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Playing it Safe on Compensation

A recent study finds a majority of executives would choose fixed pay over a potentially larger bonus. Experts say that the onus is on HR leaders to develop compensation and incentive plans that show executives the link between their contributions and their pay.

Tuesday, June 26, 2012
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Imagine this scenario as a sort of present-day version of "Let's Make A Deal" for executives: Behind Door No. 1 is a clear-cut compensation package with fixed pay. Behind Door No. 2 is a riskier, bonus-driven package that's less defined but potentially more lucrative. Which option do you think most executives would choose?

Perhaps not surprisingly, a recent PricewaterhouseCoopers and London School of Economics study finds that a majority of executives would choose the former.

The study, which polled 1,106 senior executives representing 43 countries, found only 28 percent of executives indicating they would opt for a more ambiguous pay package with a potentially higher bonus over a clearer, fixed pay package.

That particular finding shouldn't come as a great surprise, says Scott Olsen, head of New York-based PricewaterhouseCoopers' U.S. human resource services practice.

"Executives are no different than other groups of people, in that they are basically risk-averse," says Olsen. "And executives, like investors, demand a premium for more risky forms of pay."

While not unexpected, this particular finding may be "something of a red herring," according to David Wise, senior principal and director of practice development with the Hay Group, a global management consulting firm with its U.S. headquarters in Philadelphia.

"Humans tend to react more strongly to loss than we do to gain, so the choice between a 'sure thing' and an uncertain outcome is usually going to be an easy one, he says. That's why most executives aren't given this choice. Being an executive in America means having some pay that will flex with performance. Period."

Nevertheless, the findings should remind HR leaders of the value executives place on the "sure thing," adds Wise. "This comes into play in annual and long-term incentive plan design when companies are determining how to set some basic value floor, whether it's where to set threshold performance levels, or providing a core level of less-variable equity incentives like time-vested restricted stock, for instance."

For HR, each element of executive pay -- salary, short-term incentives, long-term incentives -- have different objectives in the total rewards package, adds Don Lindner, executive compensation practice leader with WorldatWork, a Scottsdale, Ariz.-based provider of research focused on global human resources issues, including compensation and benefits.

"At the executive level, the package needs to be competitive and designed to help the organization meet its business goals and, in turn, create shareholder value."

In the current economic climate, companies face even greater pressure to connect executive pay with performance, which steps up the role that short-term and long-term incentives play in today's total rewards packages for executives, he continues.

"The key is to find a balance between simplicity of design while still focusing on goals that enhance business results with a balance of internal and external measures."

Indeed, short- and long-term incentives are key components of today's executive compensation packages. The PwC study finds, however, that fewer than 50 percent of executives think their organizations' long-term incentive plan is an effective incentive, although nearly two-thirds of respondents said they "value the opportunity to participate" in their firm's long-term incentive plan. While the actual economic value of long-term incentives to executives may be much lower than the cost companies bear to provide them, these plans can still provide less tangible benefits to executives, says Olsen.

"Among these intangible benefits are the feeling of being part of an 'elite' group within the organization, and the feeling of sharing in the company's success," he says.

"The message to HR leaders is to develop plans that are relatively simple and durable, in that they don't change every year, are shorter in terms of time -- recognizing regulatory and shareholder preferences -- and focus on whether performance metrics used in such plans are seen as fair and relevant to the company's strategy and executives' scope of responsibility," Olsen continues. "Further, long-term incentives should be regularly and consistently communicated, to reinforce the intangible value that executives attribute to these plans."

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In developing incentive plans -- particularly long-term incentive plans -- HR leaders must also effectively align outcomes between executives and company stakeholders, adds Wise.

"Executives who feel that they can't directly impact their stock price don't understand why their long-term incentive pay is linked to it," he says. "The answer is that this linkage reflects the interests of shareholders, and that's important regardless of the motivational value.

"All that said, it's important to have enough in the totality of the pay program, between annual and long-term incentives, to provide a line of sight between an executive's contribution and his or her pay outcomes," says Wise.

Ultimately, pay outcomes are certainly an important factor in executive compensation packages, but shouldn't necessarily be given too much weight. In fact, the study finds that, on average, executives said they would take a 28 percent pay cut for their "ideal job." Olsen points out that the pay cut many executives indicated they would take is far less than the drop in pay (60 percent) they believe others would take for their dream position.

While this finding suggests "a bias against reducing one's current earnings, irrespective of their job," it also indicates that "improvement in job content -- more interesting work, greater sense of fulfillment, for instance -- may reduce the pressure executives feel to continuously increase their pay levels," he says.

There is a significant trade-off between how much a job pays and how much pressure, stress and poor leadership any employee, including an executive, can stand, adds Lindner.

"Organizational culture, leadership, management style, respect for individual employees, amount of control over your own work and organizational results all have a big influence on employee engagement and satisfaction, even at the executive level," he concludes. "So for companies and their HR leadership, it's important to have a well-designed and competitive pay package, but some of these other environmental factors have as much or more of an impact on recruitment and -- probably more importantly -- on retention."

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