Considerations for determining executive compensation

18 Jan 2012 Sandeep Mehta

We have often discussed problems with financial incentives.  It has been shown that stock options lead to excessive risk taking.  Corporate Executive board suggest we ask the following question in Exec Comp: The Ultimate Decider:

Will this executive compensation policy provide meaningful incentives for executives to create long-term shareholder wealth without incurring excessive risk?

Their suggestion is to keep the following in mind – it is a pretty good list:

  1. Calibrating Compensation: The ideal exec comp plan is less about motivation than about providing guidance to executives as they navigate ambiguous decisions.
  2. No Silver Bullets: Do not put faith in any one policy, such as mandatory share ownership, for aligning executive and investor incentives. Use a mixture of long-term metrics appropriate for your company.
  3. Reasonable Ceilings: While setting stretch targets for annual variable cash compensation, high performers also impose a reasonable ceiling to discourage unchecked risk taking.
  4. Longer Vesting: The executive labor market is increasingly converging on longer vesting periods of four or more years.
  5. Balanced Equity Vehicles: Executives can over-optimize to any individual metric, including share price. Embrace some extra complexity to encourage a more three-dimensional view of firm performance.
  6. Objective Performance Measures: Reduce the role of board discretion in your compensation; use more objective metrics, even for soft factors like customer satisfaction and employee engagement.

Clearly this is hard to do, but as Prof. Kaplan pointed out, “If you have high power incentives, you’d better have even higher power controls.”

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