Pay Differentials and deciding compensation

In the management field some believe that CEO pay should be roughly twice the amount paid to the next management level, and that a differential by a factor of two is felt fair. There seems to be something to this ratio, in that the difference in every real level of work would lead to a doubling of pay.
Among S&P 500 companies the median does indeed approximate a factor of two. But the problem is that there are many outliers. We have seen differentials of 27 times, or even of 50 times.
In conducting an internal equity check, directors should look at all the elements of the pay package and not just at the differential in base salary. While base pay may show the right differential, when including equity incentives or benefits, the differential is often much larger.

So, it is as if there is a constant, a natural stability or scale in the relation between compensation and the number of people in an organisation. Hence, an entire management pay structure could be built with a scaled model that has a differential factor of 2.0 or 2.5 at the most, across the levels, from the single global CEO (level 1), to the group of COO / Sector CEO / Sector President (level 2), to a larger group of Business Unit Presidents (level 3), and onto an broader group of Business Unit VPs or SVPs (level 4), and finally to the large group of Senior Managers / Directors (level 5).
If the differential is less than 2.5, then your organisation may have too many levels in its management structure. Real differential in work is the only justification for pay differentials. Directors can set certain red flags and tell the company to reduce over-layering and over-titling.
If CEO pay is more than three times that of their direct reports, then this could be an indication of a weak Board and poor corporate governance. Pay differentials that are larger than a factor of 3.0 could also be an indication of person risk and potential CEO succession problems.

It often points to excessive company compensation, poorly structured performance metrics, and poor delegation of work cascading down the organisation. Such a structure would give the impression that only the CEO, and not the senior management team is accountable for the future value of the company, its growth and innovation. It could impel towards acquisitions rather than organic growth and excessive balance sheet leverage at the risk of long-term sustainable value creation. It could also be indicative of broader and more systemic governance risks.
Of course, the danger of the internal equity approach is that you might be underpaying compared to the market. In response, the committee could study what the internal relativities are in the same industry. One could study CEO pay in relation to that of the company’s whole workforce, or the aggregate pay of all senior managers against that of the company’s total employee population.
Another approach to determine executive pay is to set wealth accumulation targets over a number of years, given a pre-determined level of performance. Once executives start to exceed these levels, pay would be adjusted in terms of future base pay increase or future equity awards.
This approach would limit pay that is due solely to increase in the stock price. Again, this approach could leave pay uncompetitive against the market or penalise executives for (so-called ) success. But, it makes sense for the board to have a longer term perspective, especially for new hires, and say, if we reach X level of performance over the next 3-5 years, our new CEO should have accumulated approximately $Y in terms of wealth.
The final perspective on determining pay is to set it in relation to the company’s profits or net revenue , as is done in many professional service firms, such as by investment banks, private banks and consulting firms. For example, among the investment banks or commercial banks with a substantial investment banking arm, total compensation and benefits typically constitutes between 30% and 50% of net revenues.
A percentage of profit could also be used to determine the value of the merit increase pool, cash bonuses and equity awards. This pool would then be allocated to the executives based on their performance. The advantage of this approach is that it ties compensation of senior executives to the success of the firm. The disadvantage is that pay could be either far in excess or far below the market rate, depending on business performance and the divergence of the profit from stock price growth.
Directors serving on remuneration committees with four perspectives or approaches given above can use in interpreting and passing judgment on executive pay proposals. Not all perspectives may be relevant in every single instance.
Nevertheless, all things considered, it would still be useful to keep these perspectives in mind, and apply them when necessary. In this way, directors on the remuneration committee exercise their duty of due care to the corporation.