Many directors serving on remuneration committees are not experts in compensation. Yet, they have a duty of due care. They need to ensure that they have been informed and advised, so that they can make decisions in good faith. Hence, they require a viewpoint, a perspective, an opinion based on analysis on how to determine executive pay.
Compensation advisors and management need to improve the tools of analysis that are to be placed at the disposition of members of remuneration committees. It is not enough to just tell directors that pay for a certain executive is reasonable or in-line with market. What is required is analysis on the basis of which directors can make their pay decisions.
This article presents four perspectives on how executive pay can be determined, and each of these ways of setting executive pay should be kept in mind when making pay decisions. They are:
1. Market Assessment
2. Internal Pay Equity
3. Wealth Accumulation
4. Profit set-aside
Market assessment: The first step in conducting a market assessment is â Peer Group Selection in light of the level of role complexity and job worth differences. The appropriateness of the peer group is an important issue that is raised constantly by members of remuneration committees.
The rule of thumb is that one should select 12 to 20 companies, and that the market capitalisation or revenue size of these peer companies should be plus or minus 50% of the revenue or market cap of the company being benchmarked. The industry should be as close as possible to that of the company, and the performance of peer companies should be representative. Of equal importance are organisational complexity, risk profile, domestic versus international operations and whether the business operations are pass through or manufacturing.
Oftentimes there are major problems in conducting a benchmarking study, in that the business and the top jobs included in the survey are not comparable. Data is mixed together from companies whose business models are not comparable. Regressing pay on the basis of revenue is inaccurate. In addition, many studies do not contain an analysis of business performance.
Even though revenue sizes may be comparable, the business complexity and the geographic and regulatory complexity among the peer companies can be very different. Directors should no longer accept peer groups and the resultant pay percentiles at face value. They have to exercise their own judgement as to the process that should be used in developing peer groups and in conducting pay analysis. Hence, the compensation committee should conduct a quality assurance check on the reports being presented. Directors are often quick to pick up on data integrity and analytical problems and, at the end of the day, should exercise their own judgment.
They can do so by checking whether the report mixed executive roles in terms of level of work and the complexity across industries and sectors. They need to review whether industry sub-sectors have been mixed together, which would lead to unreliable pay percentiles. They should not accept reports that regress on revenues, or that are based on peer companies whose revenue size or market capitalisation are so much bigger than those of their company, so that the information would be skewed to the larger companies. Finally, they should also check that there is no mixing up of jobs with a domestic, regional and international scope. After all, not all C-level jobs are created equal.
The information obtained from benchmarking and pay surveys is just one aspect of how executive pay should be determined. Another perspective would be to keep an eye on how CEO pay is set in relation to that of their direct reports. How is compensation distributed around the organisation? The internal equity approach would remove concerns that pay is too much driven by competitive market data and by outside consultant surveys, and it would help mitigate market biases.