A good compensation mechanism maximizes effort, focusses on bottom-line long-term outcomes, provides no incentive for manipulation, and is equitable to all stakeholders (social, environmental, financial, executives).
Practically, a good compensation model offers executive a stake in realized social value creation, largely consists of a fixed salary and a long-term variable component, requires (significant) skin in the game post-term, and is as simple, transparent and non-discretionary as possible.
In order to function in a compensation model, a yardstick must be tied to a remuneration mechanism that translates value creation to an incentive for the executive. This essentially is a question of the pay mix and the pay-out model. Targets should not be ‘too short term’ in order to guide the appropriate focus towards long-term, strategic, pro-social outcomes. A natural implication then is that a pay structure needs two main components: annual fixed pay, and long-term variable pay. Minor components can include pension contributions and miscellaneous compensation but not significant short-term variable pay. Short-term incentives are more appropriate for sub targets at an operational level but should not be incorporated in the pay package of the executive who is responsible for the long-term strategic vision.
Incentivising the long term requires a specific remuneration structure. We already noted that short-term pay should be avoided. More generally, the compensation design should avoid ‘wrong’ incentives in terms of risk-taking or the timing of rewards (a ‘no harm’ principle for compensation design). Given the fact that annual vesting cycles reintroduce short-termism in executive behaviour, annual vesting should be avoided as well.
Taken together, for appropriate remuneration design there are several ‘phases’ to be considered. The first phase is the pre-term phase. The executive has no influence over the strategic direction of the company in this phase. The second phase is the term phase. During these years, the executive develops and implements a long-term vision. Here, value creation is equivalent to SLTVC above and beyond the counterfactual SLTVC that would have been generated in the absence of purposeful executive decisions. In the third phase, this value creation continues, but at some point, less and less of this post-term value creation is attributable to the old executive, and more and more to his/her successor (the fourth phase).
Based on this, the executive should be rewarded in proportion to SLTVC during phase 2 and 3, but with the final settlement of the reward at the end of phase 3 (i.e. after his/her post-term value creation has ended). Deferring final settlement until the end of phase 3 creates an incentive for the executive to be mindful of the long-term success of the company even after his/her term has ended.
Continue reading on
Empirical Data Analysis
Continue We are currently developing several incentive design models that could accommodate this post-term SLTVC remuneration structure. Based on the preceding sections, all designs share the following guiding principles: Below, we sketch two options satisfying these principles. DIA-like escrow account with yearly mutations based Share based reward scheme where a nominal ^Contingent liability approach
on stakeholder value creation or destruction with
(gradual or instant) cash settlement after a predefined
point in the future (but with at least significant
exposure post term), i.e.
executive is added to a running total of value added
(“area between the curves”);
executive (either periodically or instantly, but in any
case, ensuring long-term skin in the game).Adjusted equity grant approach
number of shares are settled against a mark-up
or discount based on stakeholder value creation
performance, i.e.
awarded a nominal expected pay-out of M;
pay-out is converted to S shares at a
discounted or mark up price of P +
performance bonus/malus;
more periods.
Continue reading
