Your customers are going to see these numbers. Be ready to explain them.
Real Data Point #5: Rethink the Real Value of Company Equity
Stock options and equity are increasingly important parts of executive compensation packages.
Which makes some calculations rather difficult.
For example, Jack Dorsey didn’t draw a salary in 2017. Does that make him the least-compensated CEO in Silicon Valley? Almost certainly not.
Larry Page was paid a single dollar in 2017, for a CEO-to-employee pay ratio of 0.000005:1. He didn’t need a salary, because he’s already worth $44 billion.
These executives are earning in equity.
If you don’t know how much equity in your company is worth, it’s difficult to figure out how much you’re paying your executives.
Evaluate the value of company equity on a yearly basis, and you’ll have a much better idea of what you’re really offering.
Or skip the equity altogether. Nitzan Shilon makes a compelling argument that equity pay for long-term performance provides “perverse incentives for managers to destroy shareholder value and behave manipulatively and recklessly.”
“It is also economically wasteful, and its wastefulness, which is exacerbated by agency costs and cognitive biases, significantly contributes to the immense explosion of executive compensation.”
Shilon’s paper recommends a system of cash bonuses for long-term performance. Take some time to consider implementing a new system for better results.
Fight Through the Noise to Solve Executive Compensation Issues
Solving executive compensation issues comes down to collecting and acting on the right data.
When the companies you’re competing with for talent are throwing a lot of money around, it can be hard to be patient and disciplined enough to take a more scientific approach.
But by taking the right data into account, you can make a better decision for your company, move the economy away from bad CEO pay habits, and still attract top talent.
It’s a win all around.
Of course, once you hire a new executive with a great compensation package, you’ll need to onboard them quickly to make sure they can earn it. So be sure to check out our piece on how to onboard a new CXO next.