“Significantly underpaying or overpaying executives – compared to the market – is a risk most organizations can’t afford.” Rich Brock, Luke Kaplan and James Reda deconstruct the inherent complexities of designing effective compensation packages.
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Assembling affordable executive compensation and benefits — that achieve leadership recruitment, retention and motivation objectives — has always required rigorous effort. While that process has recently grown more daunting under the influence of market trends and tax law changes, customized solutions and creativity are helping employers effectively navigate tougher challenges.

Executive compensation and benefit packages typically include salary, short-term incentives (STIs), long-term incentives (LTIs), severance and retirement programs, as well as health benefits and other rewards. Each component needs to stand on its own, and they all must work better together to attract and retain key executives, including the right leadership team.

Financial rewards are not the only factors influencing recruitment and retention outcomes. Other fundamentals include the organizational culture as well as the executive’s risk tolerance, career stage, advancement expectations, existing relationships and comfort level with the job.

Nevertheless, compensation and benefit packages form the foundation for building and sustaining successful leadership performance. Significantly underpaying or overpaying executives — compared to the market — is a risk most organizations can’t afford. In addition, the transparency required for public companies and nonprofits obligates them to consider how internal and external stakeholders will view the packages they provide.

The inherent complexity of designing effective executive compensation and benefits makes a clearly defined compensation philosophy paramount. Besides describing the program objectives, it should:

  • Determine the relative focus on internal and external pay equity — especially for executives whose unique skill sets are critical to the organization’s success
  • Identify the appropriate peer organizations for benchmarking compensation as well as financial performance — each focus may require a different group
  • Define the pay positioning strategy in conjunction with financial performance goals — as an example, targeting the 60th percentile of peer organizations
  • Align financial performance expectations and incentives with the organization’s strategic plan

Addressing all of these elements helps assure compensation committees that the approach they’re taking to competitive package design and execution is sound.

LTI and severance programs bring staying power

LTI programs can give executives the opportunity to share in upside risk, while helping to align pay with performance. And because compensation is deferred, these programs also serve as tax-advantaged “golden handcuffs” until the participant is vested. In public corporations, the most common types of LTIs are restricted stock, stock options and performance shares. The specific mix can significantly affect LTI payout depending on corporate performance. Most large companies use a blended or balanced approach that yields a flatter payout curve, allowing them to provide retention payouts even in an adverse business climate.

Severance programs promote retention by offsetting the employment risk for executives — especially when there’s uncertainty surrounding key business developments such as a pending merger or a takeover threat from an activist investor. In addition, these programs are important for persuading external recruits to take a chance on a new situation that may or may not be a good fit. One reason severance programs are attractive for the organization is they’re only recognized as an expense once they become implemented.

Long-term market trends are changing the game

Leadership transitions are picking up in public, private and nonprofit organizations as baby boomers move into retirement and Gen X leaders step into their roles. The emerging cohort of leaders tends to have different expectations for their careers than their predecessors. And if that trend holds, it may have implications for executive compensation and benefits design for decades to come. For example, younger generations are more likely to want an earlier retirement and, on average, the millennials among them expect that age to be 56.¹

Most employers are well aware that the strong economy has increased the competition for talent. And there’s a growing recognition that the leadership skill sets required in a complex business environment are hard to find — especially given the steep learning curve for mastering the intricacies of today’s organizations. Retaining the next tier of leadership and promoting from within are even more essential in this context.

Generational leadership transitions make it especially important to include the next tier of top talent in succession plans — but these future leaders are often the toughest to retain. It’s worth emphasizing how strongly the workplace cultural experience of succession candidates influences trust and the stability of their two-way commitment with the organization. Yet the rewards package remains as critical as ever, making it equally important to strike a competitive balance between compensation and benefits.

New strategies and solutions create new opportunities

Customizing retention packages to the needs and preferences of individual executives has become a higher priority than ever before. The development of these solutions is more than a board-level exercise, and often requires some creativity and the executive team’s direct involvement. It’s important to proceed with care, because customization makes it more challenging to determine what’s fair and reasonable — from both the market and regulatory perspectives.

Funding mechanisms also warrant careful consideration. Investment options need to be competitively priced and structured to manage the risk of losing an executive due to departure, nonperformance, disability or death. In those situations, organizations need to make sure that assets are available to fund the recruitment or retention of executives who fill the vacancies.

Changes brought by federal tax legislation starting in January 2018 are another complicating factor. A provision of the Tax Cuts and Jobs Act stipulates that public companies can no longer deduct an executive’s performance-based compensation in excess of $1 million annually. Nonprofits now face an excise tax on executive compensation above that threshold. Many organizations have responded by restructuring executive compensation to mitigate this tax. In doing so, the organization’s benefits expense may decrease while the benefit to the executive is improved or maintained.

Fortunately, employers now have more tools at their disposal to address these changes. Insurance policies are the primary funding mechanism for deferred compensation, and carriers are offering institutionally-priced policies to smaller organizations, as well as using algorithmically-priced underwriting processes. These developments make it much easier for most employers to customize their solutions.

Compete in the present with an eye toward the future

Three key priorities should guide organizations in developing and implementing executive compensation and benefits. One is a solid compensation philosophy that provides the essential framework for rewards packages that sustain strong leadership. Another is staying current on market trends and regulatory developments to build competitive agility. And at some level, a sense of belonging matters to almost everyone. So equally important is a welcoming and supportive culture that motivates executives to perform at their best in the present — and secures their commitment to lead the organization to an ever better future.

This article is an excerpt from our 2019 Organizational Wellbeing & Talent Insights Report – U.S. Edition.
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Contributors:


Rich Brock
National Practice Leader, Executive Benefits

Rich works with nonprofit and for-profit organizations to develop executive benefit plans and strategies, specializing in the design, implementation, and administration of non-qualified plans. He directs his team in delivering solutions that help clients attract, retain and reward key leadership.

Luke Kaplan
Area Vice President, Great Lakes Region

Luke helps simplify advanced life insurance planning. He brings the ability to see the market for advisors and their clients, represent clients to the entire marketplace, remove as much uncertainty from the equation as possible, and build stable, suitable and tax-efficient insurance portfolios.

James Reda
Managing Director, Executive Compensation Consulting

James works closely with compensation committees and management on issues related to executive and board compensation. He is an industry leader and recognized authority on assessing competitive pay levels for executives and directors, as well as designing, implementing and disclosing pay programs.

Endnote:
¹Monster Worldwide, “Monster’s 2019 State of the Candidate Survey,” February 2019