Executive remuneration
high
definition
in
Article two – a high definition
approach to benchmarking
Our latest series of papers turns a high definition lens to different aspects
of executive reward. This second article examines the use of benchmarking.
What is executive remuneration in high definition?
Sensible remuneration
strategy is often
undone by poor
execution.
©2010 Hay Group. All rights reserved
When looking at the remuneration policies
of new or potential clients, we often find that
an apparently sensible remuneration strategy
is undone by poor execution. This usually has
its roots in ‘low definition’ thinking – too many
remuneration committees are satisfied with a
set of fine sounding policy statements without
realising that these are being undermined by
the reality of how they are applied.
The good news is that these problems are not
difficult to fix. The solution is to dig a little deeper,
to ask the ‘why?’ question and to prod and poke
the policy to see if it is robust: in other words to
look at executive remuneration in high definition.
This article is the second in a series turning a high
definition lens on a particular area of executive
reward. Please email [email protected]
for a copy of the previous edition which was
focused on relative TSR.
Executive remuneration in high definition
Benchmarking – does it
really matter?
It’s important that
the market data used
is fit for purpose.
Our ‘new map for executive reward’ argues
that many remuneration committees focus too
much effort on benchmarking at the expense
of developing pay arrangements that reflect
the organisation’s business strategy and
approach to talent management.
Yet we find that those same remuneration
committees often rely on low resolution data
that at best paints a very approximate picture
of the competitive position and at worst may
systematically over or understate the level of
competitiveness.
And even if you accept Hay Group’s ‘new map’
approach to executive reward – with market data
of less importance than organisation strategy in
determining reward – it’s still important that the
market data used is fit for purpose.
Why so fuzzy?
Most UK remuneration committees have a
median policy and most remuneration reports
are very clear about this. And remuneration
committee members normally have a reasonable
understanding of the comparator group(s) used
and the definition(s) of remuneration (base
salary, annual compensation, total compensation
etc) under consideration.
However, there are some other key questions
which non-executive directors have not
(at least historically) been encouraged to consider.
n I
f our
policy is to use a broad comparator
group of companies of similar size, how
should these companies be selected?
n I
f our policy is to pay at the median, what
does this mean if we are one of the larger or
smaller companies in the comparator group?
n E
ven
if our on-target total compensation
is at median, how does our remuneration
compare if we perform particularly well or
particularly poorly?
In the rest of this paper, we consider the answers
to these questions and others and set out how
benchmarking in high definition can work.
Choosing comparator groups –
introduction
Today, comprehensive disclosure in annual
reports means that anyone with a computer
can produce market comparisons. This means
that comparisons are no longer limited to a
consultant’s own clients, transparency is much
greater and competition has driven costs down.
However, the downside of this new world has
been a reduction in definition with a tendency
to over-simplify comparisons and / or to ignore
potential flaws in the comparisons made.
Happily these problems are easy to solve. It just
requires remuneration committees to remind
themselves of some essential truths that they
already know.
©2010 Hay Group. All rights reserved
Choosing comparator groups –
Broad peer groups
A common approach is to use market
capitalisation as a measure of organisation
scale. Market value is an extremely transparent
measure of an organisation’s scale and it also
reflects the organisation’s index (FTSE 100,
Mid 250 etc.). However, it is not a perfect
measure of scale for the following reasons.
n M
arket
capitalisation can be volatile and
any changes in market capitalisation will be
impacted by the Beta of the firm’s shares.
n M
arket
Comprehensive
disclosure in annual
reports means
that anyone with
a computer can
produce market
comparisons.
capitalisation is aligned to
(expected) profitability rather than scale.
It can therefore understate comparisons
for companies in low margin sectors and
arguably inflate salary and annual incentive
benchmarks for speculative enterprises
such as oil exploration or biotechnology.
Similarly market capitalisation depends
on PE ratio. And whilst a high PE ratio may
result partly from the market taking a
positive view of the management team’s
ability, there are many other possible
explanations which should not have an
impact on pay.
n F
inally,
the relationship between business
scale and market capitalisation can be
significantly distorted by gearing. As a
result, businesses of otherwise similar scale
may have very different levels of market
capitalisation.
In light of the above, a high definition approach
suggests considering whether any broad
comparator group based on market-cap needs
to be amended to exclude businesses of very
different operational scale. There may also be
a case for looking at enterprise value (market
cap plus debt).
The obvious alternative to market cap in
most sectors is turnover. Turnover is nearly
as transparent as market cap but is more
representative of business scale. That said, even
turnover has its problems when comparators are
drawn from diverse sectors. Common sense tells
us that running a global business that designs,
manufactures and distributes a wide range of
products is more challenging than running a
business of similar scale that focuses on one part
of the value chain, has a simple product range
and is primarily focused on the UK.
For this reason, even with a turnover-based
comparator group, a high definition approach
would involve excluding obviously different
sectors.
The most high definition approach would
be to use job size / grading or possibly a
multivariate analysis which also allows for
employee numbers, internationality and so on.
This is the best way of capturing the scale and
complexity of a business whilst still using a
wide set of comparators and is thus the ultimate
high definition approach. The downside is
a loss of transparency. Whether this level of
sophistication is necessary will depend on the
organisation’s circumstances; in our experience
these approaches make most sense:
n f
or
organisations which are at the top or
bottom of a comparator group
n f
or
injecting some rigour in the process
of assessing the appropriate impact of an
organisation change on pay levels
n f
or
comparing roles below main board
level where job title matching alone can
be extremely imprecise, particularly in
today’s complex matrix structures where
roles with the same title often have very
different responsibilities. For example
the ‘Head of Asia-Pacific’ could be a role
in an entirely autonomous business unit;
a role in a business unit which although
operationally autonomous has its support
functions managed from head-office; or
a role in a business unit with little control
over investment decisions or policy.
Choosing comparator groups –
sector peer groups
The challenges with smaller peer groups
are different. Here, the key questions for
the remuneration Committee to consider
are as follows.
Where do we fit in the peer group?
This means looking at the scale (and perhaps
complexity) of our business and seeing our
ranking. Operating a median policy does not
necessarily mean targeting the literal median
of the peer group. If we are one of the larger
(smaller) companies in the sector then a median
policy stance perhaps implies focusing on the
upper (lower) quartile of the group.
Should we necessarily job match
like-for-like?
When looking at a sector peer group the obvious
approach is to compare CEO to other CEOs,
CFO to other CFOs etc. However, for a
comparator that is much larger there may be a
case for comparing their COO or CFO to our CEO.
Similarly for a comparator that is much smaller,
we might compare our CFO to their CEO. In our
experience this approach can be quite effective
in the UK but does not work well in territories
where the CEO premium over other roles is larger
– for example the US.
Are there any contextual
factors to consider?
For a small peer group the benchmarking
should identify any factors that might distort
comparisons. For example the background
of the comparators CEO might be relevant if:
he/she owns a large chunk of the business; has
moved from another sector; previously worked
in another country or is newly promoted.
This intelligence doesn’t necessarily change
the comparison but is important context to
consider when interpreting the data.
The final point to note is that remuneration
committee members should not be afraid to
rely on their own judgement (or that of their
advisers) in making comparisons. After all,
data is only data – it’s not the infallible truth.
International comparisons
What are the implications of using international
data? In some sectors it is important to consider
international practice as there is a genuine
international market for talent. However, this too
requires a high definition approach, as follows.
What are the currency effects?
Any international comparison requires a currency
conversion and therefore the ‘answer’ will vary
from time to time.
Should we allow for taxes
and cost of living?
This may be a step too far. However, there
is no doubt that taxes and cost of living have
– at least – an implicit influence on pay
differentials between countries.
What definitions of remuneration
are we considering?
Some countries have packages of very different
shape to the UK. For example annual bonus
payments are higher in Germany and LTIs are
higher in North America. This implies a need to
look at total compensation and also the individual
remuneration elements in isolation.
Remuneration committee members should not be afraid
to rely on their own judgement in making comparisons.
Taking account of pay shape
One of the most low definition aspects of
much benchmarking is the tendency to rely on
a single point estimate of pay. Having median
total compensation for on-target performance
is no guarantee of having appropriate
competitiveness in other performance scenarios.
For example, we recently prepared a report for
a company that had median total pay and an
above-average proportion of pay in the form
of long-term incentive. One might therefore
assume that this company would pay more than
most of its peer group if share price performance
was good. In reality, because of the way its plans
were designed, this wasn’t actually the case.
If the remuneration committee is serious about
offering ’median pay for target performance
and upper quartile pay for outstanding
performance’ then it needs to look at pay
in a variety of scenarios. This adds definition
to the benchmarking but more importantly
it feeds into the pay strategy and incentive
design processes and allows the remuneration
committee to develop a total pay package that
is the right ‘shape’ as well as the right size.
The appropriate shape of remuneration – and
how it should compare to remuneration shape
elsewhere – will vary depending on the nature
of the company – its risk appetite, its volatility,
its cyclical exposure, the proportion of costs that
goes on people etc. Again, how remuneration
shape compares to the market needs to be right
for the business rather than tied to the market.
Market data will always have a role to play in setting senior pay. How else
can non-executive directors ensure that pay is sufficient without squandering
shareholder funds?
However, the approach to benchmarking needs to be fit-for-purpose.
This means selecting the right comparators, taking the context into account
and looking at competitiveness in various performance scenarios.
Hay Group has 60 years’ experience in this field and would be glad to
demonstrate a high definition approach to you.
Peter Boreham | UK director | executive reward
T 020 7856 7146 | E [email protected]
©2010 Hay Group. All rights reserved
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