- On October 19, 2016
We frequently describe Sheffield Barry’s approach to compensation consulting as “Principled, but not Dogmatic”. What exactly does that mean?
We have a number of principles which guide our advice to clients. However, we reocgnize that none of these principles ought to supercede the business priorities of our clients. In most situations, our principles do not conflict with our clients’ priorities, but rather serve to support and reinforce their business needs.
As our thinking has evolved, we’ve attempted to articulate and “open-source” our principles, so that our clients and the entire executive compensation community can benefit from, consider, comment, disagree and most importantly help refine our thinking.
Our principles include:
- Pay for Performance
- Let internal needs drive pay decisions
Let’s disccuss each of these in more detail:
Pay for Performance
The phrase is ubiquitous. Everyone believes in Pay for Performance.
However, not everyone agrees on what P4P means.
Here is a starting point: Pay for Performance can be defined by ensuring that three dimensions are addressed:
a. Paying for the RIGHT performance
b. Paying for the RIGHT AMOUNT of performance
c. Delivering the RIGHT AMOUNT OF PAY for the right amount of performance
Across these three dimensions above, (a) implies the need to identify the right measures of performance. Understand which financial and non-financial measures will lead to increases in the value of the enterprise when such measures improve. Whether growth, improvements in profitability, expansion of market share, returns on capital, or other measures, the measure or measures identified should correlate with shareholder value and align with the company’s business strategy.
(b) Paying for the right amount of performance implies a strong understanding of the goals associated with the measure(s) selected in (a). Reasonable performance goals must be both MEANINGFUL and ACHIEVABLE. Meaningful in the sense that achievement of such goal will result in increases in enterprise value. A goal that won’t result in an increase in value when it is achieved is obviously not meaningful. Achievable goals are not so agressive that they can’t be achieved. Indeed, unachievable goals will either result in a demoralized team, or will encourage behavior that may be unethical, illegal, or otherwise not aligned with the overall long-term business goals. (see recent Wells Fargo retail account scandal.)
Finally, (c) delivering the right amount of pay for the right amount of performance implies a payout calibration appraoch that makes sense for all stakeholders. Typically, this involves establishing a minimum or threshold payout level that begins at a level of performance below target, and setting a maximum payout level that is consistent with a superior level of performance.
Once you have addressed these three dimensions, test various performance scenarios and ensure that pay outcomes are reasonable under anticipated performance assumptions. After the performance period is complete, test actual pay results against actual performance results. Did your 80th percentile performance translate into 80th percentile pay for your executive team?
Keep in mind that other influencers of executive compensation (including and especially shareholder advisors, institutional investors, and others) all have their own definition of “pay” and separately of “performance”. However, if the three dimensions of P4P described above are addressed in a systematic manner, materially stronger pay programs will result. And your company will have a pay for performance philosophy that is easily defensible to shareholders, customers and employees.
Balance is important in virtually all things. For every business, 100% focus on anything carries risks. A 100% focus on growth will often come at the expense of profitability or returns on capital. Conversely, 100% focus on maximizing profitability will limit growth opportunities.
Such is the case with compensation as well. A 100% formulaic approach to compensation will bring with it risks of not being able to address external issues that affect a company’s performance. 100% emphasis on equity compensation will risk not being able to attract and retain talent that values pay delivered in a different currency, like cash or paid time off. Compensation focused on individual performance may fragment the workforce rather than encouraging everyone to focus on important corporate goals. Likewise, a focus on the short term may often limit long term sustainable success. A focus on results may not appropriately reward exceptional effort in a less-than-favorable business environment.
We believe that all elements and design dimensions of compensation should be in a state of balance and should not over-emphasize a single goal, currency or other focus. Short-term pay balanced against long-term compensation. Cash and equity. Financial performance and market performance. Quantitative performance and qualitative performance. Corporate results, business unit results and individual results. Performance and retention.
We don’t suggest that each of these dimensions should be balanced 50%/50%. Instead, the balance point for each of these elements and dimensions should differ depending on the company, the situation and its business strategy. And even within a company, the balance point should likely differ for various employee groups, business units or departments, geographies, and other segments.
Let Internal Business Issues Drive Pay Decisions
One of the frequent frustrations we have encountered with clients over the years is the tendency of Compensation Committees and management teams to latch on to external competitive benchmarking data and adjust pay levels or program designs simply because their pay looks different than “market.” While misguided, this inclination is completely understandable. It provides an easy way to defend pay decisions that may be unpalatable in some way to other audiences. Unfortunately, allowing external market practices drive your pay decisions may leave you with a compensation strategy that fails to support your business strategy, your internal circumstances, or other business needs.
Instead, let your internal business needs drive your compensation strategy and pay decisions, with external market practices serving as an input to that process. If your business needs require heavier investments in IT talent or legal resources because of your business model or priorities, then don’t be afraid to pay above market for those teams. Pay for various parts of your company will always differ from external market benchmarks. And probably should.
However, there are risks associated with paying talent above market competitive rates (your cost structure will not be competitive), just as there are risks associated with paying talent below market (turnover and employee engagement risks). Companies should feel free to allow pay for individuals to be well above or well below market, but unless circumstances dictate otherwise, total aggregate pay should likely trend toward external market reference points.
Use external market data wisely. Consider ways to deviate from market practices and pay levels if there are better approaches to support your company’s internal business needs and goals.
Consultants love to demonstrate their expertise in designing extremely sophisticated pay programs — incentive approaches especially — to try to address every business issue, mitigate all uncontrollable externalities, and to protect all parties against every potential contingency. Every consultant desires to demonstrate their extreme intellect, experience, creativity and innovation. Over the past 25 years, we’ve seen every compensation consulting firm develop, market and promote every type of new incentive approach as the new “silver bullet” of incentive design. Indexed Stock Options. Market Stock Units. Phantom Stock Options. Performance-based Leveraged Stock Matching. EVA-value sharing programs. Bonus banks. Premium-priced options. Performance-vesting stock options with multiple retesting periods. And many more that I can’t remember.
We admit that we, too, are guilty of recommending similarly overengineered solutions earlier in our careers, though we like to think that we have outgrown such hubris. As we have gained more experience — particularly experiencing how various incentive vehicles work (or don’t) through multiple business cycles — we have realized that simplicity is a compensation design principle that is not given as much priority as it deserves.
The most sophisticated compensation program has zero value if employees are unable to understand the program, and more importantly, how their day-to-day activities contribute to the performance being rewarded via the compensation program. Unless time and resources are invested in communicating the program effectively and providing participants the knowledge required to “use” the program and calculate potential compensation outcomes, the effectiveness of the program will be lost. An easier approach is to default to the simpler approach when considering alternative compensation programs.
Simplicity should be a key principle guiding the design of all compensation programs.
The recent Wells Fargo phantom customer account scandal has re-focused the world of compensation professionals on risks involved with incentive programs (as well as clawbacks, whistleblower protocols, and a host of other compensation and governance issues). In the Wells Fargo case, incentive programs designed for managers and retail bankers rewarded bankers for selling as many products to (read: opening as many accounts for) each customer who walked into the branch or answered a cold call from bankers dialing for dollars. The incentive program and the aggressive sales goals associated with the program resulted in retail bankers opening accounts for customers without their permission. (See our in depth discussion of the Wells Fargo scandal and implications for Compensation Committees here).
Ultimately, 5,300 bankers at Wells Fargo lost their jobs, including Wells Fargo CEO John Stumpf. It remains to be seen what kind of fallout the Compensation Committee or other Board members will suffer.
One of the key lessons from the Wells Fargo scandal is that HR, the Executive team, and the Compensation Committee all need to understand the potential risks associated with key incentive programs, including the behaviors and decisions encouraged, the magnitude of potential risk involved, and the mitigators of such risk. While most companies have a relatively robust risk review process, now may be a good time to re-review such processes.
Just as Simplicity, Pay-for-Performance, Business-led Pay Design, and Balance should serve as important compensation design principles, so too does an understanding of Risk.
These principles serve to guide compensation design and decision-making and form much of the basis of our advice and guidance to clients. The principles “fence off” an area in which compensation decisions can be made to support each company’s unique needs, while avoiding poor pay practices to the best extent possible. However, in no event do we argue that these principles are more important than the need for pay programs that support a company’s business strategy. These principles do form the key areas that ought to be thoroughly discussed among HR and management teams, outside advisor (like Sheffield Barry) and Compensation Committees.
Sheffield Barry is a Compensation and HR Consulting firm, focused on providing effective and customized advice to clients in an efficient manner. We leverage technology to deliver data and analysis as efficiently as possible, so we can invest more time understanding our clients’ unique business issues to develop custom solutions and advice. Please visit us at SheffieldBarry.com or email us at info@SheffieldBarry.com.