The focus on directors to ensure good governance processes for the determination of executive pay makes it important to consider the steps that should be employed in benchmarking executive remuneration. 

This article provides a checklist to review your own processes.

1. Benchmark pay against a relevant peer group

Compensation benchmarking is the first step to be taken in setting executive pay levels.  It involves selecting an appropriate peer group, desirably identifying competitors of the same size and within the same industry.  These may be refined from an initial selection of companies chosen from the GICS (Global Industry Classification Standard).  The companies should be both larger and smaller, with the objective of establishing a median size that closely approximates the company’s size.  A common convention is to include companies that are in a range between approximately half the company’s size (usually by market capitalisation) and twice the company’s size.  Numerous studies, including the Australian Productivity Commission’s recent review, have confirmed the close correlation between market capitalisation and remuneration.  Market capitalisation is also likely to be more valid than revenue when assessed across varied industries in cases where an adequate peer group cannot be constructed from sector-specific companies.

2. Find and set appropriate performance measures

Appropriate performance measures are a fundamental element of a performance pay system.  Establishment of the basis for receiving payment involves:

• selecting performance measures that support the business strategy
• setting challenging goals, and
• calibrating payouts based on the level of achievement 

The measures may be financial, operational or strategic.  Financial measures can be accounting, economic or market-based.

Accounting measures are well understood, externally audited, and easily communicated, but do not capture strategic factors that may be vital to success, and do not necessarily reflect how efficiently capital is being used in the business.  Examples include growth in revenues, net profit after tax, return on investment (ROI), and earnings per share.

Economic measures (such as economic value added or EVA®, and economic profit) recognise that cash flow and not accounting earnings creates shareholder value, and return expectations of investors given their risk exposure.  The recently amended APRA prudential guidelines suggest their application for regulated financial institutions in the wake of the global financial crisis (GFC).  Outside of regulated financial institutions, economic measures are well suited to highly capital intensive companies.  But these measures can be complex and difficult to communicate, and experience suggests that it is unwise to link them with reward programs unless they have been well established and understood within the business for broader management purposes.  In their early stages of application for incentive plans a careful simplification of the measures can often be undertaken with a high degree of success.

Market measures are transparent and directly aligned with shareholder interests.  Examples include relative total shareholder return, and share price.  However, the degree of influence exerted over them by executives (that is, the “line of sight”) is arguable but can be assessed and tested before any decisions are made.  These measures are not particularly well suited for those executives who are not at the most senior levels of the organisation. 

Operational measures focus on the efficiency and quality of business operations.  Examples may include stockturn, customer satisfaction, safety, sales and administrative costs etc. But while important, these may sometimes miss the key business drivers that could hugely impact shareholder value. 

Strategic measures are to an extent subjective, and require a very high degree of business judgement.  Examples could include business divestment to strengthen the balance sheet, acquisitions to better control market access and distribution, or new product development for longer term growth.  They need to be clearly defined to ensure that clarity of the objectives and how they will be measured is not compromised at the end of what can be a long performance period. 

In Australia, market and financial measures are most commonly applied to long-term incentives.

3. Performance calibration

Calibrating award payments requires identification of a minimum acceptable level of performance, a target and a maximum award (assuming a decision not to provide an uncapped payment).  A decision must also be taken as to whether goals will be based on internal results or measured in relation to a peer group or external benchmark. A common approach is to use internal goals for short term (annual bonus) programs and external references for long-term incentives.

A balance must be achieved in the goal-setting process.  Insufficiently challenging goals will result in guaranteed bonus payments and an expectation of annual payments.  Shareholders may also not be happy with generous rewards for mediocre performance.  But overly-difficult goals will be de-motivating to executives, contributing to dissatisfaction and executive turnover.  Realistically achievable results are therefore the aim, but there should also be opportunity for significantly heightened payment where the executive delivers clearly superior outcomes. 

4. Relativity of pay and fairness within the company

Internal pay equity considerations require the organisation to address the relative internal value of a particular position and to ensure fairness in its overall remuneration practices.  In some cases, an organisation may place greater emphasis on a position than the market does, due to its specific operational or strategic considerations.  At very senior levels, the organisation might also wish to look carefully at the relationship between CEO pay and that of direct reports, as too large a disparity can sometimes be seen as indicating potential problems of succession and risk to the company, as we have reported previously (see HERE).

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