It should come as no surprise to, well, anyone that executive compensation packages are a key element in the hiring of top talent. For top positions, nearly any qualified candidate will have multiple opportunities available and compensation, as well as how that compensation is determined, will often be a deciding factor.
In recent years, it has become common for companies to begin basing executive compensation packages on a formula. There are certainly reasonable arguments for the formula tactic. Most obvious is the idea that a formula focuses strictly on performance and such quantitative measurements are the fairest way to determine compensation. However, companies are increasingly finding fault in compensation formulas and turning towards other methods of determining salary and bonuses.
What the Compensation Formula Usually Looks Like
Companies will take into account qualitative measurements, including overall revenue, earnings per share, and return on capital to determine a typical executive compensation. Most formulas are based at least in part on the total shareholder return generated during the executive’s tenure, which can including the aforementioned measurements. Board members plug the TSR and other financial metrics into the company formula, and the compensation numbers come out the other end.
The Limits of a Compensation Formula
While a formula based on actual returns certainly has its appeal, it also has its problem. Perhaps most notably, when compensation is based purely on short-term financial results, the long-term future of the company can suffer. The typical formula can prevent executives from taking risks that may pay off in the long run because short term numbers would decrease their compensation. Further, a compensation formula does not take into account action that may have an immediate, positive financial impact but that could damage the company’s reputation in the long run. For example, some choice that immediately boosts stock prices but leaves customers unhappy and causes long-term brand image consequences would still trigger rewards in some models. A formula like this can also have the problem of being influenced heavily by outside factors. If the overall stock market is down because of economic factors that are no fault of the executive in question, her package could still suffer. By the same token, when the economy is doing well, an executive could be rewarded even though it was not his choices that led to the boost in stock prices. Ultimately, sticking to a strict formula for executive compensation packages can be terribly shortsighted and not truly reflective of an executive’s experience.
Compensation Formula Alternatives
Luckily, many companies are coming to realize the error of the status quo. Company performance is dependent on more than short terms gains, which means putting a policy in place that incentivizes sustainable growth rather than short-term boosts. Instead of relying solely on quantitative measurements, new formulas give board members the freedom to analyze those numbers and determine how much impact the executive had on any particular metric. The result is a system that is more accurate and fair, and that supports the long-term position of the company.
For more elaboration on this topic, be sure to check out the Wall Street Journal’s recent article: Why Basing Executive Compensation on a Formula Doesn’t Work