Components of Compensation

In crafting the executive compensation program, companies need to determine where they want to position their compensation relative to the market. Most want to be at the market median, while a substantial minority seeks to be above market. One major challenge in establishing market-competitive compensation provisions for executives is identifying an appropriate group for benchmarking. That benchmark can consist of direct competitors, companies with comparable revenue or employee populations, companies in the same region and companies that the organization would like to emulate. The executive compensation portfolio can be made up of six elements.

1. Base Pay

This comprises a decreasing portion of executives’ total compensation. That is a natural corollary of the increasing importance of incentive-based rewards. In recent years, base pay annual increases for executives have averaged only a few tenths of a percentage point more than increases for the broader employee population. For chief executive officers (CEOs) of companies in the S&P/TSX Composite Index, base pay averaged about one-third of total compensation.

It averaged about one-fifth for the 60 largest companies on the index. The mechanics of executive base pay programs are much the same as for other employees. Executives earn increases based on individual performance, internal equity and competitive market rates for comparable positions. The percentage of total compensation made up by base pay is inversely proportional to the executive’s ranking in the organization.

2. Non-Discretionary Cash Bonuses

These are a significant element of executive compensation. They are the largest incentive compensation component in organizations that are privately held, and where stock-based incentive programs are not applicable. Non-discretionary bonuses are tied to the achievement of measurable targets. There is usually a threshold level of performance required before any payout is made, a target level of performance at which the target payout is made and a higher level of performance at which the maximum allowable payout is made. These bonuses are usually based on performance within a fiscal year. The shorter time frame for measuring and rewarding performance is consistent with short-term (quarterly and annual) shareholder expectations.

3. Discretionary Cash Bonuses

These bonuses are not linked to specific performance measurements or targets. Discretionary bonuses may be appropriate where company performance is weak, thresholds for non-discretionary cash bonuses have not been met and where there is a need to provide additional compensation to key executives for retention purposes. In some cases they are used for valued achievements that are not rewarded through other components of the compensation package. Despite these opportunities, they are decreasing in use.

4. Stock Options

Stock options, or other share-based instruments, are intended to align the interests of executives with those of shareholders by encouraging executives to increase share prices. A stock option program provides an executive with the option to buy shares — typically at the Fair Market Value (FMV) of the stock as of the day the option grant is issued. Some companies have begun to price options above the FMV so that the options will not have any value unless the stock price attains a stipulated increase in value. The options usually vest over a period of three to five years. The option recipient usually has five to 10 years from the option grant date to exercise the options. One emerging trend has companies making the vesting of options dependent on the achievement of specified performance objectives, rather than simply on the passage of time. Stock options do not completely align the interests of executives and shareholders. Unlike direct share ownership, stock options do not entail the possibility of financial loss, and do not reflect returns to shareholders via dividends. Accordingly, an increasing number of companies are requiring executives and board members to have a defined amount of personal share holdings. One of the criticisms of stock options is that, in a bull market, even poorly managed companies experience an increase in share price. That rewards executives even when their organization’s performance is below average. Companies can mitigate this risk by pricing options above the FMV as of the date of the grant, or by providing shorter time frames (perhaps five years rather than 10) for the exercise of options.

5. Stock Appreciation Rights

These are like stock options, except that the recipient does not actually have to buy and then sell the shares vested. Stock appreciation rights involve notional stock. They have the advantage of providing cash compensation if the share price increases, but not diluting shareholder equity. They are often used by multinational corporations for executives in countries where stock option programs are not allowed by law.

6. Share Unit Plans

Under stock option and stock appreciation rights plans, executives are compensated only on the increase in the value of the shares over the option price. Under share unit plans, executives receive the full cash value of each share unit granted rather than just the appreciation of the share price. Depending on the plan, the share unit holder may receive cash or actual stock at the point of exercise. Share unit holders will also normally receive the same dividends as regular shareholders because each share unit has more value than a stock option, fewer units need to be granted to provide the same compensation value to the executive. Share unit plans can be criticized for rewarding executives even though the stock price may have declined. Also, because of the smaller number of units typically granted, there is less upside (compared to stock options) for increases in share price. However, they encourage executives to protect or increase the existing value of shares, and to preserve or enhance dividend yields. Income gained under share unit plans is currently taxed, upon receipt, as ordinary income. There are three types of share unit plans:

• Restricted Share Units: These units vest under a predetermined schedule, typically at the end of a specified period such as three years.
• Performance Share Units: These are increasing rapidly in popularity as an alternative or complement to traditional stock options. Performance share units vest depending upon the achievement of certain predefined and time-bound performance objectives.
• Deferred Share Units: With these units payment is deferred until the executive’s employment with the company ends. They direct executives’ attention to the long-term performance of the organization. An unintended consequence of deferred share units may be to encourage executives to leave if they anticipate a significant reduction in share price.