Article summary
- Executive pay is a topic of discussion among stakeholders, with institutional shareholders demanding justifiable reasons for high pay packages to prevent economic downturns and risky behavior that can harm the company and its shareholders.
- Performance measures are essential to evaluate the efficacy of the board, with common metrics such as revenue growth rate, total shareholder return, and profit margin. Linking compensation to these metrics can motivate boards to make choices that benefit the company and its shareholders.
- Benchmarking executive compensation to determine pay packages based on other executives in similar roles and industries can create a “Race to the Top” in executive remuneration, but boards also consider skills, expertise, and experience when setting executive pay packages.
Recently, the issue of executive pay has received momentum, this topic has been a subject of discussion among academics, financial and business experts, policymakers, and the general public.
Another group that is immensely concerned about executive pay are shareholders, especially institutional shareholders, who are now asking that the board of directors give justifiable reasons for high pay packages; this scrutiny on executive pay has intensified post-pandemic due to an economic downturn. When one is accessing the pay vs. performance discussion, it is also imperative to look at it holistically.
The gap between the wealthy and everyone else is getting wider, income inequality has grown to be a serious issue. Many have questioned whether the executive pay issue is a symptom of more serious problems with wealth inequality and concentration problems.
One of the issues of contention is the gap between executive compensation and company performance. Critics have submitted that in some cases, regardless of the company’s profitability, executives often receive huge compensation packages, which in turn has led to an economic downturn.
It has been argued that a compensation system of this kind encourages executives to engage in risky behavior that can ultimately harm the company and its shareholders. It is worth noting that striking a balance between board member compensation and performance measures can be challenging. Notwithstanding, doing so is crucial for the long-term success of the business.
The issue of executive pay is so delicate that when managed effectively, it improves corporate performance by synchronizing directors’ conduct with the business strategy.
Consequences of poor management
On the other hand, when there is poor management of executive compensation, it can have disastrous consequences such as critical personnel departures, low morale, misaligned objectives, and deteriorating shareholder returns.
Finding the appropriate remuneration is crucial for the board and management team because the risks are significant.
This article will examine how to balance performance measures and pay for board members, in order to ensure that the executives are motivated to make decisions that are in the best interest of the firm and its shareholders.
Moreover, it is essential to briefly note and also equally important to consider the cultural factors that contribute to executive compensation issues.
Executives are often given large compensation packages to demonstrate their worth and success, and executive compensation is often a symbol of status and prestige. Addressing this challenging cultural mindset is critical to building a fairer and more sustainable reward system.
The Duties of the Board and why is it Tied to performance indicators.
The board of directors is tasked with the responsibility of determining the strategic direction of the firm, supervising management, and managing the finances of the organization.
In order to access the efficacy of the board, setting performance measures for the board is imperative.
The effectiveness of the board can be evaluated based on how it successfully performs its duties, such as completing its strategic plans.
What are the common performance indicators/ metrics for boards and how does one Connect remuneration to these performance metrics?
According to Groysberg, Abbott, Marino, and Aksoy common performance metrics are revenue growth rate, total shareholder return, and profit margin. The best method to ensure that the board is motivated to make choices that are in the best interest of the firm and its shareholders is to tie compensation to performance measures.
For instance, if performance metrics, such as an increase in revenue growth, profitability, or shareholder value, is the focus of the company, it should also be the focus of the remuneration plan for the board.
Accordingly, such organizations link long-term incentives to the major element of executive compensation in order to promote top-line growth, profitability, or increased shareholder value.
Recently, there has been a push to include meeting Environmental, Social, and Governance (ESG) strategic goals as a means of boosting or reducing executive pay.
For instance, in the United Kingdom (UK) investors are establishing standards and objectives for remuneration measures connected to ESG strategic targets.
What do boards consider in order to execute an executive pay package?
Benchmarking compensation: it is not uncommon for companies to base executive compensation in their firm on what other executives are being paid. This method will be coined for the purpose of this article as ‘’the market determines the pay package approach’’.
It has been submitted that firms access what their peers pay executives, and compare it with theirs; in other to ensure that they are not paying way less than their contemporaries, which could lead to executive attrition.
Furthermore, it has been asserted that another reason for benchmarking remuneration is, a low-paid board in comparison to the industry standard reduces shareholder confidence in the board.
- Professor Rau Stated that ‘…no one wants to look like an idiot. You do not want to say to your shareholders: ‘Look, we have a brilliant CEO, and as proof of his brilliance he accepted peanuts to come and work for us…’.
He further opined that whatever treatment is given to the CEO will be accorded to the rest of the board.
However, the method of benchmarking pay in order to create an executive compensation package has been criticized as it has been said to create a ‘Race to the Top’ when it comes to executive remuneration.
Thus, this rivalry can push executive compensation to a state where pay is no longer determined by performance metrics and company values but by a rat race of who can pay more. Additionally, it was asserted that benchmarking executive pay in other to determine executive pay could be self-serving.
This is due to the fact that directors sit on multiple boards within the same industry or in industries that complement each other; and if they can raise the bar for pay on one board, the other boards they sit on will be incentivized to increase pay, which in turn is a win-win for them. They will keep cashing out.
- Skills, expertise, and experience of the directors: The skills, expertise, and experience of the board are also used to determine an executive package. Directors who have the experience of serving on different boards are usually paid more for their wealth of experience. Additionally, directors with specific skills, who are experts in the field or industry the company they serve, get paid more for their skills and expertise
Why is it important to maintain an equilibrium between Performance metrics and executive pay?
While it is vital to link remuneration to performance measurements, nonetheless it is just as critical to make sure the metrics are balanced. The board may decide to favor short-term benefits over long-term goals if the performance indicators are too heavily geared toward financial measurements.
Additionally, the remuneration package must also be fair, and practical, and reflect the effort of the board in executing their roles and duties.
Ways in which executive pay can improve Performance metrics and the bottom line
- Equity compensation: According to a survey carried out by Groysberg et al for Harvard Business Review, it was opined by a director that equity compensation motivates board members to think like owners. It was further stated, based on the director’s experience as a board member on a board, where the CEO held a sizeable equity stake that the CEO said ‘We should do the right thing’. ‘…We’ve got to grow the value of the equity…’. On the other hand, the director gave an example of another board he sat on, where the CEO had a less substantial stake, the CEO employed a typical manager-focused approach with an eye toward income incentives only. Consequently, this resulted in a situation where there were doubts as to whether the company’s goals has actually been accomplished.
- Compensation based on survival instead of growth: it has been submitted that often times when compensation packages are based on growth companies tend to invest more which could eventually affect the bottom line. However, a push for an incentive package that changes the company’s focus from growth to survival might enable companies to weather the storm during times of volatility. Groysberg et al opined based on a case study of an oil and gas company, that focused its executive package on survival over growth; it was submitted that not only did the company survive the volatility of the oil market, they also built strategies around sustainability.
Thus, it can be argued that a compensation package that is linked to the company’s strategy on survival over growth can ensure that the company becomes sustainable. The importance of sustainability cannot be reiterated enough. Hence I will coin this quote ‘Think sustainably to achieve longevity as a company’. Therefore it can be submitted that prioritizing survival and thus tying executive packages linked to sustainability /survival performance metrics, would lead to the long-term success of the company.
- A mixture of base salary and performance-related incentives: To address the issues that pertain to executive salary versus performance, it has been asserted that a compensation structure that mixes base salary with performance–related incentives could be implemented. It has been suggested that paying executives a base compensation equal to the average employee salary and performance-based incentives based on certain measures will be advantageous to the organization’s long-term success. This method of linking bonuses to performance will ensure that executives meet their targets because they are aware that the implication will mean they earn the same basic pay as ordinary employees at the company.
What role does the remuneration committee play in ensuring an equilibrium between performance metrics and remuneration?
The remuneration plan for the board must be created and put into effect by the remuneration committee. Members with experience in corporate governance, finance, and compensation packages should be on the compensation committee to ensure that the remuneration package is just and equitable. Furthermore, the committee should also liaise with external experts in attaining a fair pay package.
An effective and transparent mode of disclosure should be imbibed by companies when it comes to executive remuneration. The pay package should be published to shareholders and other stakeholders and should be elucidated in a transparent manner to ensure that the board’s compensation is fair and reasonable.
The importance of reviewing and modifying the compensation package periodically
To make sure that the remuneration package is accomplishing its intended objectives, it should be frequently examined. Constant reviews by the remuneration committee will ensure that the pay package continues to galvanize the board to make decisions that are in the best interests of the firm and its shareholders. Therefore, the remuneration committee should examine the performance measures and modify the reward package as needed.
Conclusion
In conclusion, balancing performance metrics and board remuneration is an essential duty that needs a well-thought-out process. The board can be motivated to act in the organization’s and its shareholders’ best interests by linking compensation to performance measures. However, it’s also crucial to make sure that the pay plan is suitable and fair, and that the performance indicators are balanced. The fairness and reasonableness of the pay package depend on transparency and disclosure as well. Companies can make sure that their board of directors is motivated to take actions that optimize long-term shareholder value by adhering to these guidelines.
Oluwaseun Modupe Ogungbe is the Lead on (Research and Publications) at the Society for Corporate Governance Nigeria
About The Society for Corporate Governance Nigeria
SCGN is a registered not-for-profit organization committed to the development of corporate governance best practices in Nigeria. Today, the Society is the foremost institution committed to the development and promotion of corporate governance best practices in Nigeria.
moluwaseun@corpgovnigeria.org