The No Bullsh!t Guide to Remuneration

Episode #358 The No Bullsh!t Guide to Remuneration

IT’S IMPORTANT TO UNDERSTAND REMUNERATION

The biggest cost item on most P&Ls is labour. You’ll probably spend more money this year paying people than you will on any other operating expense. 

But do you know what you’re paying for? And do you know how to get the most from this major investment of your company’s resources?

We’ve had several questions from the leaders in our current cohort of Leadership Beyond the Theory on the relationship between remuneration, motivation, and performance.

That’s why, in this episode, I’m going to give you a definitive overview of how remuneration works. It gets pretty complicated in parts, so to make it easier, we’ve produced a free downloadable PDF (scroll up), which has the complete remuneration guide.

This provides the essential foundation for next week’s episode, where I’ll take all this knowledge, and show you how to apply it with real life examples. 

Let’s face it, you’re making decisions that affect people’s livelihoods, so it’s important you know what you’re doing.

My goal today is to completely demystify remuneration for you, so that you can be more judicious about how you apply financial rewards.

I’m going to cover:

• Base salary;
• Short term incentives (STI);
• Long term incentives (LTI);
• On Target Earnings (OTE); and
• A few of the more novel ways that senior executives get paid.

BASE SALARY

This is for performance of the day job. The organisation pays this to every employee in exchange for their time, effort and expertise.

Who gets paid a base salary?

Every direct employee of the organisation. Contractors and casuals will usually have different payment arrangements.

How is base salary determined?

It’s attached to the role, not the individual. Salaries are often expressed as ranges or bands, providing leaders with some flexibility on the exact salary amount that each employee receives.

Salary bands are generally determined by one of two things:

1. Market Forces; OR
2. Collective agreements

Base salary ranges are relatively easy to determine. Reputable personnel firms produce salary guides for every role in a given location, so the question, “How much should I pay for a marketing coordinator in Melbourne” is easy to answer these days.

Collective agreements are company-wide employment agreements that are negotiated on a periodic basis (say, every 3-years) between a company and their employees, who are represented by labour unions.

These agreements typically weigh heavily in favour of employees, and reduce managerial flexibility.

How are base salary increases assessed?

There are a few factors that go to base salary increases. Cost of living increases are common, often linked to Consumer Price Index (CPI).

There may also be periodic salary reviews based on the value the employee is delivering, which is assessed by some form of review process.

Sometimes, base salaries are increased purely as a result of an employee’s length of tenure, especially in the case of collective employment agreements.

The most important consideration for any base salary increase should be: How well did the individual meet the expected standards for both behaviour and performance in their role?

This would ideally be a holistic rating, assessed against pre-determined categories, for example: Commercial, Leadership, Management, Safety, Customer Focus etc

 Interesting facts about Base Salary

Studies find that pay is not the most important driver of job satisfaction – it only rates as number 5 or 6 in terms of motivating factors.

Having said that, Ep.357: The Business Research Scam No One Talks About is worth considering before taking this statistic on face value!

The most common question I’m asked about Base Salary

“Marty, should I give someone a raise when they ask for it?”

In general, the answer is “no”, but you do have to think about the potential impact on the business:

• Would you be at risk of losing a stellar performer?
• What is the cost of disruption / transition / replacement to the business?

If you give them the payrise they ask for, it usually doesn’t lock them in long term – you’re just kicking the can down the road.

If someone is really worth a lot to you, you’ll need to do some hard yards to keep them. Don’t fall into the trap of being lazy around remuneration.

If they are worth a lot more, you should have already been paying them a lot more.

If you have a genuine star, find a way to give them rapid salary advancement. This might require a battle with HR. But you can justify it easily if you remove a non-performer and don’t replace them.

As a rule of life, lean to quality – spend twice as much, and buy half as many! Have a listen to Ep.350: Fewer, Better People.

SHORT TERM INCENTIVES (STIs)

STIs are discretionary bonus payments that an organisation might offer to employees once they reach a certain level. They’re awarded over and above the base salary, and are usually paid annually.

STIs are awarded for delivery of discrete outcomes, most often defined in Key Performance Indicators (KPIs). Other commonly used terms for KPIs are:

• Key Result Areas (KRAs)
• Objectives and Key Results (OKRs)
• Management by Objectives (MBOs)

Who gets STI payments?

Normally mid-level leaders and above but, occasionally, STI structures will be implemented right through to the front line. If KPIs are set for individual contributors, they are normally collective KPIs for the team, with relatively low STI payment percentages attached.

How are short-term incentives determined?

STI payment percentages are usually set as part of remuneration policy, not negotiated into individual employment contracts. KPIs are set for individuals, as part of the annual planning and assessment process, and then these are linked directly to STI payments.

In most cases, total STI available is expressed as a percentage of base salary.

STI calculation example:

Let’s say you have a salary of $100,000:

• You may be eligible for a short-term incentive bonus at 30% of your base, a maximum of $30,000 ($100,000 x 30%);
• If you have 4 KPIs, each weighted evenly, then each will contribute to 25% of your total potential bonus (in our $30,000 STI bonus example, that’s $7,500 per KPI);
• If you were to achieve 3 of your 4 KPIs in a given year, you’d be eligible for 75% of your total maximum bonus, or $22,500 ($30,000 x 75%);
• Your total earnings for the year, adding base salary and STI together would be $122,500.

STI remuneration policy example:

The more senior the role, the higher the percentage of base salary available as an STI, for example:

• Front-line employees might not be eligible for STI payments at all;
• Mid-level leaders may be eligible for an STI equivalent to 30% of their base salary
• General Managers may be eligible for an STI equivalent to 50% of their base salary
• Executives may be eligible for an STI equivalent to 70% of their base salary
• A CEO may be eligible for an STI equivalent to 100% of their base salary (providing the opportunity to double their base salary if they hit their targets).

You can see how moral hazard is built into the STIs. In many industries, the incentives are strong enough to induce widespread gaming of the KPIs (and Long-Term Incentives are even worse!)

How is performance assessed?

Each KPI will be weighted based on its relative importance. The total of all KPIs will add up to 100% of the potential STI payment – it’s then easy to translate individual KPIs into dollar amounts.

Often, individual KPIs are expressed in ranges, to reduce gaming and keep the incentives aligned with the desired outcomes. This can make a KPI more complicated to assess, but provides greater flexibility.

Using ranges to assess KPI performance

Say we wanted a KPI for a salesperson to achieve $5m of sales. We might set up a range with different trigger points. This provides a little more granularity, and sets the incentive to outperform.

The KPI target of $5m in sales might be expanded to a range of possible outcomes:

• “Threshold” performance might be set at, say $4.75m;
• “Target” Performance might be set at $5.0m;
• “Stretch” Target might be set at $5.25m.

The three possible performance outcomes might earn different proportions of the STI:

• Threshold = 50%
• Target = 70%
• Stretch = 100% 

The range of outcomes where they would earn an STI payment for achieving that KPI is between $4.75m and $5.25m.

If they want the full bonus to be paid, they have to outperform… but if they fall just short, they don’t leave empty-handed – they can earn half their bonus allocation for that KPI if they get close.

Interesting facts about STIs

On top of the different STI awards at different hierarchy levels, different industries also typically pay different percentages. For a senior executive, STI ranges might be, say:

• 100-150% of base in banking and finance (a historically overpaid industry);
• 70% of base in less glamorous industries, like mining;
• And perhaps even lower, at 40% of base in manufacturing.

To spell out the reality of this, for every $100,000 of salary, a manufacturing executive might earn a maximum overall income of $140,000… but a bank executive might potentially earn $250,000!

STIs are most commonly set to be paid on achievement of KPIs, which encourages managers to set low-ball targets to make them more achievable. There are a few ways that individuals can game KPIs to maximise their personal rewards, for example:

• Knowing that you can easily achieve, say, $5m in sales, but setting the KPI to pay the full STI amount if you achieve $4m in sales; or
• Finagling the accounting treatment of certain expenses to ensure the achievement of EBIT targets.

If the CEO games the outcomes, the benefits flow downstream through the company, which is why virtually no one calls out this type of unethical behaviour. Everyone is financially better off as a result and, let’s face it, it’s not like you did the gaming – you’re just a fortunate recipient of the decisions made above you!

One of the problems with STIs is that they can become an entitlement, rather than a variable reward that has to be earned. Many people spend the money before they earn it… they rely on the bonus payment to fund their lifestyle… and if they don’t earn it in full, it can cause extreme negativity.

The most common question I’m asked about STIs

 “Marty, what if someone meets their KPIs, but performs poorly overall?”

This is extremely common, which is why you need to use multi-dimensional performance assessments.

For example, at CS Energy, we created Individual Performance Agreements (IPAs) covering 4 key areas of performance outcomes:

1. Behaviour – rated against the corporate values and code of conduct;
2. General performance – rated against the performance standard for the role; 
3. KPIs – as delivered according to specified targets; and
4. Development plan – to map their forward progress in the company.

If someone isn’t conducting themselves appropriately, or if they aren’t meeting the performance standard for their role level, they might get paid their STI, BUT… they could still face the threat of their employment being terminated if they don’t improve.

The standard is the standard!

LONG TERM INCENTIVES (LTIs)

Most commonly, LTIs are paid in the form of share allocations. They’re granted at a certain point, but don’t vest until a later point (hence the concept of “long term”).

LTIs are awarded based upon the performance of the business as a whole, generally over a 3-year period, and they are the main source of executive wealth in many public companies, where the potential for remuneration from LTIs well exceeds base salary and STIs.

Who gets LTI awards?

Normally LTIs are reserved for a company’s senior leaders. As is the case with STIs, different levels of leaders are awarded different LTI percentages. Entry into the LTI club often delivers a step change in remuneration.

How do LTIs work?

This can be pretty complicated, so I’ll break it down in a simple example:

• At the start of a 3-year performance period, the company grants an allocation of performance shares to eligible executives;
• These aren’t physical shares yet, but the right to receive the shares if long term targets are met;
• Like STIs, the value of the shares is usually determined as a percentage of base salary;
• This amount is converted into a physical number of shares, based upon the share price on the grant date;
• Let’s say the share price was $10, and you had an LTI entitlement to, say, $100,000 worth of performance shares – you would be awarded the rights to 10,000 shares ($100,000 / $10);
• These shares are held for you until the vesting date;
• In 3 years’ time, if the company has met its LTI targets, the 10,000 shares are redeemed… remember, these shares cost you nothing – you just happened to be in the LTI club;
• Here’s where it gets interesting: the shares that were awarded when they were worth $10 may now be worth $20;
• This means that, just as the share price has doubled, the value of your LTI award has also doubled;
• Using the $20 ‘strike price’, the 10,000 shares that were originally granted are now worth $200,000!

Now, just imagine a fast growth company, whose share price increases rapidly. Performance shares granted based on a $5 share price might vest 3 years later with a strike price of $50. An executive can get pretty rich that way!

Sometimes, options are also awarded, where an executive is granted an option to purchase shares at the grant price at some agreed future date.

How is LTI performance assessed?

There are a range of measures that can be used here but, since they’re designed to reward long-term performance, Total Shareholder Return (TSR) is a common yardstick.

Here’s a brief example of how long-term performance is assessed for an LTI award:

• A set of peer companies is initially established for comparison purposes (let’s say, 20 companies);
• Their TSRs are easy to calculate over the 3-year LTI period. It’s a simple sum of all the dividends they’ve paid to shareholders, plus the growth in market capitalisation, based on the company’s increase in share price;
• After three years, TSR performance is assessed against the set of predetermined peers;
• The LTI percentage is then calculated based on the company’s position with that comparator group;
  • If your company is in the 2nd quartile, you might be awarded 100% of your LTI share grant allocation;
  • If your company is in the top quartile, you might be awarded 150% of your LTI share grant allocation, and so on.

Interesting facts about LTIs

LTIs are supposed to be the ultimate way to align the interests of shareholders and the executives who make decisions that most affect their returns. But a standard 3-year performance window still doesn’t provide this alignment.

The average public company CEO might have a 5-year tenure, which is really only 2 or 3 LTI vesting periods.

When you think about it, there are easier ways to pump up the share price than actually improving the business fundamentals in such a short time period.

To increase TSR you could go through the hard yards of, say:

• Revenue growth;
• Cost control;
• Profitable market penetration;
• Prudent capital allocation (e.g. value-accretive M&A transactions); and
• Good strategy that sells the growth story to investors (lifting the P/E ratio).

But there are also a number of ways to pump up the TSR to maximise the LTIs, without improving long-term shareholder value:

• Asset sales that increase TSR, but don’t reflect underlying performance;
• Market announcements that lift the share price just before a TSR assessment; or
• Share buybacks, which reduce the number of shares, and create artificial demand for the stock, pumping up the price (once again, lifting the P/E ratio).

The most common question I’m asked about LTIs

“Marty, how do I put myself in the position to earn LTIs?”

There are two main ways position yourself for LTI awards:

1. Work for a large company with a well-structured compensation and benefits policy, and work your way up until you’re eligible for LTI awards; or
2. Join a small company that will trade off some of your base salary for stock options, and hope that the company is successful in the longer term.

Each of these options involves risk, and the outcome is not assured. But the option of growing with a smaller company, while high risk, is where many millionaires (and billionaires) are made! 

Learning to lead for performance is the best way to set yourself up for entry into the LTI club. Driving performance in your team is great for your STI award, and increases the likelihood that you’ll be promoted into the LTI club.

WHAT IS OTE?

You may have heard the expression, “OTE”. This simply stands for On-Target Earnings. It’s the total income that may be earned in a particular role, and it takes into account base salary, STI, and LTI payments, if they were awarded at 100% of their value.

Elite executive search firms, like Heidrick & Struggles and Spencer Stuart, charge as much as 25% to 30% of OTE as their search fee. In these cases, the search fee to place a senior executive in a large company can amount to hundreds of thousands of dollars. 

And despite this, they don’t always get it right!

As you rise through the ranks and find yourself in the mix for more and more senior roles, it’s important to evaluate OTE when you’re thinking about accepting a role, not just the base salary on offer.

OTHER WAYS TO PAY PEOPLE

There are a number of other ways that people can be paid, some of which depend on the type of role they are in, and others that depend more on the amount of leverage they have when negotiating their entry into the most senior corporate roles.

Remember, your best opportunity to negotiate a profitable exit is often before you accept a role.

Commissions

These are normally part of a salesperson’s contract. To create incentives for selling more product, they’re able to earn a percentage of each sale that they bring in over a certain threshold amount.

Commissions are calculated purely on sales performance, and are often paid monthly or quarterly. And, if you are setting up a commission structure in your business, you’ll have to structure it carefully to avoid unintended consequences.

For example, if you only incentivise your salespeople to achieve top line revenue, they may offer deep discounts to make sales, which damages profitability. In these cases, revenue quality can be eroded long before you pick the problem up.

 Sign-on Bonuses

To attract the most sought-after executives, a company will often pay a sign-on bonus. This is a lump sum that’s paid purely for signing the employment contract.

The logic is that most top executives are already working for companies where they have LTI awards at stake – to leave that value on the table is hard, because they can potentially be worth millions of dollars.

So, to entice them to walk away from that value, the new company might put an unconditional one-off cash payment into the contract to sweeten the deal.

It’s like a transfer fee paid between rival sporting teams, but the individual executive benefits the most.

Retention Bonuses

Often, if you’re in a critical role, the company may want to lock you in for a period of time. This could be to reduce the risk of you leaving, if you have unique capability, or knowledge that can’t be replaced.

Then again, for a CEO it may just be to guarantee continuity at the top.

A retention bonus is usually an agreed amount, where the only criterion for receiving the bonus is to still be employed on a given date.

I’ve seen colleagues absolutely clean up with a combination of sign-on bonuses, retention bonuses, and LTIs – and I’m talking tens of millions of dollars!

Ex gratia payments

You can use these at any time, if you have the financial discretion to do so. This is one way to get around restrictive rem structures that stop you from rewarding your really high-end performers.

The quantum of the payment should reflect the base salary of the role. Ex gratia payments are normally given to high performers in lower-level roles to reward them for exceptional performance on a project or assignment.

In the past, I’ve approved ex gratia payments for, say, $30,000 for someone on a $150,000 base salary (which is 20% of base).

When the bonus and rem structures are insufficient to pay a high performer their true value, this can mitigate some of the flight risk.

USING REMUNERATION TO MOTIVATE

OK, that’s a pretty comprehensive fly over the top of the compensation and benefits space. When you look at the different ways of paying people, the most important thing is to differentiate between individuals.

Each person needs to be rewarded as much as possible for their good work, and those who carry the majority of the performance load should be the ones who are allocated most of the variable reward.

Using this information as a base, in next week’s episode, I’m going to show you specifically how to do this, with a range of practical examples and scenarios.