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L&A Original Article: What are We Paying For?

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Add together the volatile ingredients of egregious CEO pay articles, gender pay gaps, say-on-pay votes, CEO pay ratio legislation, media bias, market volatility, compensation lawsuits, collegiate athlete pay debate, the corporation of ISS, proxy board elections, etc. and it’s easy to understand why nearly everyone has a strong opinion on what other people should make, especially executives.

Since we spend 100% of our time in the corporate boardroom, or even courtroom, defining what is reasonable compensation, we have heard lots of interesting debates on the topic.

And there is no question that individual and company performance is a major consideration for determining how much to pay an employee. However, it is not the only factor. There are a number of strategic and tactical factors that should be considered to create the right range of reasonable compensation.

The following is a list of non-performance factors that can have a significant impact in shaping reasonable compensation ranges.

What other companies pay for similar roles and responsibilities should be the starting point. This scientific analysis is such a critical input to determining pay that compensation accrediting organizations dedicate an entire certification course to market pricing. These courses include inputs to defining reasonable compensation such as job description, roles and responsibilities, company industry, company size, and geography.

While critics sometimes scoff at the approach of “keeping up” and the seemingly self-inflicted ratcheting effect that occurs, the reality a company faces is – if it doesn’t pay its people competitively with the market, somebody else will. According to The Carrot Principle, by Gostick and Elton, a rule of thumb for the cost of replacement is 2x – 3x base salary, and the new incumbent will be paid at the market rate regardless of how high or low the exiting incumbent was compensated.

What many governance experts who opine on compensation fail to realize, is certain industries have way more demand than supply of certain skills. This shortage of key talent simply becomes a cost of doing business in those industries. The result is a company that wants to compete in one of these industries will often pay for retention. Providing proper handcuffs on key employees through retention grants of restricted stock can and should be considered in high competitive industries. There certainly is a cross-over between pay for retention and pay for performance, and a properly designed compensation program should take into account both in a tight labor market.

Pay for Investment, Not Pay for Expense

The single most important asset to an organization is its employees. However, some companies fail to realize this is a key investment decision, not an expense decision. Just like with any investment, the outcome is uncertain until value is realized. With employees, this often gets manifested through a compensation philosophy that targets total rewards above the market median. What may seem like a larger investment into setting the best compensation structures going forward is much better than the reverse of a high-turnover/cheap work environment where employees are not satisfied. Bottom line, the greatest ROI any company has, will always be its people.

In dealing with justifying pay for highly compensated individuals, sometimes experts are required to justify or uphold compensation decisions made by a company. The Internal Revenue Code has determined under Section 162 that a taxpayer may deduct compensation if reasonable through nine specific factors. A few key factors are the employee’s qualifications and work experience, the size and complexity of the business, compensation of comparable positions, and the amount of compensation paid to the incumbent in previous years. The last factor under IRC 162 offers a seemingly simple compensation strategy to reward key employees for all of their years of service. For example, this is particularly helpful when a CEO has served a company well for a significant number of years, yet has been compensated relatively low versus the market. The resulting compensation for prior years’ service analysis offers a board of directors a judicious and reasonable way to compensate the CEO for all of the value created over time.

Many times a turnaround or even start-up company will attract a key player from a much larger company with a successful track record. This does typically come at a cost. In order for an experienced executive to make the leap of faith, they command a premium to their existing total rewards package. If a company were to use a traditional approach of normal market pricing based on the start-up size, it may never be in a position to attract that valuable player. One approach is to offer the large company player the “chance” to earn significantly more than their existing total rewards package through long-term incentives. How much more? Total Annualized Rewards x 2 is a good starting place. But performance is key in those scenarios.

Companies continuing to refine their variable pay programs balance the need for formulaic versus discretionary measures. A purely formulaic program may show alignment to actual performance but may not necessarily drive intended results. The use of discretion as a component of variable compensation allows management teams and compensation committees to align individual performance with the intangibles a formula cannot capture. As accurately stated by one compensation committee chairman, “A spreadsheet at the beginning of the year cannot determine performance better than I can at the end of the year.”

The answer to the ever elusive question: “What are We Paying for?” is often more than just performance. Companies should consider internal and external factors in making compensation decisions throughout all levels of the organization. Bottom line: Find the best employees, train them, invest in them, and compensate them appropriately, and the returns will come.